Let market judge credibility of debt raters

The role and economics of credit-rating firms are among the most important issues to be addressed in any financial-reform legislation. Many kinds of financial institutions rely on ratings firms to measure the safety of fixed-income investments. Without believable assessments of creditworthiness, investors would demand far higher interest rates to offset the uncertainty of investing in such securities, meaning greater borrowing costs and ultimately less economic growth.

But the credibility of the three major bond-rating firms in particular has suffered significant damage. As a result of the financial crisis and the bursting of the real estate bubble, securities rated triple-A by the ratings firms — especially collateralized-debt obligations — suddenly were downgraded.

Besides clobbering individual investors and institutions — including mutual funds, endowments, charitable foundations and even sovereign-wealth funds — the sudden downgrades forced many banks to boost their reserves under the Basel II accords on capital adequacy. Those rules allowed them to operate with lower capital reserves — if those reserves were held in securities rated triple-A by companies the federal government designated as “nationally recognized statistical rating organizations.”

The sudden need for greater reserves as a result of the downgrading of the CDOs from triple-A to as low as double-B or double-B-minus caused many banks to cease lending and even to call in loans, worsening the economic and financial crisis.

Many critics charge that the Big Three among the ratings organizations designated as NRSROs — Moody’s Investors Service, Standard & Poor’s and Fitch Ratings Ltd. — failed in a number of areas.

The most serious charge against the firms centers on their conflicted interests. Because ratings are paid for by issuers and because ratings firms are for-profit entities, critics charge that the NRSROs tailored their ratings of mortgage-backed securities and CDOs to the demands of the issuers. In some cases, the ratings agencies even provided instructions to issuers about how to structure securities to win the coveted triple-A rating.

In effect, the critics argue, the conflict of interest at the ratings firms converted ratings from useful investor tools into tools for issuers of structured-debt products.

Another problem cited by critics is the agencies’ implied government seal of approval. Although smaller ratings firms exist, investors have paid them relatively little attention because until recently, only the Big Three have had the NRSRO imprimatur from the Securities and Exchange Commission.

A third problem is that the ratings firms, though profitable, can’t compete with investment banks in attracting financial talent.

They can’t afford to pay the million-dollar bonuses that investment banks pay out annually to their best and brightest. Therefore, credit analysts at ratings firms may be outsmarted by the Wall Street whiz kids.

Unfortunately, these problems aren’t easily solved. The SEC has chosen to recognize more credit-rating firms as NRSROs, but that is just adding a few more firms to the cartel.

An investor pay model, whereby large investors would pay for analysis of the creditworthiness of issues in which they were interested, no doubt would lead to fewer issues’ being rated. Worse, information about rated issues would be closely held and not be available to the general market.

Probably the best solution would be for the SEC, federal law and Basel II to drop the requirement that securities be rated by the NRSROs. Instead, ratings by several different ratings firms might be required, allowing the market to determine which firms are the most credible.

As a quality check, investors also could compare the credit default swap prices of similar securities rated by different firms. If Congress and the SEC gave these two market mechanisms a chance, they might overcome the structural flaws revealed by the financial crisis.

Related Topics: Securities and Exchange Commission