Treasury's reform plan gives the credit raters a pass

A Triple-A Punt. WSJ Editorial
Treasury's reform plan gives the credit raters a pass.
The Wall Street Journal, Jun 22, 2009, p A14

If world-class lobbying could win a Stanley Cup, the credit-ratings caucus would be skating a victory lap this week. The Obama plan for financial re-regulation leaves unscathed this favored class of businesses whose fingerprints are all over the credit meltdown.

The government-anointed judges of risk at Standard & Poor's, Moody's and Fitch inflicted upon investors the AAA-rated subprime mortgage-backed security. They also inflicted upon the world's nest eggs the even more opaque AAA-rated collateralized debt obligation (CDO). Without the ratings agency seal of approval -- required by SEC, Federal Reserve and state regulation for many institutional investors -- it would have been nearly impossible to market the structured financial products at the heart of the crisis. Yet Team Obama suggests only that regulators reduce the agencies' favored role "wherever possible."

It's a revealing phrase, implying that there are situations when it's appropriate to rely on ratings from the big three instead of actually analyzing a potential investment. Can anyone name one? Probably not, which makes one wonder how the ratings-agency lobby could be so effective.

The truth is that the strongest defenders of this flawed system are mutual funds, state pension administrators and the federal regulators now managing the various bailout programs. Digging into the underlying assets in a pool of mortgages or judging the credit risk in a collection of auto loans is hard work. But putting taxpayer or investor money in something labeled "triple-A" is easy. Everyone is covered if the government's favorite credit raters have signed off.

The Obama plan also calls for regulators to "minimize" the ability of banks to use highly-rated securities to reduce their capital requirements when they have not actually reduced their risks. Minimize, not eliminate? Does the Treasury believe that some baseline level of fakery is acceptable in bank financial statements? To review, a critical ingredient in the meltdown was the Basel banking standards pushed by the Federal Reserve. Among other problems, Basel allowed Wall Street firms to claim that highly-rated mortgage-backed securities on their books were almost as good as cash as a capital standard.

The Obama plan does make plenty of vague suggestions, similar to those proposed by the rating agencies themselves, to improve oversight of the ratings process and better manage conflicts of interest. The Obama Treasury has even adopted the favorite public relations strategy of the ratings agency lobby: Blame the victim. "Market discipline broke down as investors relied excessively on credit rating agencies," says this week's Treasury reform white paper. After regulators spent decades explicitly demanding that banks and mutual funds hold securities rated by the big rating agencies, regulators now have the nerve to blame investors for paying attention to the ratings.

Even the Fed, which until recently would accept as collateral only securities that had been rated by S&P, Moody's or Fitch, has lately acknowledged the flaws in this approach. The New York Fed has anointed two more firms, DBRS and Realpoint, to judge the default risk of commercial mortgage-backed securities eligible for the Term Asset-Backed Securities Loan Facility (TALF). Since the passage of a 2006 law intended to promote competition, the SEC has also approved new firms to rate securities that money market funds and brokerages are required to hold.
But inviting more firms to become members of this exclusive club isn't the answer. As long as government requires investors to pay for a service, and then selects which businesses may provide it, it's unlikely investors will get their money's worth. History says it's more likely that investors who use the agencies' "investment-grade" ratings as a guide will be exposed to severe losses -- ask people who went long on Enron and WorldCom.

It's time to let markets decide how to judge creditworthiness. One lesson of the crisis is that the unregulated credit default swap (CDS) market provided a more accurate measurement of the risk of financial firms than the government's chosen ratings system. Apparently even the largest provider of these government-required ratings, S&P, has taken this lesson to heart. The company recently introduced a new "Market Derived Signals" model that incorporates the prices of CDS contracts "to create a measure that facilitates the interpretation of market information."

This looks like a signal that even the prime beneficiaries of a government policy believe that the policy failed. So why won't the Obama Administration embrace real reform?