Everyone (except Wall Street bankers) seems to be outraged about Wall Street banks, which made billions by trading complex confections of dicey mortgages and then passed us the tab when the investments went belly up. But what about the agencies that bestowed triple-A ratings on many of the noxious financial products?
Moody’s, Standard & Poor’s and Fitch, whose ratings assured investors that the newfangled investments were as safe as United States Treasury bonds, arguably bear as much responsibility for the financial crisis as the banks that put the investments together. But the raters have mostly avoided public scrutiny, and from the look of Democrats’ current proposals to overhaul financial regulation, it looks as if they will remain off the hook.
From 2004 to 2007, agencies made hundreds of millions of dollars rating thousands of deals in residential mortgage-backed securities and collateralized debt obligations. Their fees could exceed $1 million per transaction, on top of annual “ratings surveillance” fees of tens of thousands of dollars.
Ninety-one percent of the triple-A securities backed by subprime mortgages issued in 2007 have been downgraded to junk status, along with 93 percent of those issued in 2006 and 53 percent of those issued in 2005. On Jan. 30 of 2008 alone, Standard & Poor’s downgraded over 6,300 subprime residential mortgage-backed securities and 1,900 C.D.O.’s.
Triple-A is what the raters assign to United States government debt. Had they warned investors that the new mortgage-based products were just high-tech junk bonds, it is unlikely so many financial institutions would have loaded up on the stuff.
It is not just that ratings agencies are incompetent, made wrong assumptions about the housing market and used flawed models to evaluate mortgage-backed securities. Their business is rife with conflicts of interest. The banks pay the raters and have an enormous incentive to shop around for ratings. E-mail made public in April indicates that raters give in to the temptation to manage their ratings in order to acquire more business.
A 2004 e-mail message from one Standard & Poor’s employee to another referred to a meeting to “discuss adjusting criteria for rating C.D.O.’s of real estate assets this week because of the ongoing threat of losing deals.” A 2007 e-mail message from a Moody’s employee to a Chase banker suggested a colleague was “looking into some adjustments to his methodology that should be a benefit to you folks.”
And yet, the financial reform bills before Congress have only vague proposals to fix the agencies. They would have to register with the Securities and Exchange Commission, and the Senate bill would allow the S.E.C. to pull their registration if they were consistently wrong. Raters would have to disclose conflicts of interest, and investors would be able to sue for blatant recklessness.
That is not enough. Some good ideas are floating around to do much better. If raters are considered to be a public good, they should be financed like a public good, with a tax or other levy, and paid by the government. Another option would be to let banks pay for ratings but take away their ability to choose who rates their bonds, letting the S.E.C. decide based on raters’ performance.
If there is no way to improve raters’ track record, a more drastic step would be to eliminate them, or at least eliminate the legal requirement that some insurance companies, pension funds and other entities hold assets with high ratings, a rule that gives the raters enormous quasi-regulatory power.
This is not a perfect solution. A world with no rating agencies would leave many investors at sea. But it is not much of a life raft if agencies cannot do better than they did during the housing bubble.