It's about time the credit rating agencies owned up to their role in the credit crunch. At this year's globalization hootenanny in Davos, Moody's Investors Service CEO Ray McDaniel admitted that the industry had made mistakes in assigning triple-A ratings to mortgage securities that turned out to be closer to junk. That's a start. And during the American Securitization Forum in Las Vegas last week, both Moody's and Fitch Ratings announced they were changing their methodologies to acknowledge the possibility of such mistakes. Standard & Poor's followed suit last Thursday. In effect, the agencies want to include the equivalent of warning labels on credit ratings on collateralized debt obligations and other types of asset-backed and securitized debt. The idea is to warn investors not to rely exclusively on ratings when deciding whether a piece of such a securitization is worth taking a flier.
That, we suppose, is also progress. But it is hardly enough. After all, credit ratings are already supposed to reflect the worst-case credit scenario for an instrument's issuer. Strictly speaking, that has to do with its ability to pay interest and principal, not with the market value of the issue at any given moment. But most investors no longer buy and hold individual bonds to maturity; even individuals, the proverbial widows and orphans of years past, today invest mostly through mutual funds run by managers compensated to outperform benchmarks, and thus to trade. Are the agencies suggesting that those fund managers not rely on their ratings for that purpose?
Consider the much-prized designation from the Securities and Exchange Commission of nationally recognized statistical rating organization. This imprimatur is a putative source of authority and independence, and was expanded to include four other companies in addition to Moody's, S&P and Fitch after Enron's fraudulent use of off-balance-sheet gizmos showed how little use to investors the investment-grade ratings the company received were. That step, alas, did nothing to prevent the subsequent meltdown of the mortgage market. And while increasing competition beyond the current oligopoly might help, it may not be feasible, as past efforts along those lines came to naught amid industry consolidation.
Ultimately, something must be done about the conflict of interest the firms have in charging issuers for ratings. Although the obvious solutionhaving investors payleads to problems of its own, there are ways around those. For example, the new conflict that might arise in favor of investors could be avoided by setting up an industry pool of fees levied on all institutional investors (and perhaps issuers as well, though not for individual issues or we're back to square one) and shared by the ratings firms.
Some ideas would go further. The International Organization of Securities Commissions, an umbrella group of regulators, suggested last week that an outright ban on the agencies' participation in structured finance might be advisable. Such a ban, of course, would leave investors to demand information from issuers on their own, and that in turn might produce some of the transparency that securitization now sorely lacks. Yet it's hard to see how larger investors in the public markets wouldn't then end up with better information than smaller ones, unless issuers are prompted by, say, the Federal Reserve, which could refuse to lend against securities that didn't meet certain minimum standards of disclosure.
One thing is clear: It's time for U.S. regulators to weigh in. For reasons hard to fathom, the SEC has remained mum. So we were encouraged last week to hear Mary Schapiro, the straight-shooting regulator who put the National Association of Securities Dealers' self-regulatory efforts on a firmer footing after a scandal there in the early 1990s, promise a thorough examination of these issues by the Financial Industry Regulatory Authoritya body formed last July through the combination of the self-regulatory authorities of the NASD and the New York Stock Exchange. Eventually, however, the SEC is going to have to make its own position clear. The sooner, the better. FW