Where credit ain’t due: The rating agencies

For once, I agree wholeheartedly with a Wall Street Journal editorial.  (OK, I could do without the mixed sports metaphor in the title (“A Triple-A Punt.” How bush league).  The piece raps the Obama Administration’s new financial reform plan for giving the credit rating agencies a free pass.  Some key excerpts:

‘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.”. . .

‘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.

‘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?’

That last point about CDS contracts outperforming the rating agencies as identifiers of default risks is important to keep in mind.  CDS contracts themselves played no small role in the crisis, yet CDS spreads do seem to provide extremely valuable market signals.  Mend them, don’t end them.

The editorial seems to imply that the rating agencies are superfluous at best.  I have to think that they once performed a valuable service and in many cases still do, but that meaningful reform would open that industry up to real competition instead of continuing a government-sanctioned oligopoly (the Moody’s/S&P/Fitch seal of approval is valued because the government gave them and only them its seal of approval) and would end the conflict of interest of having companies pay the rating agencies directly.

More to come on this big topic, especially as Congress weighs in on the reform plan.

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One Response to “Where credit ain’t due: The rating agencies”

  1. democommie Says:

    While the WSJ may be right about the gist of it, they very conveniently omit the fact that they were standing there cheerleading the run-up to Armageddon.

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