BUSINESS
07/18/2009 05:12 am ET | Updated May 25, 2011

Credit Rating Agencies Spared Major Reforms In Obama's Overhaul

They've been called the culprits of the financial crisis but their role has remained largely unexamined. And they were largely spared any major reforms in the financial regulatory overhaul announced today by President Obama.

The credit rating agencies, which awarded high ratings to subprime mortgages and other complex securities that helped fuel the economic meltdown, will now be required to publicly disclose how they measure performance and the risks assessed in their ratings.

However as Reuters reports, one crucial reform was left untouched:

But the blueprint does nothing to address what critics call the industry's key shortcoming: That the biggest agencies are paid by issuers whose securities they rate, creating an incentive to win more business by assigning high ratings.

That potential conflict of interest has led to situations in which firms claim they were threatened with lower ratings if they didn't pay particular ratings agencies.

Critics say the pay issue is responsible for the dominance of the big three rating agencies - Moody's, Fitch and Standard & Poor's - impeding competition in the industry.

Those three agencies are being sued by Connecticut Attorney General Richard Blumenthal, who claims that they allegedly gave the state's municipalities artificially-low credit ratings, costing taxpayers millions of dollars. The agencies deny the allegations.

Blumenthal told Huffington Post that he has collected evidence showing how "the amount of payments to agencies seems to affect their ratings. In one case, he says, an agency "threatened to downgrade a rating if a company failed to provide all of the business to that rating agency."

The attorney general's lawsuit is the first court action in an investigation into possible antitrust violations, consumer protection and potential other violations by the agencies.

"Our investigation concerns practices that relate to conflicts of interest and methods and types of payment," says Blumenthal.

In the past, the firms have defended the issuer-pay model. Standard & Poor's white paper on the subject states: "Firms employing the issuer-fee model have a long-term track record of success... [and] historically, the issuer-fee model has fostered the greatest levels of transparency."

The proposals were criticized by industry veterans, reports the New York Times:

"This is not an effort to remake the industry," Jerome Fons, a former managing director of credit policy at Moody's, said of the administration's proposals. "If we believe the system is broken, this doesn't offer a fix."

Another reform that remains to be addressed is the issue of liability. Consumer Federation of America president Barbara Roeper says:

"If they're going to have this legally sanctioned gatekeeper role, then they need to lose their First Amendment rights. They claim their ratings are just opinions, but that argument has been challenged. If they were legally liable, if they knew they could be sued for being reckless and issuing ratings of which they have inadequate basis, then they might be more careful... or to say 'I don't know' about risks they don't understand. At the very least, if they were liable, they might have reexamined their methodologies."

The agencies have been criticized for missing several of the financial world's biggest collapses: Enron had an investment-grade rating four days before the company went bankrupt in 2002.

Today, the agencies welcome the government proposals, saying that they favored improved ratings quality and transparency.

In anticipation of the overhaul, the industry has been heavily lobbying the White House, the Treasury Department, the SEC and Congress.

According to the Center for Responsive Politics:

The 10 firms accredited by the SEC to issue credit ratings spent $370,000 on lobbying during the first three months of 2009, an increase of 42 percent compared to the 1st Quarter of 2008,

Several lawmakers who have been critical of the agencies did not return calls for comment. Rep. Henry Waxman, former chairman of the House Oversight and Government Reform Committee, told a hearing last year that "The story of the credit rating agencies is a story of colossal failure."

Blumenthal asserted, "If there is one culprit in this financial crisis, debacle and meltdown so far, a culprit that's escaped the blame they deserve is the rating agencies."