Reel in the Credit-Rating Agencies

04/24/2009 05:12 am ET | Updated May 25, 2011

Alas, the taxpayers are not done enriching the robber barons of Wall Street. The just-announced Treasury plan to partner with private investors in purchasing "toxic assets" will almost assuredly result in additional profits for the credit-rating agencies--primarily Standard & Poor's, Moody's Investor Services, and Fitch Ratings. We already know this is the case with the Federal Reserve's rescue plans. As the Wall Street Journal announced on Friday, the Fed's program alone could result in over a billion dollars flowing into the credit-rating agencies' pockets.

Why should you care? Quite simply, credit-rating agencies are the institutions that made this whole global economic crisis possible. The credit-rating agencies are supposed to serve as financial gatekeepers, issuing evaluations on the creditworthiness of public companies and securities. These ratings ultimately determine the value of a bond or security by telling an investor how much risk they are assuming when purchasing these notes. A low credit rating means investors are going to be willing to pay less.

Now here's the kicker. The rating is paid for by the firm issuing the bond or security. This is the same as having a used car dealer pay the credit-rating agency for an authoritative endorsement proclaiming there is not a lemon to be found on his lot. Good deal for the used car dealer, profitable for the credit-rating agency, bad news for you and me.

But this would never happen in America...right? Wrong. Less than a year ago two of the top three credit-rating agencies gave high marks to 11 of the largest distressed financial institutions. They gave AIG an AA rating, and Lehman Brothers had an A rating less than a month before it collapsed. Furthermore, until very recently the same credit-rating agencies maintained AAA ratings on thousands of the now-toxic subprime-related securities.

As two former high-ranking officials from the credit-rating agencies told the House Committee on Oversight and Government Reform in October 2008, conflicts of interest within the rating industry resulted in risk assessments that left banks around the world holding assets that are essentially worthless. And we are currently preparing to pay the same credit-rating agencies billions of dollars to help save us from the mess? Shame, shame.

But far be it from me to scold on my own. Representative Henry Waxman (D-CA) did a much better job last October when he declared, "The story of the credit-rating agencies is a story of colossal failure....Millions of investors rely on them for independent, objective assessments. The rating agencies broke this bond of trust, and federal regulators ignored the warning signs and did nothing to protect the public."

That was in October--since then another 2.5 million Americans have lost their jobs. What has Washington done to fix the credit-rating agencies? Frankly, not much. Unlike the Europeans, who crafted legislation aimed at preventing the conflict of interest problem and separating pay rewards in the credit-rating industry from revenue generation, Washington--specifically, the Security Exchange Commission (SEC)--has largely sat on its hands.

Rather than reeling in the $5 billion-a-year failed credit-rating industry, the SEC has rejected proposals requiring ratings of complex securities...the very essence of the toxic asset distinguished from more traditional securities like corporate or municipal bonds. The SEC also rejected proposals requiring strict separation of the credit-rating analysts and the firms' employees charged with generating revenue. In early March 2009, all the new SEC Chairwoman could tell Congress was that her agency "probably" had not done enough to address the problems at credit-rating agencies. She was, however, kind enough to invite proposals for fixing the problem.

OK. In the interest of serving the taxpayer and preventing further Wall Street theft from domestic and foreign investors, the SEC should immediately stipulate credit-rating agencies undertake the following actions:

1. Require ratings of complex securities--i.e., the toxic assets tied to student loans, mortgages, or auto deals--be clearly distinguished from more traditional securities. In essence, this requires the credit-rating agencies separate the wheat from the chaff, and declare each has a much different value.

2. Require credit-rating agencies definitively separate their analysts from the revenue generators--or be prepared to close. This conflict of interest problem is directly tied to the issue addressed in step one above. Unless, or until, credit-rating agencies honestly assess all a potential client's assets in specific detail, investors will continue to be very unpleasantly surprised.

3. Strictly cap compensation a credit-rating agency may receive when evaluating assets tied to any government bailout program. The taxpayer should not be further enriching the credit-rating agencies--particularly as these agencies are directly responsible for no small portion of the crisis we presently confront.

4. Immediately implement steps that put an end to reliance on the credit-rating agencies. An important step in the right direction is to encourage investors to seek alternative information sources and stop employing credit-ratings-related language in financial contracts. The resulting competition should serve to help address the issues specially targeted in steps one and two above.

If Treasury Secretary Geithner is serious about resolving the current crisis in a permanent manner and meeting President Obama's pledge to address taxpayer concerns about further Wall Street malfeasance, he and the SEC must take direct aim at the root cause of our ailments. That means fixing the credit-rating agency problem now.