Explaining FinReg: The rating agencies
Imagine a school with three teachers. But this isn't a public school. It's a private school testing out an innovative new funding system: The kids write the tests, fill them out and then pay the teachers to grade them. If they don't like the grade they get, they don't have to go back to that teacher.
That's not how we run schools, of course. But it is how we run Wall Street. The three major ratings agencies -- Standard & Poor's, Moody's and Fitch -- are paid by banks to grade (or "rate") their products. The problem here isn't just theoretical: One internal e-mail from Standard & Poor's saw an employee taking a group of analysts to task for their ratings. “We are meeting with your group this week to discuss adjusting criteria for rating C.D.O.s of real estate assets this week because of the ongoing threat of losing deals,” the e-mail said.
So why does anyone use these ratings? Two reasons: First, investors need some way of evaluating financial products that they don't have the time or resources to test on their own. Maybe it shouldn't be that way, but it is. Second, a variety of laws and regulations makes the ratings necessary. Under Basel II (a set of international regulations), for instance, banks can take on more leverage if they hold assets with AAA ratings. Other laws tell mutual funds and pension plans that they have to hold a certain amount of AAA securities.
In fact, the government actually credentials the rating agencies. So Standard & Poor's, Moody's and Fitch aren't just companies; they're "Nationally Recognized Statistical Rating Organizations." They've been blessed by the Feds.
The Dodd bill doesn't do a lot on rating agencies. It doesn't change their status or their business. A proposed amendment from Al Franken, Chuck Schumer and Bill Nelson would get at the conflict of interest by setting up a new agency that would decide which raters got to look at which securities. That way, there wouldn't be a financial incentive for the rating agencies to please the banks. On the other hand, this could create a sclerotic industry that banks find even easier to game.
So you probably need to go further. If you want to keep the laws using ratings in place, you need to bring the agencies much further into the public fold. I'd go so far as to say you should have a public agency rating securities and then private agencies offering second opinions. If the idea of AAA is that we want to sanction low-risk products for public policy, let's give the responsibility to someone who has the incentive to be conservative in handing the rating out and whose first responsibility is to the relevant policy objections.
But better than that would be to go in the other direction and get rid of the public credentialing entirely. These organizations are not, and never will be, infallible. So putting them on a pedestal is dangerous. It allows bankers to confidently trade products they don't understand. The letters AAA substitute for "buyer beware." But buyers should be wary of both financial products and ratings. And a more competitive market for ratings that doesn't have the government's blessing will move us toward both goals.
For more from the Explaining FinReg series: Head here.
Photo credit: Fred Prouser/Reuters
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