Hearings Shine a Spotlight on the Conflicted World of Credit Raters

Credit rating agencies were a topic of financial reform hearings.One of the more interesting observations in the Financial Crisis Inquiry Commission hearings last week came not from the witness stand, but from one of the commission members. In his questioning, Byron Georgiou, a lawyer who played a lead role in the Enron prosecutions (and pictured left), called attention to the conflicts embedded in the business practices of the rating agencies at the heart of the financial crisis -- as he termed it, "a conflict of interest of gigantic proportions."

Sure, it's often pointed out the credit rating agencies -- Standard & Poor's, Moody's Investors Service and Fitch Ratings, the only three raters designated as nationally recognized statistical-rating organizations by the SEC -- have an inherent conflict of interest, since they are paid by the very institutions who issue the securities being rated.

But that's just the start of it.

You might presume that the rating organizations are getting a flat fee from the issuers for their services. But, as Georgiou noted, frequently, the raters are paid as a percentage of the ultimate deal. The higher the rating, the bigger their likely fee.

No buyers? No fee.

Since pension funds and some other big institutional investors by law can only buy tripe A-rated securities, the credit agencies have a major incentive to give securities AAA ratings to ensure they get sold, and at lofty prices. In a system like that, it's easy to see how junky subprime loans, with a little financial slicing and dicing, were regularly transformed into securities with stellar triple-A ratings -- the same grade given to the US government!

Yet, despite those conflicts and the reliance that investors put upon the ratings, credit rating agencies enjoy a Teflon-like aura of protection from accountability. Thanks to the Credit Rating Agency Reform Act of 2006, the organizations are shielded from prosecution or punishment by the SEC. They've generally been shielded from lawsuits as well.

"The credit rating agency issue is more serious than just the issuers paying," Georgiou said. "I think it's very important for the public to understand what happens here."

In the five years leading up through 2007, the agencies gave top ratings to $3.2 trillion worth of securities stuffed with subprime loans -- most of which has been since written down. During the same period, they booked record profits.

The rating agencies got their share of scrutiny back in the fall of 2008, when the financial meltdown prompted an investigation by a House Oversight Committee. (That's when an email exchange between two S&P employees discussing a particularly risky mortgage-backed security were made public, with one employee writing, "We rate every deal. It could be structured by cows and we would rate it.")

But little has been changed since then. Indeed, the agencies seem to have been forgotten, or at least overshadowed by the furor over Wall Street bonuses and the theater of big bank chiefs being grilled on the stand.

Georgiou suggested that perhaps it might be a good idea to change the compensation structure for the raters, so that their pay is tied to the long term success of failure of the securities they rate, thereby giving them some skin in the game. (That notion has been referred to as "eating your own cooking" at the hearings. But the correct phrase -- "eating your own dog food" -- seems much more apt.)

SEC Chairman Mary Schapiro said her agency is exploring "risk retention" measures, and has proposed that credit rating agencies be subject to liability the same way that auditors and lawyers are.

It seems a very reasonable step to take.
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