Credit rating agencies are no longer first rate

by Jackie Speier 

San Francisco Chronicle

December 17, 2008 
 
If a straight A student flunks her final exam, her grade-point average also takes a hit. Why, then, do corporations on the verge of bankruptcy retain their stellar credit ratings? A few weeks ago, at a meeting of the House Committee on Oversight and Government Reform, I hoped to get an answer for this. Unfortunately, all that was offered by executives representing the three largest credit-rating agencies - Standard and Poor's, Moody's and Fitch Ratings - were excuses.

Credit-rating agencies were established in the 1920s as a safeguard for investors. For decades, investors paid the agencies to evaluate and rate bonds in an unbiased manner. Then, in the 1970s, the Securities and Exchange Commission transformed the agencies by requiring institutions to acquire bond ratings before bringing bonds to market. What was once a responsibility to protect buyers often became a responsibility to ensure the bond sellers a more profitable product.

The agency executives defended this transformation by asserting that their firms' trustworthiness is guaranteed because their reputations are on the line with each rating. But e-mail conversations presented at the hearing between employees expressed a different view.

One Standard & Poor's staffer commented that a bond "could be structured by cows and we would rate it" as another answered wistfully, "Let's hope we are all wealthy and retired by the time this house of cards falters."

Decisions like these have serious consequences. In my congressional district, which covers San Mateo and San Francisco counties, an investment account used by local governments and school districts lost $150 million when Lehman Bros. went belly-up. Much of the blame for our financial situation has been placed at the feet of the subprime mortgage market, and rightfully so. But foreclosures among subprime mortgage holders began to spike in the summer of 2005 and by the start of 2006, home prices were falling nationwide. But until 2007, the ratings agencies hadn't made any significant move to downgrade financial instruments containing mortgage-backed securities.

On Dec. 7, the New York Times reported that in 2005, Moody's "graded a pool of securities underwritten by Countrywide Financial, the nation's largest mortgage lender. But Countrywide complained that the assessment was too tough. The next day, Moody's changed its rating, even though no new and significant information had come to light..."

Something must be done to return confidence to our financial markets.  Here are four ideas:

1) Pay rating agencies from a fund that is paid into by bond sellers, similar to the method the Food and Drug Administration uses to fund drug research. This arm's-length transaction would return the rating agencies to answering to investors.

2) Prohibit rating agencies from providing consulting services to the institutions they rate.

3) Create a Consumer Financial Products Safety Commission. Like the Consumer Products Safety Commission is empowered to stop dangerous toys and other products from being sold, a financial productions commission would have the authority to prevent overly risky financial instruments from reaching market.

4) Provide better transparency of mortgage-backed securities by allowing easier access to information documenting their likelihood of default.

Our capitalist system has benefited America in countless ways. The idea that anyone can "pull themselves up by their bootstraps" is a dearly held tenet of American society. But capitalism, unchecked by reasonable regulation, can be dangerous. The new administration and Congress will have much on our plates. The survival of the auto industry, revitalizing our health care system and taking steps toward a cleaner energy policy are all vitally important. But there is no task more central to the future soundness of our economy than reforming the way credit-rating agencies do business.

(Jackie Speier represents the southwest quarter of San Francisco and most of San Mateo County in the U.S. House of Representatives.)