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?

This isn’t the first time Washington has tried to overhaul the raters. The Credit Rating Agency Reform Act of 2006 granted the SEC new authority to inspect credit-rating agencies and required that it report to Congress on credit-rating quality and conflicts of interest or inappropriate sales practices. Like the latest legislative initiative, it, too, required the rating agencies to establish internal controls aimed at managing conflicts of interest.

Yet here we are again.

“Why is it that after a series of failures we haven’t had any real reform in this industry?” asks Sean Egan, managing director of Egan-Jones Ratings Co., a small ratings firm that, unlike most of its competitors, gets paid by its institutional-investor clients rather than securities issuers. “We’ve had a near-meltdown of the whole financial system, and yet we still don’t have any real change.”

History Repeating

Part of the problem is that Congress is grappling with a ratings system that the government itself embedded in the nation’s financial system over the course of seven decades. Seeking to strengthen bank reserves following the Crash of 1929, the U.S. Comptroller of the Currency ruled in 1931 that Federal Reserve member banks could carry at cost any bonds that rating agencies had accorded investment-grade status, but would have to mark to market any that were rated below investment grade.

In 1936, the Comptroller of the Currency further decreed that Federal Reserve member banks could invest only in bonds considered investment grade by the established rating agencies of the day: Moody’s Investors Service, Fitch Publishing Co. (now Fitch Ratings), Poor’s Publishing Co., and Standard Statistics Co. (the latter two merging in 1941 to become Standard & Poor’s, now a unit of McGraw-Hill). All this made financial institutions, by law, dependent on the rating agencies’ work.

Over the ensuing decades, this government-ordered dependence on rating agencies deepened as state insurance regulators adopted minimum capital requirements for insurance companies and linked those requirements to bond ratings, too. In the 1970s, federal pension regulators did the same for pension funds. And in 1975, the SEC instituted new capital requirements for banks and broker-dealers that again referenced credit ratings.

To guard against the use of bogus ratings, the SEC further specified that those ratings be furnished by a “nationally recognized statistical rating organization” (NRSRO). Initially it accorded that status to just three firms: Moody’s, S&P, and Fitch. It added four more in subsequent years, but thanks to a series of mergers the ranks of the nation’s NRSROs had been pared back to three by 2000, effectively cementing their status as an oligarchy.

Today, the number of NRSROs has climbed to 10, but the Big 3 continue to account for the lion’s share of the market. And while all 3 played a role in the subprime-mortgage crisis, Moody’s and S&P were the bigger players by far, consistently rating 80% or more of the CDOs issued during the second half of the last decade. By contrast, Fitch saw its role in the CDO market dwindle dramatically after 2004, as it began to tighten its rating standards.

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