Credit-rating system needs overhaul

Many aspects of the U.S. financial system must be reformed in the wake of the financial crisis. So far, attention has been focused on improving securities regulation and the performance of the Securities and

Exchange Commission, and increasing the Federal Reserve’s role in regulating banks and quasi-banks.

One area that has received little discussion is improving the performance of the credit-rating industry. Congress has yet to focus on what steps are needed.

That is a serious oversight because the capital markets won’t fully recover until the credibility of credit ratings has been repaired.

Investors can be forgiven if they have little faith in the credit ratings issued by the major agencies.

Those agencies contributed to the mortgage meltdown by giving triple-A ratings to mortgage-backed securities and collateralized debt obligations backed by large numbers of subprime mortgages.

Many of those securities should have been rated below investment-grade. Their collapse in value wiped out investors, The Bear Stearns Cos. Inc. and Lehman Brothers Holdings Inc., both of New York, and much of the capital of the commercial banks.

The most recent failures of the ratings agencies come less than a decade after they failed to recognize the fraud at such companies as Enron Corp. and WorldCom Inc.

We don’t yet know whether Wall Street’s mathematical wizards took advantage of flaws in the ratings firms’ models, or if the agencies allowed their models to become obsolete, or whether the agencies provided the ratings the investment banks wanted so as to retain the banks’ business. Perhaps all these factors played a part in the failure of the ratings agencies to rate the securities, now known as “toxic assets,” properly.

Naturally, there is great suspicion that the major agencies allowed their ratings to be colored by the fact that the issuers of the securities were paying for the ratings. If an issuer got an unwelcome rating from one agency, that agency might not get the business the next time.

The ratings agencies, of course, deny that their ratings were affected in any way by the issuer pay business model, but given the recent failures, that must been greeted with skepticism.

Other than the federal government’s banning the issuer pay model for ratings agencies — an unlikely development — there are two ways that the credit-rating system could be improved.

First, the market could discipline the major ratings agencies.

One way for this to happen is for institutional investors to pay for ratings on any fixed-income securities that they plan to buy from the smaller investor-pay-based ratings agencies as a second opinion.

This would provide competition for the major agencies, and any significant discrepancy between the ratings of the major agencies and the small investor-pay-based agencies would be quickly highlighted and would again raise questions about the objectivity of the majors.

The second way would be for the SEC to monitor more closely the ratings agencies, to audit their ratings frequently and to recognize more of the investor pay agencies as Nationally Recognized Statistical Rating Organizations.

The first way would clearly be more effective and could be implemented quickly, but institutions too often have proven reluctant to pay for ratings. That is why the issuer pay agencies have come to dominate the ratings business.

So it may well fall to the SEC to monitor and discipline the ratings agencies.