You hardly need a headline in Le Monde to tell you "Nous sommes tous resident mortgage-backed securities holders."
On some level, the feelings of economic vulnerability and helplessness in the latest crunch may rival the uncertainty and fear over national security after Sept. 11. As the financial crisis spreads across geographical and industry borders, and imperils countless businesses, homes and livelihoods, WorldCom Inc. and Enron Corp. seem not-so-distant memories. There are numerous reminders, from Sarbanes-Oxley to warrantless wiretapping and the invasion of Iraq, that the law of unintended consequences applies to legislation and acts of the administration.
In addition to reviving the economy, President-elect Obama and the new Congress will have to fix the systemic issues underlying the problems.
The credit ratings agencies, and the rosy view they took of deeply troubled securities, are an easy place to start. The Securities and Exchange Commission addressed the rules governing the so-called nationally recognized statistical ratings organizations, or NRSROs, or credit agencies. Current rules require many firms to invest only in securities with favorable ratings from an NRSRO, so any flaws in their models can easily affect a swath of the investment community.
Securities and Exchange Commission Chairman Christopher Cox and other commissioners spoke at length of making the credit ratings more transparent and more competitive, eliminating conflicts of interest and otherwise rendering them less prone to faulty judgment. The SEC punted on one of the key questions, whether the government should continue to enshrine the agencies in securities rules.
The largest credit ratings agencies, Fitch Ratings Inc., Moody's Investors Service Inc. and Standard & Poor's Ratings Services, are paid by issuers of securities they rate. The new rules require them to make samples of their ratings histories public so investors can gauge their accuracy. There are measures that are meant to reassure the markets that ratings are not affected by issuers' fees. When a rating diverges from the risk implied by a firm's models, the agency would have to explain why. Gifts worth more than $25 are prohibited. Employees who work on an issuer's ratings cannot be involved in fee negotiations.
The major agencies say they support the SEC's goals of greater reliability, independence and transparency in credit ratings. They have taken steps, and are taking more, to restore confidence in the capital markets. While the SEC implemented new rules, it shunned bolder moves. Larry White, professor of economics at New York University's Stern School of Business, says the SEC went in "exactly the wrong direction" in its December decision.
The SEC made two sets of proposals during the summer. One entailed detailed regulation of what the ratings agencies do and how they do it, he says. The other suggested backing away from the NRSRO structure. "Unfortunately, the actions are following the course of the first set of proposals and not following the course of the second, and I think that is a major error in policy."
The SEC considered removing the term NRSRO from many of its rules this year. During the December hearing, Commissioner Kathleen Casey acknowledged the SEC may have inadvertently given the impression that "we were somehow anointing those NRSROs and elevating their status." The commission did not rule on whether to remove the NRSRO requirement.
Stern professor White says the SEC "more than anointed" the large ratings agencies. "They artificially thrust them into the center of the whole bond market structure."
Sean Egan, managing director and co-founder of Egan-Jones Ratings Co., calls the commission's actions "window dressing." Says Egan: "It doesn't address the underlying problem, the natural incentive for issuer-supported ratings firms to generally inflate ratings. In our view the current system is set up for serial failures, and that's exactly what we've experienced."
Part of the debate centers on the business model and who should pay for ratings. The large agencies moved toward an "issuer pays" business model and away from charging subscribers in the 1970s. "It is very clear that on its own it hasn't worked," Egan says of the issuer-pays model.
Either model can present conflicts. Issuers want high ratings because they lower the cost of borrowing. All things equal, investors benefit from lower ratings because riskier securities pay higher interest. "We believe the key is how well potential conflicts are managed," a Moody's spokesman says. In the issuer-pays model, all ratings changes are released to the public simultaneously and at no cost. "Larger, wealthier parties therefore no longer have an advantage over smaller rivals," he says.
Beyond the structural question of who pays, there is the practical matter of how much a business model really helps or hinders an agency as it tries to foresee a company's problems or a market collapse. Would an agency's ratings be more acute under different business models?
"No," says Jonathan Macey, deputy dean and professor of law at Yale University and at the Yale School of Management.
Macey does not dispute that Egan-Jones, which charges subscribers rather than issuers, has been more accurate than the Big Three in ratings on many occasions.
But he suggests that would still have been the case if the firm charged issuers.
"Egan-Jones, for many, many years, unlike S&P and Fitch, did not receive from the SEC an NRSRO designation," Macey says. "So people didn't hire them for regulatory reasons. People hired them because they had high quality."
The government has increased competition among credit ratings agencies by expanding the number of NRSROs. The list now includes A.M. Best Co., DBRS Ltd., Egan-Jones, Fitch, Japan Credit Rating Agency Ltd., Lace Financial Corp., Moody's, Rating and Investment Information Inc., Realpoint LLC and S&P. Still, Standard & Poor's, Moody's Investors Service and Fitch Ratings account for roughly 98% of total ratings and collect 90% of the revenue.
Macey says you don't solve the problems by letting Egan-Jones and others into the cartel. You do away with the cartel itself. Get rid of the whole NRSRO charade," Macey says, which would put the responsibility for evaluating the quality of a security on the investor and its board.
Mandatory ratings provide "illusory camouflage" for people who "aren't making thorough investigations" before investing, Macey says. "They say, 'You can't blame me because the [collateralized debt obligation] is rated AAA by Moody's and Standard and Poor's.' "
The argument for requiring reliance on the credit ratings agencies is that, whatever potential bias the business model may apply, they are a third party. "It would be a bad idea to take ratings out of the money market fund rules and out of the net capital rule," says Hardy Callcott of Bingham McCutchen LLP, formerly general counsel at Charles Schwab & Co. "Even with their flaws, it's better to have those ratings done by independent ratings agencies rather than the firms themselves rating securities they hold."
If deeper changes are made, they may have to come from outside the SEC. Callcott says Congress has given regulators only limited authority over ratings agencies. The SEC can rule on conflict of interest and disclosure, but not on larger issues such as the actual quality of the ratings.
Moreover, the NRSROs are not just creatures of the SEC. References to the official credit agencies are embedded in the rules set by Treasury and other government bodies.
"It is really quite insidious," Yale's Macey says. "It's like some kind of weird, horror-movie blob that has kind of metastasized itself into the skeletal infrastructure of the economy."
As metaphors go, The Blob is almost quaint and reassuringly outdated, compared with the shadowy nature of contemporary derivatives and the greater economic quandary.
Removing the references to the ratings agencies would involve challenging the status quo, which can be daunting in its own right. Whether the new government revisits the rules could provide an early glimpse of what change means to the Obama administration.