More about credit rating reforms, bills

I have been on a rant about credit rating agencies (S&P, Moody, Fitch) and Wall Street having a conflict of interest when rating new issues. So many of the collateralized debt obligations at the center of the financial meltdown in 2008 were rated AAA by ratings agencies when in fact much of the mortgage debt in those CDO's was junk. There is clear evidence that the agencies did a shoddy job rating mortgage backed securities. They relied on outdated models of the mortgage market and obsolete data on mortgage delinquencies not to mention taking direction from the actual issuers when attempting to rate securities. In addition, it is now known that ratings analysts advised investment bankers on how to structure securities to gain the coveted AAA rating. Last time I checked, that is cheating.

Investment bankers packaging securities wanted AAA ratings because many potential institutional investors (such as mutual funds) were allowed to invest only in high rated securities. These mutual funds were for conservative investors who were interested in preservation of principal and some income.

Rating junk or delinquent mortgages as AAA was a clear conflict of interest, but the ratings analysts knew that if they did not provide the desired rating, the investment bankers would take their business elsewhere. At that point, what value could investors place on these ratings? Most investors were not even aware that all these shenanigans were going on and if they were mutual fund investors, their prospectus did not disclose the dangers hidden in mortgage backed securities.

Currently, the Senate has approved an amendment to it's financial reform bill, sponsored by none other than Sen. Al Franken D-Minn, under who the Securities and Exchange Commission would establish an independent board charged with assigning which rating agency would evaluate each new structured financial security.The issuer would no longer be able to choose which agency they wished to use for ratings. No longer would issuers be able to shop for more favorable ratings on their securities, playing one agency against the other. Credit analysts would no longer be incented to tailor their ratings to the wishes of the issuer, but actually put the needs of the investor first. Wow, what a concept!

When I read this, I just shook my head. Credit ratings agencies were always supposed to put the investor first and if all of them had stuck to their guns and stuck together, the investment banks could not have manipulated them. It was all pure greed and how many people worldwide have had to pay the price.

I see two potential problems in the Franken plan of doling out business to the ratings agencies. First, it is not the way the free market works and there is the possibility of "agency capture." This happens when employees of a government agency develop close relationships with those they regulate, leading to lax oversight and favoritism. Agencies that are not "in favor" with those doling out the work could find themselves cutting corners on research to sustain profitability.

A possible offset to these flaws is that both the House and Senate reform bills attempt to make it easier for investors to sue the ratings agencies for false or misleading statements about the securities that they rate. This may provide some additional incentive to keep things honest.

I think it is a sad thing that we have come to this. When I was an advisor, I used and trusted the research of the ratings agencies. I sold a lot of individual bonds and without the ratings agencies doing most of the work, I would have been pouring through red herrings and research reports all night.

I find it disturbing that people have to be forced into doing the right thing anymore. It is hard enough anymore to have faith in Wall Street, but not knowing if you can trust the ratings agencies makes you feel that buying certain securities may be nothing more than a crapshoot.

• Carol Perry has been a Northern Nevada resident since 1983. You can reach her at carol_perry@worldnet.att.net.