Nationalize the rating agencies!

Why should we trust the likes of Moody's with judging creditworthiness, when their profits depend on keeping clients happy?

Published April 23, 2008 9:39PM (EDT)

In "The Ratings Game," an investigation of the role played by the credit rating agencies in Wall Street's recent woes that will appear in Sunday's New York Times Magazine, financial reporter Roger Lowenstein knocks another one out of the park. The author of a very good biography of Warren Buffett, and an entertaining account of the demise of the hedge fund Long Term Capital Management, "> Lowenstein is one of the best in the business at the task of demystifying the inscrutabilities of high finance.

Among other delights, "The Ratings Game" provides a lucid dissection of the chicanery otherwise known as "structured finance" and possibly the best explanation yet of how subprime mortgage loans were miraculously transformed into gold-plated securities. Much of it will be familiar to those who have been following along as the credit crunch has unfolded. But one data point was new to me.

The Big Three ratings agencies, Moody's, Standard & Poors, and Fitch, began as completely private entities. But in the wake of the startling corporate bankruptcy of Penn Central in 1970, says Lowenstein, people began to pay more attention to the problem of credit risk and pressure grew on the government to do something to protect investors from getting burned.

Government responded. The Securities and Exchange Commission, faced with the question of how to measure the capital of broker-dealers, decided to penalize brokers for holding bonds that were less than investment-grade (the term applies to Moody's 10 top grades). This prompted a question: investment grade according to whom? The S.E.C. opted to create a new category of officially designated rating agencies, and grandfathered the big three -- S.&P., Moody's and Fitch. In effect, the government outsourced its regulatory function to three for-profit companies.

The conflict of interest spawned by this arrangement is obvious. The creators of new securities pay the agencies to get their "paper" rated. But if they don't get the Aaa "investment-grade" rating that they desire from one agency, they might just take their business to another. The structural imperative of the market forced the ratings agencies to give everyone a gold star.

So here's a very specific regulatory suggestion. In-source the ratings game. Make evaluating the creditworthiness of new securities the responsibility of the Fed, or the SEC. The private sector proved itself manifestly incapable of guarding its own henhouse in the case of collateralized debt obligations tied to subprime mortgages. Why should we think they'll do any better when the next round of "innovation" comes down the pike? And who knows? Maybe it will even be cheaper for the government to nationalize the credit ratings game than to bail out investment banks before they blow up.

By Andrew Leonard

Andrew Leonard is a staff writer at Salon. On Twitter, @koxinga21.

MORE FROM Andrew Leonard

Related Topics ------------------------------------------

Globalization How The World Works