Today the Senate’s Permanent Subcommittee on Investigations held a hearing on the role credit ratings agencies played in the financial crisis. These are the companies that gave high marks to securitization deals, like the one Goldman Sachs is currently being sued over, even though the underlying collateral—namely, home loans—was pretty much crap. As today’s hearing illustrated, the ratings process became particularly corrupt in recent years, as companies like S&P and Moody’s slapped AAA lipstick on collateralized debt pigs, bending standards to keep the investment banks doing these deals happy and profits gushing in the door.
In today’s hearing, Eric Kolchinsky, a former team managing director at Moody’s, said he considered what had taken place—that is, what he saw go on first hand—to be securities fraud. Another witness, former Moody’s vice president Richard Michalek, explained the term IBGYBG. “I’ll be gone, you’ll be gone,” he said. “That thinking was driving what was going on.” Make your money, then get out before the whole thing blows.
The good news is that Congress addresses credit ratings companies in the financial reform legislation it is currently working to pass. The bad news is that what’s in both the House and Senate bills does practically nothing to take on the true, underlying problem.
That problem is this: the people who pay for ratings are the ones selling the stuff getting rated. A purer conflict of interest would be hard to find. This “issuer pay” model has been taken to task in the past. For example, despite plenty of warning signs, the major ratings companies all kept investment-grade ratings on Enron until just days before it declared bankruptcy. In the most recent go-round, this conflict reached epic proportions, with analysts being pressured on a daily basis to rate mortgage-related securitizations highly, lest the banks creating them decide to take their business elsewhere. Bonuses were directly tied to firms’ share of the securitization-rating market.
The bill that the House passed in December and that the Senate will soon start considering do very little to change this status quo. The Senate version commissions a study on alternative means of compensating ratings companies, but no direct action along those lines is taken. At the hearing today, Senator Carl Levin made a note of that. “There has got to be a way to eliminate this conflict of interest,” he said. “It’s not in the bill yet, but it’s got to be in that bill.”
Unfortunately, the obvious way to change the system—get the users of ratings to pay for them—comes with its own set of serious problems. When issuers pay for ratings, those ratings are available to anyone who wants to see them. Were the investors, banks, insurance companies and regulators that use ratings to pay for them, then the ratings wouldn’t be public. (If they were, then why would users pay?) We would be left with a system where only the biggest, richest players got to see what the ratings agencies thought. That set-up is arguably just as bad, if not worse, than the one we currently have.
Another approach is to leave the issuer-pay model intact, but to change other sorts of accountability in order to balance out the pressures ratings companies face. The House and Senate bills attempt to do this by making it easier for ratings companies to get sued. Astoundingly, the ratings companies have been very good at deflecting lawsuits, even when their ratings prove to be devastatingly off the mark, partly because of exemptions handed to them by Congress. Thankfully, the two bills start to change this. The bills also begin to chip away at the federal government’s own reliance on ratings—a reliance which implicitly endorses the validity of those ratings—although not nearly as substantially as they could.
But a more forceful attempt to dissolve the deep and destructive conflict of interest inherent at ratings agencies is missing from both the House and Senate bills.
What would a more forceful attempt even look like? My favorite proposal so far comes from a group of economists at New York University. The gist is to set up a credit ratings clearinghouse. Issuers still pay to have their securities rated, but they don’t get to pick which company does the rating. An intermediary does, thereby breaking the mechanism by which issuers can pressure ratings companies. In the current system, ratings companies lose business if issuers aren’t happy. In the new system, they lose business if the clearinghouse notices that ratings don’t prove accurate over time. If you want to know more about how such a clearinghouse would work, you can read a summary of the proposal here or buy the book in which it is described here.
In the meantime, let’s all hope that Senator Levin was serious about doing a better job of addressing conflict of interest in the pending legislation. The future stability of our financial system could depend on it.