Ratings Disaster

Congress takes another stab at reforming the credit-rating agencies, whose AAA seal of approval helped fuel the subprime crisis. But will any change truly make a difference?

If Moody’s Investors Service and Standard & Poor’s were running nuclear reactors instead of credit ratings, would they still be in business?

Given their record as architects of one ratings failure after another over the past decade — from scoring Enron an investment-grade credit just days before its bankruptcy to issuing platinum ratings on trillions of dollars of doomed mortgage-backed securities — the answer is almost assuredly no.

Yet even as Congress appears poised to pass the most sweeping financial reform legislation since the Great Depression, the proposed regulations may do nothing to change how the agencies operate. Tainted they may be, but beyond a reputational hit they seem poised to carry on as before.

The Wall Street Reform and Consumer Protection Act of 2009, passed by the House in December, does call for rating agencies to beef up their internal controls, register with the Securities and Exchange Commission, bear more government supervision, and disclose more detail about their ratings methodologies. And it gives investors slightly more leeway to sue the agencies for gross negligence in their rating activities. A companion bill in the Senate, the Restoring Financial Stability Act of 2010, calls for many of the same changes, and also gives the SEC authority to deregister any agency for providing bad ratings over time.

But those proposals leave many critics unimpressed. “These kinds of things don’t have much meaning,” says Arturo Cifuentes, a structured-finance expert and professor at the University of Chile. As a former banker, CDO (collateralized debt obligation) fund manager, and senior vice president at Moody’s, Cifuentes knows the rating-agency world well, and has testified extensively on rating-agency reform before Congress. “They are token things done in order to make the public vote for you in the next election,” he says of the proposals.

No Shortage of Controls

Consider the call for internal controls, which is aimed at muting the conflict of interest inherent in a business model where agencies are compensated by the issuers of the very securities they are rating. The legislation would seem to suggest that such controls don’t already exist when in fact they do — often to little apparent effect.

Moody’s, for example, had a credit policy group tasked with ensuring sound rating methodologies and procedures, according to former Moody’s managing director Eric Kolchinsky, who testified to a House committee in September. Moody’s also had a compliance group entrusted with enforcing laws and internal policies, but Kolchinsky claimed the credit policy group was routinely overridden by line managers in the name of winning business, while the compliance group was understaffed and had little professional compliance experience. Kolchinsky was suspended from his post last year after complaining about the firm’s practices.

“Just because you have a fancy board and some guy named ‘chief compliance officer’ doesn’t mean that down on the ground things are going to go right,” warns NYU Stern School of Business economics professor Lawrence White. “We’ve seen lots of examples where fancy boards didn’t ensure that.”


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