MFG 2.0

Ratings Agencies = Sub-Prime Culprits

With SEC Chairman Chris Cox's speech this past Wednesday, it seems that the SEC is finally waking up to the fact that the pay-for-play model for the ratings industry is flawed and in need of elimination (or at least total overhaul).

Some operative quotes:

...in reality the negative impacts of these bad policies and practices were spread more broadly throughout the markets by financial instruments that packaged the risky loans into products that carried top credit ratings issued by the world's leading credit rating agencies.

I love the phrase "in reality" being used by the nation's top financial regulator. Where else have you been living, buddy?

And this gem:

Just as significantly, conflicts of interest ingrained into the business models of credit rating agencies were amplified as structured products were specifically designed to achieve high ratings for certain tranches and as credit rating agencies sought to gain business and market share by assisting in this process.

Wow. Who could have foreseen that having ratings agencies get paid by the people they were rating would cause a fundamental conflict of interest?

There was also a class action lawsuit filed against Moody's recently, to wit:

Specifically, the complaint alleges that throughout the Class Period, Defendant misrepresented or failed to disclose that the Company assigned excessively high ratings to bonds backed by risky subprime mortgages including bonds packaged as collateralized debt obligations which was materially misleading to investors concerning the quality and relative risk of these investments. Moreover, even as a downturn in the housing market caused rising delinquencies of the subprime mortgages underlying such bonds, Moody's maintained its excessively high ratings, rather than downgrade the bonds to reflect the true risk of owning subprime-mortgage-backed debt instruments.

The plaintiffs are the Teamsters. It must be fun to sit around the office and contemplate how the Teamsters consider you to be guilty of blowing a couple billion out of their pension fund. (I wonder if AIG sells kneecap insurance?)

As far as I can tell from a little digging, the entire business model depends on each of these three ratings agencies being a "nationally recognized statistical ratings organization" (NRSRO) or trusted enough for other market participants to rely on the ratings. If an entity is required to hold only A rated or above securities, they can depend on Moody's ratings only because the SEC says Moody's is OK to rely on.

If ratings agencies are a necessary evil, the SEC should simply strip the three stooges (S&P, Fitch, Moody's) of their legitimized status and open up the playing field for some other group -- a group that can actually be trusted to evaluate investment instruments, for instance -- to assume the business. It will be interesting to see if someone (perhaps taking advantage of this market opportunity, as well as the excess of financial services specialists currently available on the labor market) starts up a new ratings firm to compete.

Of course that assumes that the free marketeers on Wall Street actually believed in free markets. By now, though, it's clear free markets are for the little people.

(Manufacturing workers, for example.)

TAGS: Innovation
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