Rating firms could lose their special status.

If the past decade’s financial over-engineering was a crime, rating agencies were the getaway drivers. The punishment for putting their stamp of approval on collateralized-debt obligations, bond insurers, and various undeserving dross is becoming clearer. On July 21st the Obama administration proposed legislation that is more comprehensive than many expected.

The proposals focus on tackling conflicts of interest and on increasing openness. If an analyst is hired by a customer, his past work will be subject to extra scrutiny. The agencies will have to disclose their fees, ratings history, and a lot more about their methodologies. They may not do consulting work for ratings clients.

Such measures should curb the “ratings shopping” that was prevalent in the boom. Greater disclosure will also make it easier for investors to prove in court that agencies were reckless-the industry faces dozens of lawsuits from investors, including CalPERS, a giant Californian pension fund (which, ironically, Moody’s put on review for a downgrade this week).

Like the European Union, which approved its own reforms in April, the Americans stop short of blessing a particular way of paying for ratings. The dominant model, in which the bond issuer pays the rater directly, encouraged coziness between the two. But the alternatives have flaws too. The “investor pays” approach encourages free-riding among non-subscribers; and investors, like issuers, have incentives to influence the process. A government ratings utility may be tempted to minimize downgrades when the economy sours.

The main problem, in any case, lies elsewhere. Rating firms have become an anointed oligopoly (with margins to match) because they are embedded in regulations. Pension and money-market funds are restricted from holding lowly rated securities; banks get capital relief for holding highly rated ones. Investors flocked to AAA-rated firms such as American International Group, which could take big risks without having to post collateral with counterparties. David Einhorn, a hedge-fund manager, calls it “the curse of the triple-A.” Ratings are also procyclical, he says. In good times upgrades fuel bubbles; in bad times downgrades automatically send markets spiralling.

The obvious solution is to strip the rules of references to ratings where possible, so that the market, rather than a government mandate, determines the extent of their use. The American proposals, which must be reconciled with several bills in Congress, merely urge regulators to determine where references can be removed. But momentum is building. Before long, the industry could face its own multi-notch downgrade.


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