The Justice Department's lawsuit against Standard & Poor's has finally brought the role of the ratings agencies in the creation of the subprime mortgage crisis into the spotlight. There are debates about whether the first amendment protects S&P's ratings as a form of public opinion, and whether ratings agencies are even obligated to provide anything more, but whatever the outcome of the case or these debates, one thing is crystal clear. The problem with the ratings agency business is not particular to S&P, Moody's or Fitch, but systemic.
The overarching problem is the business model of the ratings agencies, which depends on getting paid by the very people whose products they need to evaluate objectively. It is an automatic and an egregious conflict of interest. If a ratings agency gives a major bank, for example, a bad rating on something they want to sell, that bank is very likely to take its many millions of dollars of business elsewhere - and to someone who will give it the results it wants. The upshot is that the ratings agencies are under tremendous pressure to keep their big clients happy, which can sometimes mean compromising the integrity of their analysis. The principle of self-interest makes it almost impossible for the ratings agencies to function any other way.
True objectivity requires independence but in the business model outlined above, independence takes a back seat to expedience - also known as profits. That is what happened before 2008, when banks decided to collect and securitize risky mortgages and sell them to investors, for which they needed to dress up their product with ratings. Investors, for their part, wanted to be sure that the reward they stood to receive from their investment was commensurate with the risk, and good ratings by S&P or Moody's gave them a sense of comfort.
In an ideal world, if the ratings agencies had analyzed the assets properly, they would have realized that the underlying mortgage pools were not only risky because of the adjustable rate feature (which could spike up suddenly and catch borrowers by surprise) but that many borrowers themselves were grossly unqualified to begin with. The collateralized securities were not clever financial instruments; they were ticking time bombs.
But the ratings agencies did not do their homework, either because of sloppiness or because it would have upset their clients, and as a consequence, investors everywhere got duped into thinking that they were buying gold whereas in reality they were investing in highly rated crap. While investors themselves share some blame for their blind faith in the ratings, that does not equate to a free pass for the ratings agencies, who trade on their reputation for objectivity. Our markets depend on that objectivity and so for the agencies to let profits dictate their recommendations is a patent violation of that trust.
That is why the only viable solution is to create a national ratings agency that can function independently of the sector it evaluates. Despite the bad behavior of the existing agencies, the service they provide is an essential one. In the modern world, where capital markets form the lynchpin of every industry and indeed our entire economy, and where an increasingly complex global marketplace, creative accounting techniques, and esoteric financial instruments make investments harder to analyze and risks more difficult to predict, the need for reliable, objective, and expert assessment of financial products is more critical than ever, and so ratings are a necessary part of the system.
Of course, with a multi trillion dollar deficit, sequestration, the debt ceiling, and a deep partisan division in Congress all hanging over our nation right now, the last thing that the Obama Administration needs is another unfunded government program, and so a national ratings agency would need an alternative, quasi-private-sector mechanism for funding.
That structure can be a "ratings tax" from business organizations that commission ratings for any purpose. This could include banks, hedge funds, public companies, and other entities, all of whom would pay for the use of a ratings service provided by the US government through a mixture of a flat tax and a pro-rata tax for the number of financial products that they want rated. The key difference from a private sector solution is that the government agency would not be a profit-fueled machine requiring maximum patronage from large clients but would employ analysts depending solely upon need.
Our financial institutions would benefit from such an independent body not beholden to anyone since the ratings on their products would be truly credible to investors and free of the taint that has attached itself to the business. It would also put pressure on private rating agencies to clean up their act and perhaps limit their focus to specialized arenas where they have a unique and demonstrable expertise - like highly complex derivatives.
The goal here is to create a crucial degree of separation between a ratings agency and its so-called clients so that conflicts of interest are eliminated, confidence is restored in a system that drives the buying and selling of trillions of dollars of financial products worldwide, and future financial catastrophes are (perhaps) averted.
SANJAY SANGHOEE has worked at leading investment banks Lazard Freres and Dresdner Kleinwort Wasserstein as well as at a multi-billion dollar hedge fund. He has an MBA from Columbia Business School and is the author of a thriller entitled "Merger" (St. Martin's Press) that Chicago Tribune called "Timely, Gripping, and Original". Please visit www.sanghoee.com to sign up for updates.