Party at Moody’s

Anyone interested in the proper balance between market and government in the securities field should check out Roger Loewenstein’s article on the ratings agencies from the NYT. Here’s the bottom line:

[By 2006], [a]lmost all of . . . subprime loans ended up in securitized pools; indeed, the reason banks were willing to issue so many risky loans is that they could fob them off on Wall Street. But who was evaluating these securities? Who was passing judgment on the quality of the mortgages, on the equity behind them and on myriad other investment considerations? Certainly not the investors. They relied on a credit rating.

Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody’s and Standard & Poor’s that set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. Effectively, they did the job that was expected of banks and government regulators. And today, they are a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more.

What’s particularly interesting here is how the ratings agencies’ dominance in their field can be in part attributed to their own failure to foresee the Penn Central collapse:

[S]everal trends coalesced to [improve raters’ profits]. The first was the collapse of Penn Central in 1970 — a shattering event that the credit agencies failed to foresee. It so unnerved investors that they began to pay more attention to credit risk.

Government responded. The Securities and Exchange Commission, faced with the question of how to measure the capital of broker-dealers, decided to penalize brokers for holding bonds that were less than investment-grade (the term applies to Moody’s 10 top grades). This prompted a question: investment grade according to whom? The S.E.C. opted to create a new category of officially designated rating agencies, and grandfathered the big three — S.&P., Moody’s and Fitch. In effect, the government outsourced its regulatory function to three for-profit companies.

Bank regulators issued similar rules for banks. Pension funds, mutual funds, insurance regulators followed. Over the ’80s and ’90s, a latticework of such rules redefined credit markets. Many classes of investors were now forbidden to buy noninvestment-grade bonds at all. Issuers thus were forced to seek credit ratings (or else their bonds would not be marketable). The agencies — realizing they had a hot product and, what’s more, a captive market — started charging the very organizations whose bonds they were rating.

How to solve the problem? Here’s Alan Blinder’s view:

Dilip Abreu suggests paying ratings agencies with some of the securities they rate, which they would then have to hold for a while. Robert Pozen, head of MFS Investment Management, wants independent investors in the conduits to hire the agencies instead. Another idea would have a public body, like the S.E.C., hire the agencies, paying the bills with fees levied on issuers. If you have a better idea, write your legislators.

Might some form of liability for reckless ratings also help? One thing is certain: the cozy relationship between the raters and the rated has to end. Frank Partnoy has been writing about this for some time; he’s probably one of the few who would be unsurprised by this catalog of conflicts compiled by Aaron Lucchetti:

[By 2006, Moody’s] became willing, on occasion, to switch analysts if clients complained. An executive overseeing mortgage ratings went skydiving with a client. . . . [Profits at Moody’s] rose 375% in six years. The share price quintupled. . . . As Moody’s staff grew to accommodate the surging mortgage market, [a top executive] arranged off-site meetings for employees to get to know each other better. At one, he sung as a Blues Brother, while at another, two Moody’s executives entertained by wrestling in fat suits.

When the de facto market regulators are aping Austin Powers movies, something’s gotta give.

Frank Pasquale

Frank is Professor of Law at the University of Maryland. His research agenda focuses on challenges posed to information law by rapidly changing technology, particularly in the health care, internet, and finance industries.

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