Wednesday, May 5, 2010;
BY NOW, the conflict of incentives embedded in the Wall Street credit ratings agencies' business model is well understood. Moody's, Standard & Poor's and Fitch generally get paid by the same companies whose securities they are evaluating. Familiar as this issue is, however, it was still a bit stunning to see it so bluntly described in internal e-mails recently released by a Senate subcommittee. One employee wrote that his mortgage-backed security ratings unit had "become so beholden to their top issuers for revenue they have all developed a kind of Stockholm syndrome which they mistakenly tag as Customer Value creation."
Given the role that misbegotten ratings played in inflating the now-burst bubble, credit-rating reform should be central to the financial overhaul effort underway in Congress. Yet the Senate version of the legislation doesn't do much more than tweak the status quo. It would create a new ratings-agency office within the Securities and Exchange Commission, require the agencies to disclose their methodologies and expose them to lawsuits when they knowingly or recklessly fail at due diligence. The Senate bill, which is even more tepid than the House-passed bill, would require a study of conflicts of interest, which would empower the SEC to force disclosure of any conflicts.
This is especially disappointing because there is no shortage of creative ideas for shaking up the ratings business. Professors Matthew Richardson and Lawrence White of New York University's Stern School of Business have called for an independent clearinghouse to assign rating jobs randomly and collect fees on behalf of agencies. We have previously discussed British financial analyst George Cooper's idea of requiring agencies to grade securities "on a curve," rather than passing out unlimited AAA ratings. This would reduce the incentive to "sell" favorable ratings, because an upgrade would require an offsetting downgrade.
But even that suggestion does not address the agencies' quasi-official status as "Nationally Recognized Statistical Ratings Organizations," empowered by the SEC to determine what securities are solid enough for pension funds and other institutional investors. The result of this policy, as SEC commissioner Paul Atkins put it in 2008, is that "credit ratings have become a crutch," which investors lean on instead of their own analysis. Professor Frank Partnoy of the University of San Diego School of Law has urged ending the agencies' privileged position and requiring institutional investors to rely on market signals about creditworthiness, such as a periodically updated average of prices for default insurance. Neither the House bill nor the Senate proposal embraces that position -- though the House goes much further than the Senate, which merely calls for a Government Accountability Office study and federal agency review of the issue.
If the financial meltdown has taught us anything, it is that there's no such thing as perfect information. But it also demonstrated that those who flourished in the crisis were those investors -- famed mortgage "short" John Paulson comes to mind -- who constantly questioned conventional wisdom of the kind often peddled by ratings agencies and relied on truly independent analysis. The more Congress can do to encourage everyone to behave that way, the safer and fairer the system will be.