3 fixes for the credit crisis enablers

Where they got their paychecks

It would be relatively comforting to believe the rating companies got it so wrong on billions of dollars in debt and derivatives because their analysts were in over their heads when trying to understand the instruments created by their much more highly paid counterparts. But hearings conducted by Rep. Henry Waxman, D-Calif., in October stripped away even that shred of comfort:

• "Profits were running the show," testified Frank Raiter, who for 10 years was in charge of mortgage ratings at Standard & Poor's.

• "While the methods used to rate structured securities have rightly come under fire," said Jerome Fons, who was managing director of credit policy at Moody's until 2007, "in my opinion the business model prevented analysts from putting investor interests first."

• The hearing also offered an internal presentation to the Moody's board committee staff in which CEO Raymond McDaniel said that "analysts and MDs (managing directors) are continually 'pitched' by bankers, issuers, investors." Sometimes, he continued, "We drink the Kool-Aid."

But to me the most interesting -- maybe "appalling" is a better word -- testimony involved former Standard & Poor's manager Raiter. In an e-mail produced by the committee, Raiter asked for detailed loan data so that his staff could rate a collateralized debt obligation. S&P managing director Richard Gugliada responded in e-mail (.pdf file): "Any request for loan level tapes is TOTALLY UNREASONABLE!!! . . . It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so." In other words, rate the darn securities even if you don't have the data you think you need.

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3 steps toward rating sanity

• Let's all stop calling them "agencies," as if they were some kind of government entities or nonprofit organizations. These are businesses, designed to make profits. We get into trouble when we forget that. Let's call them what they are.

• Let's pass regulations, as we did in the aftermath of the bursting of the technology stock bubble in 2000, to reduce the conflicts of interest at the rating companies. The companies should not be allowed to accept fees for rating debt and derivative instruments from the financial companies that have created those instruments. If the potential buyers of debt think the ratings are valuable, they can pay for them. If not, they won't, and we'll go back to the good ol' days when the purchasers of debt did their own homework. If that puts rating companies out of business because nobody thinks their product is worth much, the market will have spoken. It is worth noting that Egan-Jones Ratings, a rating company outside the big three, doesn't take payments from issuers, and it's still in business.

• Let's spell out exactly the legal relationship between the rating companies and the customers that buy the ratings. In an effort to head off the remarkably ineffective Credit Rating Agency Reform Act of 2006, Standard & Poor's argued that all attempts to regulate the rating companies were unconstitutional because their ratings were simply opinions protected by the First Amendment. Go down that route and the rating companies' customers have absolutely no protection from even the most reckless and negligent behavior. The rating companies now face a tidal wave of lawsuits from investors who lost money when highly rated debt instruments and derivatives plunged in value. Ironically, verdicts overwhelmingly against the plaintiffs would likely do the rating companies the most damage because they would establish that the companies' customers had no protection from any kind of behavior by the companies. A decision of that sort wouldn't exactly fill customers with confidence. It would be much better for the financial markets if regulations drew a narrow standard of recklessness or negligence that gave consumers of these ratings a limited right to sue. That would certainly be more effective than the efforts of the Securities and Exchange Commission to date.

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How strong is the fear?
On Dec. 9, investors snapped up Treasury bills paying 0%. Not since 1940 have T-bills paid so little, yet demand was 4 times greater than the supply. The real problem, Jim Jubak says, is that the alternatives aren't any better.

My suggestions for fixing the rating company problem may seem a bit extreme, but the federal government already has proved that business-as-usual regulation doesn't work. The 2006 reform bill saw the solution as more competition in the field and greater efforts by the SEC to see that the rating companies produced credible and reliable ratings. The law gave the SEC the power to inspect the rating companies, but it didn't give the commission any say over the methods the companies used to produce their ratings (a good thing in my book, given the abysmal track record the SEC has built up in regulating complex financial instruments).

I don't see any signs that this approach has worked or that given time it would work. You can object that this approach hasn't had enough time to prove itself a success or failure. Fair enough. But are you willing to wait for the next crisis to find out?

My third suggestion for heading off a repeat of this crisis -- reforming the Federal Reserve -- will be the subject of my Dec. 19 column.

Continued: Developments on a past column

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