Ratings Schmatings

I was at legal conference this week to hear the lawyers’ view of the current state of financial legislation before Congress, legislation attempting to address the origins of the credit crisis. As a member of the industry now – and a non-practicing lawyer – it was interesting to hear the lawyers’ view of things. But what took my thoughts back from musing about the cocktail reception post-event was the last question of the evening (after a very lengthy Powerpoint overview presentation of the bills before Congress and their expected impact and implications for banks). The question came from a lawyer who wanted to get a better handle on what impact the legislation around the credit agencies would have on his clients.

But, honestly, there isn’t much legislation being considered seriously that would do anything to change the way the rating agencies do their business today. (And the answer from the front of the room was “wait and see.”) Nonetheless, the lawyers worry about proposed provisions for increased transparency and publication of their due diligence (though the lawyers can’t really be worrying – it only means more work and more dollars in their pockets). (See Evaluating Risk If Congress Fails to Act on Ratings Agency Reform, by Carol E. Curtis, Securities Industry News, 12/7/09)

The SEC has oversight over the agencies through the Credit Rating Agency Reform Act of 2006, but the Commission’s oversight is in the same vein that it oversees broker-dealers, public companies and investment companies. They require disclosure and policies and procedures to enforce the securities laws. But that doesn’t fix what is broken.

It’s been pretty well documented that throughout the mortgage boom that became a bust that the securitized mortgage products were being rated by agencies well into the pockets of the investment banks that paid them to rate the securities. Due diligence was non-existent – it’s not even clear that the rating agency personnel understood the nature of the products they were rating.

I think the first Naked Emperor here is the whole ratings agency process. The independent third party assessment that these companies are supposedly providing to the investment public is a sham. It’s not worth much, anyway, as we know now. But it’s a requirement by every exchange and regulator and parties to a security issuance. It’s time to rethink this process from the ground up.

Further, the current system provides monopoly status to three firms that have no incentives whatsoever to bite the hands that feed them. It sets up a whole set of principal-agency conflicts in the securities markets that we are just now identifying and beginning to discuss.

The second Naked Emperor exposed here is the apparent inability of the legislative and regulatory bodies to even address the situation – it’s completely broken, everyone knows it – and, apparently, we’re not going to do anything about it.