The Rating Agencies, A Key Reason For The Recession, Get Primed For An Overhaul

05/17/2009 05:12 am ET | Updated May 25, 2011

Much attention is being paid to the $12.1 trillion government bailout, and where that money is going. But the root cause that has created the need for this funding -- the credit rating agencies -- has been largely overlooked.

Now it seems as if the Securities and Exchange Commission is focusing its attention on the topic, holding a full-day conference earlier this week to help establish an approach to overhauling the agencies. Momentum is also gaining on the Hill, as Senator Jack Reed fine-tunes draft legislation to reform the credit rating process.

"This is a debt market crisis we are experiencing, and it revolves around the sudden loss of credit and the inability of the rating agencies to keep up," said John Coffee, a professor at Columbia University's School of Law.

Moody's, Standard & Poor's and Fitch dominate the rating industry by a wide margin, and their products have become an integral part of the financial world. For example, many pension funds and mutual funds can invest only in bonds with high credit ratings; complex derivatives often have credit rating triggers written into their contracts and many banks include credit rating criteria in their loans.

This means that a change in ratings can have sweeping consequences. In the case of AIG, for example, the insurer was a key player in a web of risky derivatives, and if the rating agencies had lowered by even one notch the ratings on these derivatives contracts, it would have triggered billions of dollars of obligations and possibly led to the company's collapse.

"It is no coincidence that when the government officials were debating the fourth round of AIG bailouts this month, they quietly called on the rating agencies to ensure that they would not downgrade the insurer," according to a New York Times Op-Ed by Jerome S. Fons and Frank Partnoy, both former rating agencies employees. "In a crisis, downgrading debt can be like firing a bullet into a company's heart."

Their role in the downturn is also clear. The rating agencies failed to downgrade much of the subprime mortgage bonds that triggered the current recession, didn't forecast the collapse of the investment banks and even gave Lehman Brother's an investment grade A rating one month before its collapse.

These lapses highlight the deep flaws in the way the agencies come up with ratings, critics say. Conflicts of interest are rife, with the companies who's debt the agencies are rating also paying their fees. The agencies also often consult the companies on how to structure debt, and then also rate that same debt.

Agencies also don't verify the accuracy of the information on which they base their ratings. Rather, they use information provided by the companies they are rating.

"The rating agencies don't do any factual verification, they just assume the accuracy of the information given them by the issuer, which becomes a self-fulfilling prophecy," Mr. Coffee said.

The agencies also have zero liability and cannot be held responsible if they are wrong on a ratings call. This is because courts have so far ruled they are protected under the first amendment. There are currently some cases winding their way through court, however, which may change this.

"The courts so far have determined that ratings opinions are commercial speech, so the first amendment applies to them," Fons, who was a former managing director at Moody's, told the Huffington Post. "But this could change, which would open them up to liability and force them to be much more careful."

The SEC under Mary Schapiro has said it will look at the rating issues, and there are several possibilities currently in play.

One approach is to reduce the overall significance of ratings. Fons and Partnoy, who is a law professor at the University of San Diego, champion this in their Op-Ed. "The only way out of the trap is to reduce reliance on ratings," they wrote.

Others, such as Coffee, are pushing for reforms that are similar to what the accounting industry underwent during the Arthur Anderson-Enron scandal. This includes having an independent firm that would verify the accuracy of the information provided by the companies, much as CEOs were asked to sign off on their companies' accounting. Coffee is also a proponent of increasing the rating agencies' liability, just as occurred with the accounting profession.

"Until the late 1990s, when the asset-backed mortgage bonds began to be issued in earnest, investment bankers would hire a due diligence firm to make sure the real estate collateral was solid," said Coffee. "We should go back to that practice."

Reed is proposing legislation that incorporates some of this. The bill, which he has yet to introduce, calls for liability for wrongful ratings. It also establishes a greater role for the SEC, with an office that would help oversee the rating firms.

There would also be a due diligence certification, and additional forms for rating agencies to file when they change their ratings or methodologies.

An independent compliance office would also have to be established, and there would be a one-year break before a rating agency employee can work for an issuer.

The legislation doesn't "help in any way to improve the competitive environment for ratings, [and] seems to emphasize more paperwork and form filing," Fons said. He added that the legislation also calls for "accurate ratings" but doesn't provide any benchmark for how the rating agencies will be judged on their ability to rate companies' debt.

"Without a very clear definition of rating quality -- hopefully one that places nearly total emphasis on the ability to discriminate (in advance) those firms or issues that default from those that do not -- we are essentially flying blind," he said.