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Missing the Mark On Ratings-Agency Reform

By Steven Pearlstein
Friday, September 18, 2009

One thing you learn from booms and busts is the importance of gatekeepers -- those professionals who are supposed to safeguard the system and keep markets honest. When gatekeepers are compromised or fall down on the job, confidence evaporates and markets collapse.

That's what happened during the tech bubble of the 1990s, when the lawyers, auditors and equity analysts decided to hop on the gravy train and turn a blind eye to stupidity and corruption. And it happened during the more recent credit bubble, when the rating agencies were seduced by fat fees to assign triple-A ratings to stuff they barely understood. Even today, large parts of the shadow banking system are still not working because investors and lenders still don't know who -- or what information -- to trust.

The dominant agencies -- Standard & Poor's, Moody's and Fitch -- continue to claim that their mistakes were intellectual rather than venal, but an investigation last year by the Securities and Exchange Commission suggested otherwise. So the firms have now moved to try to restore their reputations by adopting new measures to improve the reliability of their ratings. They have also acquiesced to a number of other measures pushed by the SEC and the Obama administration to increase government oversight, prohibit ratings shopping and bring more transparency to the rating process.

These steps are useful and significant, but they don't go far enough. They would preserve a business model that leaves the agencies hopelessly conflicted between the interests of the banks and corporations that pay handsomely to have their securities rated and investors who rely on those ratings when buying securities. They would leave in place an oligopoly market characterized by "me-too" behavior and a lack of price competition. And they would preserve a legal shield that has made it all but impossible for investors to sue the agencies for negligence when they issue ratings that they know, or should know, are wrong.

Call me simple-minded, but it seems to me that people who use a good or service should also be the ones who pay for it. That's how it works in most markets. And when it doesn't -- health care is a good example -- things tend to go awry.

It used to work that way in the credit-rating business as well, with investors paying directly for ratings and analysis through some sort of subscription arrangement, or indirectly through their brokers. But starting in the mid-1970s, following a number of high-profile bankruptcies, people decided it was important to make credit ratings publicly available to all investors. Companies that issued bonds began paying for the ratings themselves, and it didn't take long before agencies figured out that it was better for business if their ratings were a bit higher and their analysts were a bit slower to issue downgrades. By the time collateralized-debt obligations came along, it was not uncommon for agencies to provide issuers with behind-the-scenes advice on how to structure their new products to get the highest rates. The interests of the ratings agencies came to be perfectly aligned with those issuing the securities rather than those buying them.

It's all well and good to put in rules designed to prevent this kind of race to the bottom, but history suggests that they tend to break down at precisely those moments when they are most needed -- when the bubble is at its height and there are ungodly amounts of money to be made. So the best way to avoid these inevitable conflicts of interest, it seems to me, is to return to the investor-pay model.

The administration's approach, by contrast, seems to be focused on weaning investors from their reliance on ratings so they are forced to do more of their own research. I think that is unrealistic. Investors want a common set of benchmarks that they can use to assess the risk of securities, just as they want a limited number of government-supervised agencies to rate them. That number, however, can surely be larger than three. And there should also be room for dozens of smaller players specializing in different types of securities that should be able to compete with the Big Three on the basis of both quality and price. Until recently, government regulation has been a barrier to that kind of upstart competition. Much more attention should be paid to encouraging it.

Rhode Island Sen. Jack Reed (D) is also right in pushing for more private regulation. Because of specific exemptions in federal law and a claim that ratings agencies are merely peddling opinions fully protected by the First Amendment, no ratings agency has ever been successfully sued for misleading investors. On Thursday, the SEC took a first step to use its existing powers to bring a bit of legal accountability to the ratings agencies, but a better approach would be new legislation that makes clear that the ratings agencies owe the fiduciary duty of care and loyalty to their investor clients. That doesn't mean they can be sued any time an investment goes sour. What it does mean is that they would be liable if they put out a rating they knew, or should have known, was misleading after taking reasonable steps to ascertain that the information provided to them was accurate.

Such a change, of course, would only apply to lapses in the future. For lapses just past, the SEC should join with state attorneys general in filing a civil suit against the Big Three to force disgorgement of all those profits they earned providing triple-A ratings to triple-C junk during the recent bubble. That's how misled investors recouped hundreds of millions of dollars from Wall Street firms whose analysts had helped to blow up the tech and telecom bubble. Misled investors in structured credit products deserve the same.

Steven Pearlstein can be reached at pearlsteins@washpost.com.

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