Financial Reform: Why Do the Credit Rating Agencies Still Live?

Last Updated Jun 1, 2010 11:26 AM EDT

The big credit rating agencies pose an existential problem: Why are such hapless companies still alive when worthier financial firms are dead and buried?

After all, few businesses have performed worse in recent years than Standard & Poor's, Moody's (MCO) and Fitch Ratings. In a new paper, the Federal Reserve Bank of New York spells out just how poorly the three agencies fared in evaluating the quality of mortgage securities in the years leading up to the financial crisis. Before the housing bubble, the firms infamously whiffed on Enron, maintaining investment grade ratings on that corporate Ponzi scheme until days before it collapsed. Indeed, Moody's stock price soared in the years following the debacle.

As University of San Diego law professor Frank Partnoy has written:
Credit ratings continue to present an unusual paradox: rating changes are important, yet they possess little informational value. Credit ratings do not help parties manage risk, yet parties increasingly rely on ratings. Credit rating agencies are not widely respected among sophisticated market participants, yet their franchise is increasingly valuable.
That value -- or at least import -- has been on display in recent weeks. Stocks tumbled recently after Fitch downgraded Spain's credit rating. European officials also expressed frustration last month after S&P cut Greek and Portuguese debt, sending global markets reeling.
"Who is Standard & Poor's anyway?" asked EU spokesman Amadeu Altafaj Tardio, peevishly, in wake of the turmoil.
A Nationally Recognized Statistical Rating Organization, for one. That unlovely designation is no small thing. In 1975, the SEC began certifying ratings agencies as NRSROs, which meant that the financial markets could regard their ratings as credible. That special status, which Partnoy calls a "regulatory license," gave the anointed firms enormous competitive advantage and helped cement the dominance of the big three agencies.

More important, the label gave investors, bond issuers and other market players confidence -- or the appearance of it -- that a "AAA" rating meant something. And in an age when banks use securitization to pass along loans, and their underlying risks, to other parties, ratings became less a measure of asset quality than a government-endorsed stamp of approval. They became, in effect, a sales tool.

One element of financial reform being hashed out in Washington would abolish the use of NRSROs. In principle, that would open the ratings industry to new competitors and force regulators and investors to develop new ways of evaluating credit.

Another reason the ratings agencies retain their primacy is that they're almost impossible to sue. Federal regulations largely insulate the firms from criminal or civil liability. Courts also have protected the firms' market calls as expressions of free speech.
To get around the Constitution, judges have ruled, a plaintiff suing a rating agency would have to show that a firm not only made false statements, but also did so with "actual malice" -- a high legal hurdle.
For perhaps the best explanation for the ratings firms' seeming invulnerability, we must turn to the work of that major social theorist and philosopher: Charles M. Schulz. Like investors and the credit raters, Charlie Brown and Lucy van Pelt, of Peanuts fame, display a deep symbiosis. Charlie needs to kick that football, even as he knows that Lucy needs to yank it away at the last second. Each plays their part in a recurring tragicomic drama that ends in a pratfall.

The market, too, is a game. The winners keep teeing up the pigskin, and the losers keep yelling "Aaaaaargh!" Will changing the rules help? Maybe. The credit rating agencies may finally have worn out their welcome, as lawmakers ponder reform. Question is, what could take their place?

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