How to Fix the Credit-Ratings Agencies

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Jin Lee / Bloomberg News / Landov

The Standard & Poor's sign is displayed outside of the headquarters in New York.

Last July, the Securities and Exchange Commission (SEC) put out a report detailing how the major credit-ratings agencies abetted the subprime-mortgage meltdown. By wildly overestimating the quality of the dicey securities that Wall Street was churning out, the ratings firms helped investors load up on those securities — the same ones that are now, in many cases, near-worthless and clogging up the financial system. Plenty of people at the ratings agencies were aware of trouble brewing. In December 2006, a manager at Standard & Poor's e-mailed a colleague: "Let's hope we are all retired and wealthy before this house of cards falters."

The ratings agencies themselves — Moody's, Standard & Poor's and Fitch — have nowhere to hide. Their CEOs took a royal lashing from Congress in October, and in April new regulations will go into effect, largely to address what is often painted as the Achilles heel of the ratings system: companies typically pay to have their own debt rated, therefore creating a massive conflict of interest for the ratings agencies, which want to hold onto that business. (See "How to Know When the Economy Is Turning Up".)

Favorably rating structured finance products — including Frankenstein creations like synthetic collateralized debt obligations — became a major source of profits for the ratings agencies during the boom years. By mid-2007, some 37,000 issues earned top marks; thousands have since been downgraded.

The new SEC rules, among other things, require firms to say how accurate their ratings are over time, and it bans companies from rating securities they've helped to create.

Many finance experts think the rules fall far short. Including, it seems, the SEC's new chairman, Mary Schapiro. In congressional testimony on March 11, two months after she was confirmed to her post, Schapiro said, "I'm not sure if it's enough, to be perfectly honest." On April 15, the SEC will hold a roundtable, to hear from the ratings firms about what they have done to improve things on their own, and also from people who think the entire issuer-pays model needs to be scrapped. "There have been some very thoughtful proposals out there, and we've invited those people to come and speak," Schapiro told Congress. (See "Business Bucking the Recession".)

One fresh idea comes from Eric Dinallo, the New York state insurance superintendent, who in a March 3 Wall Street Journal op-ed suggested that insurance commissioners mediate the ratings process, since insurers are among the largest buyers of rated bonds. Regulators would collect a fee from insurance outfits and then use the money to buy ratings for everyone to use. If the ratings proved too rosy over time — or inaccurate in another way — regulators would switch to a different ratings company.

See 25 People to Blame for the Financial Crisis.

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