Don’t nibble around the edges of financial reform

The House Financial Services Committee has taken up the question of the credit rating agencies. These are the quasi-regulatory bodies that gave Wall Street permission to pump trillions of dollars in toxic assets out into the arteries of global finance, with consequences familiar to us all.

The financial-reform spotlight has largely been elsewhere lately — on derivatives trading, executive pay, and the powers of a proposed consumer financial protection agency, among other important issues. But we should not forget the rating agencies; nor should we imagine that the steps proposed by Rep. Paul Kanjorski (D-Pa.), and approved by the Financial Services Committee will be adequate to the task.

The credit ratings industry was born with the publication of “Moody’s Analyses of Railroad Investments” in 1909. A century later, we are learning how the company that still calls itself Moody’s Investor Services wound up, along with the rest of the industry it spawned, helping Wall Street peddle high-risk securities to insurance companies, pension funds, municipal governments, and other institutions required by law to be extra-careful with their money.

At Moody’s, “analysts and executives who warned of trouble” were demoted, reassigned, or fired, Kevin Hall of McClatchy newspapers reported recently. The purge was part of what one rueful executive described as a “systematic and aggressive strategy to replace ... a getting-the-rating-right kind of culture with a culture that was supposed to be ‘business-friendly,’ but was consistently less likely to assign a rating that was tougher than our competitors.”

 The House bill, like a similar measure offered by Rhode Island’s Jack Reed (D) in the Senate, would grant more watchdog authority to ratings regulators and more legal recourse to investors. No more would the ratings agencies be allowed to make heaps of money from their government-sanctioned role as guardians of the line between speculation and investment, and then, if their Triple-A ratings turn out to be worthless, pose as mere publishers of “opinions” enjoying the sacred protection of the First Amendment.

These are good and needed reforms. But while they could make it easier to catch problems, they would not alter the basic incentive structure that led the ratings agencies (and the economy) astray. Why did they discount or ignore so much risk? Because that was the way to haul in millions of dollars from the securities issuers and underwriters who, under arrangements that date back to the 1970s, effectively hire and pay them. (To make matters worse, the ratings agencies have also sometimes acted as consultants, helping their clients figure out how to qualify a particular set of securities for a particular rating.) It is this inherently corrupt business model that needs to be changed above all. Otherwise, when the next bubble threatens, the ratings agencies will again be tempted to stretch the definition of “investment grade” to the breaking point.

One solution, developed by economists Ahmed Diomande, James Heintz, and Robert Pollin, would have backup ratings provided by a public or nonprofit body, funded through fees on securities offerings. If the public agency’s conclusions diverged sharply from those of private agencies, investors would notice and raise questions. A public agency would also be free to declare some securities too complicated to rate. Up to now, that healthy possibility has apparently not been entertained. “We rate every deal,” a Standard & Poor’s analyst grumbled in an instant message to a colleague. A securities offering “could be structured by cows,” the analyst added, “and we’d rate it.”

Another promising approach, floated by Securities and Exchange Commission chairwoman Mary Schapiro in her confirmation testimony, would have securities issuers pay into a pool from which a rating agency would be chosen at random, so the purveyors of innovative financial products would no longer know which agency will be rating them.

Critics of regulation often complain about its complexity. Government sometimes invites that criticism by nibbling around the edges of a problem. The beauty of the random-assignment idea is the way it tackles the key problem of the ratings agencies — their built-in conflicts of interest — head-on. This one remedy, while not easy to implement, could be a game-changer.

For just that reason, of course, the Big Three ratings agencies will fight to preserve the status quo, and they will have plenty of money to expend on the effort.

Between 2002 and 2007, as the quality of their work deteriorated, their profits swelled, rising from a combined $3 billion to over $6 billion, while their CEOs earned a collective $80 million. The secret of their fabulous success was the power to dispense something precious — an investment-grade rating — without a sense of duty to properly investigate, or even fully understand, the securities involved.

It was a nice racket. Let’s put a stop to it.

Lardner is a senior fellow at Demos, a non-partisan research and advocacy organization based in New York City.