By David S. Hilzenrath
Washington Post Staff Writer
Wednesday, March 2, 2011; 10:24 PM
Passing a law with the lofty aim of preventing future financial crises was hard enough; turning it into detailed rules is proving in some cases to be no less difficult.
For example, there is general agreement that credit ratings gave the financial world a misplaced sense of confidence in assets that were no better than junk. Rating agencies such as Moody's and Standard & Poor's put their AAA stamp of approval on securities grounded in the quicksand of subprime mortgages.
Washington's regard for credit ratings sank so low that Congress directed regulatory agencies last year to comb their rules and get rid of language that uses those ratings as a formal measure of credit-worthiness.
Now, as regulators struggle to rewrite the rules, they are confronting a deeper question: What should replace credit ratings?
The Securities and Exchange Commission grappled with the issue Wednesday as it turned to the task of purging credit ratings from the rules for money-market funds.
"I have serious misgivings because it appears no appropriate substitute has been identified," SEC Commissioner Luis A. Aguilar said.
Regulators at a range of agencies are trying to translate Congress's Dodd-Frank law into nitty-gritty regulations on such complex issues as mortgage lending, derivatives trading and the amount of capital banks must hold as a fallback against losses. High-stakes lobbying campaigns that were concentrated on Capitol Hill last year have scattered to federal offices across the city.
In some cases, the challenge is magnified because the law left a lot to regulators' discretion. In other cases, regulators complain that they have been straitjacketed. The questions range from the broad to the ultra-technical.
In the realm of credit ratings and money-market funds, Aguilar said, the SEC staff faced an "impossible challenge."
Money-market funds are supposed to be safe places for consumers to park their money. Under current rules, the funds are generally required to invest in securities that have very high short-term credit ratings.
Following the Dodd-Frank law, the SEC proposed new rules Wednesday that would leave money-market funds to determine for themselves whether assets are safe enough to hold.
Aguilar outlined a series of potential problems with that approach, echoing arguments raised by a variety of critics when the SEC considered the issue in years past.
The opposite effect
Though the change is intended to make investors safer, he said, it could have the opposite effect.
Freed from the constraints of credit ratings, money-market funds could chase higher returns by investing in riskier securities. Because they could follow their own subjective judgments, Aguilar said, it would be "difficult . . . if not impossible" for regulators to police their decisions.
Barbara Roper, director of investor protection at the Consumer Federation of America, made a similar argument.
"If they're looking to juice their returns for competitive reasons . . . someone is going to abuse this new freedom," Roper said in an interview.
Funds are already required to perform their own investment analysis in addition to that performed by the credit raters. But some money-market funds could be hard-pressed to do it all for themselves, Roper said.
Credit rating agencies use armies of analysts to assess vast numbers of bonds issued by companies across the spectrum of industries.
"It's incredibly inefficient to ask everyone to internalize this responsibility," Roper said.Continue to take cue
It is also possible that the proposed rules change would make no practical difference in how money-market funds invest. Even in the absence of a formal requirement, they could continue to take their cue from credit ratings, Aguilar said.
In the past, the Investment Company Institute, an industry group, has argued that credit ratings serve as an important safeguard for money-market funds.
"We recognize that the SEC was put in a difficult position," said Karrie McMillan, the group's general counsel.
More than two years after the financial system teetered on the brink of collapse, there are also deep philosophical and political differences as to what the government should do to prevent future crises - including how far it should go in regulating incentive pay on Wall Street.
Many policymakers have concluded that incentive pay encouraged bankers and other financial wizards to take reckless risks. They would share in the initial profits but not the eventual losses if investments soured, said Boston University law professor Tamar Frankel.Compensation rules
On Wednesday, the SEC proposed compensation rules under Dodd-Frank that are meant to discourage irresponsible risk-taking at brokerage and money-management firms. For example, big firms would have to defer at least half of executives' incentive pay for three years, and any incentive pay would have to be adjusted for losses the firms incur after the pay is awarded.
The two Republicans on the five-member commission voted against the proposal.
Commissioner Kathleen L. Casey said it "removes important decision-making authority from those who oversee the firms and are in a better position to understand best how to calibrate the risks the firms can take."
Commissioner Troy A. Paredes said it could lead financial professionals "to become unduly conservative and avoid taking even prudent risks."
Both the executive pay and the credit-rating proposals taken up Wednesday are now subject to public comment before regulators take final action.