THE BLOG
08/13/2010 11:57 am ET Updated Dec 06, 2017

Abolish the Rating Agencies

2010-08-13-BenBernankewithtext81210.jpg"The sources of the crisis were extraordinarily complex and numerous," Ben Bernanke said last December. He is Chairman of the Board of Governors of the Federal Reserve System. "A fundamental cause was that many financial firms simply did not appreciate the risks they were taking."

Parsing Bernanke's words, the ignorant bankers who held collateralized debt obligations (CDOs) in their portfolios, ignored the risk. Instead, because of their voracity for increasing yields in a low interest-rate environment, they blindly invested in subprime, mortgage-backed securities, credit default swaps and other exotic CDOs that the dubious credit-rating agencies rated "Triple A."

Moody's Investor Service, Standard & Poor's and Fitch Ratings are examples of the larger credit-rating agencies. In the Securities Exchange Act of 1934, these approved agencies or "nationally recognized statistical rating organization (NSRO)," as the law called them, are registered with the U.S. Securities and Exchange Commission (SEC).

In a fiduciary role, they are supposed to independently rate securities so that you and I, and also financial institutions know the quality of their investments. Yet, the issuers of securities select the rating agencies and pay them huge fees to conjure up a rating. And since there is competition to be chosen, the rating agencies understand why they are at the table --- to provide an investment-grade rating.

Aside from the breach of the fiduciary by the rating agencies, their Ivy-League MBA-wielding tsadiks are not more highly divined than their classmates employed at the international financial institutions, pension funds and Wall Street firms that invest in CDOs.

So why do institutional investors need the rating agencies to tell them the quality of their investments? In my opinion they don't and I recommended that we get rid of rating agencies in my April 29, Huffington Post piece.

But the issuers of esoteric CDOs want federally sanctioned third parties so that they can cover their collective derrieres when highly rated investments fail to perform as promised. And furthermore, institutional investors would rather abdicate their own due diligence responsibilities when they buy risky securities.

But according to press reports, FDIC Chairman Sheila Bair is not ready to toss the rating agencies into the dung heap just yet. "Finding an alternative is going to be very, very difficult," she says, hinting that a compromise may be in the works. Instead, she, and the other bank regulators are doing what politicians do well --- asking for public comments on how to reform the rating of securities. They say it is pursuant to section 939A of the Dodd-Frank Wall Street Reform and Consumer Protection Act, recently signed into law by President Barack Obama.

"I hope the comment process will enlighten us," Bair says.

With all due respect, Ms. Bair, enlightenment came with the worst financial meltdown since the Great Depression. And what we learned is pretty basic. Wise investors know what they invest in, and don't invest in vehicles that they do not fully understand. That means they should not rely rating agencies, intermediaries or any third party to tell them the quality of their investments.

Instead, institutional investors must hire competent underwriting staff and do impeccable due diligence for every loan they make and investment they purchase. Moreover, you and the other regulators should provide guidance about what constitutes suitable risk, especially when taxpayers are at risk.

The financial meltdown is also a lesson for individuals that relied on the rating agencies and bought Triple A-rated, subprime mortgage-backed securities and other esoteric instruments. They somehow thought that the ratings would protect them against borrowers who could not afford the homes they bought.

Just like institutional investors, individuals should only invest in financial vehicles that they understand. And if they hire financial advisors, they have to vet them thoroughly to lessen the chances that they will abscond with their money.

Meanwhile, you can send the government your comments by e-mail to, regs.comments@occ.treas.gov. Put the following in the subject line without quotes, "Proposed Rulemakng Regarding Alternatives to the Use of Credit Ratings in the Regulatory Capital Guidelines of the Federal Banking Agencies."

The request for comments will also be listed in the Federal Register.

Jerry Chautin is a volunteer SCORE business counselor, business columnist and SBA's 2006 national "Journalist of the Year" award winner. He is a former entrepreneur, commercial mortgage banker, commercial real estate dealmaker and business lender. You can follow him at www.Twitter.com/JerryChautin