Feeling Moody yeah yeah yeah. (Mark Lennihan - AP)

Last week saw the first hearing in the U.S. government's court case attempting to hold ratings agencies accountable for their role in the financial crisis. Reforming the ratings agencies has turned out to be a difficult process. One would think that such an obvious institutional failure should prompt quick and definitive reform, not just from the government but also from the private sector. But that hasn't happened.

It's worth taking a step back to understand why the ratings agencies occupy such a crucial place in the financial landscape. And the real action happened during the creation of the private-label securitization market in the early 1980s, and during Alan Greenspan's efforts to let the financial sector self-regulate its capital ratios in the late 1990s.

The Reagan administration and Congress worked with Wall Street in the early 1980s to create the legal infrastructure necessary grow a private market in mortgage-backed securities. A key part of this was the Secondary Mortgage Market Enhancement Act. As Alyssa Katz noted in Our Lot, this law was necessary to "realize…an unconstrained and fully private marketplace for mortgage finance," but that meant "rewrit[ing] federal securities laws dating to the Great Depression."

This law was debated in a hearing held by the Subcommittee on Telecommunications, Consumer Protection and Finance in March 1984. The crucial question was how much to amend the Securities Act of 1933 and the Securities Exchanges Act of 1934 with respect to the treatment of mortgage-backed securities, and how much to weaken protections that had been put in place since the New Deal.

But wouldn't scaling back New Deal-era protections, put investors and others at risk? Not so, argued most of the people assembled, because the ratings agencies would be capable of regulating this new private market. The bill would require ratings for all mortgage-backed securities, and the thought was that this would be more efficient and better than the rules that were keeping the private-market out from securitization at the time.

Alan Greenspan encouraged the rating agencies to take on the role they did in the mortgage-backed security sector. (Andrew Harrer/BLOOMBERG)

As Bill Simpson, testifying for the Mortgage Insurance Companies of America, said, "The rating agencies such as Standard & Poor's are able to investigate this industry and the effectiveness of a mortgage insurer to disperse risk," and that "we believe these rating agencies, while tough and demanding in their analysis, do a good job in rating mortgage related securities. Consequently, we believe this committee can rely on them, as the supervisor of mortgage securities described in the legislation."

David Beal, president of Norwest Mortgage, testified, "The entire rating process provides considerable protection for the sophisticated investors in the marketplace." Lou Ranieri, who pioneered the mortgage-backed security, notably said, "to the notion of investor protections, we believe that the rating services do provide substantial investor protection."

At the time, some people brought up problems with this system. Richard Malmgren, secretary of the North American Securities Administrators Association (NASAA), said: "This legislation will delegate to rating services, which do not have investor protection as their primary concern, the responsibility of preventing fraud and abuse in the offering of mortgage-backed securities. NASAA does not think the responsibility for investor protection should fall entirely to entities not accountable to the general public."

Chairman Sen. Tim Wirth (D-Colo.) thought that it could be difficult to "sue [the ratings agencies] for being negligent or even reckless in giving their ratings," exactly the world investors are finding themselves in now. Henry Schechter, director of the Office of Housing and Monetary Policy of the AFL-CIO, was concerned that the definition of "sophisticated" investors was too broad, meaning some investors, like small pension funds, could get swindled.

Why does this matter now? The private-market securitization channel is completely frozen, in part because nobody trusts the ratings and the ratings agencies on these matters. With the ratings agencies obviously having serious problems, investors have had to rely on "representations and warranties" in order to get some accountability on their investments. Like a warranty for anything you buy, they are legal protections for investors that guarantee mortgage-backed securities have met basic, promised underwriting standards. And they allow investors to get their money back if it turned out those creating these securities followed bad practices. The reaction from Wall Street, as David Dayen noted, has been to try to exclude future securities from these legal protections.

To put that a different way, libertarians often argue that restaurant health codes are unnecessary because a restaurant would never want to poison their customers. As we've seen with Wall Street's behavior, not only did they poison their customers, they took out life insurance on their customers when they did get sick. Wall Street trying to void future reps and warranties is the equivalent of a restaurant that had poisoned its customers hanging a sign that said "if you get sick here, you won't get a refund." Thus, whatever happens in the upcoming conversation over Fannie/Freddie reform, the future of the housing market will have to deal with these failures when it comes to investor protections.

Another reason that the ratings agencies have become so tied into our financial system was the Fed's embrace of "internal ratings in the late 1990s. Large banks would have little internal ratings agencies calculating the risks they faced and could hold capital accordingly. This system of "internal-based ratings" could be supplemented via the independent ratings agencies' own measurements.

As Alan Greenspan said in his 1998 speech, "The Role of Capital in Optimal Banking Supervision and Regulation," this "use of internal credit risk models" could serve as a "possible substitute for, or complement to, the current structure of ratio-based capital regulations."

As Greenspan had argued elsewhere, at that point, "[s]upervision has become increasingly less invasive and increasingly more systems- and policy-oriented. These changes have been induced by evolving technology, increased complexity…not to mention constructive criticism from the banking community."

This issue drives the current battle by the Federal Deposit Insurance Corporation (FDIC) to increase the "leverage" ratio banks face. The leverage ratio is the capital banks hold that isn't adjusted by this ratings approach. The major concern is that both banks and the ratings agencies are going to put ratings wherever they want, hence the need for a secondary line of protection. One of the major proponents of this is Fed governor Dan Tarullo, whose book Banking on Basel is an excellent overview with major criticisms of this ratings approach.

Like much of the Wall Street system, the ratings agencies have resisted reform precisely because they are so ingrained into the system that has evolved in the past 30 years. That's no reason not to push for strong reforms, and a great reason to watch the evolution of mortgage-backed securities that comes out of Fannie/Freddie-reform.

Disclosure - Mike Konczal was previously a financial engineer with Moody's KMV, a San Francisco-based quantitative risk management firm that was purchased by Moody's in 2002.