Earlier this month, the Justice Department and 16 state attorneys general sued the Standard and Poor’s (S&P) credit-rating agency, accusing the company of improperly inflating the ratings of 40 collateralized debt obligations (CDOs)—essentially, securities made up of other mortgage-backed securities—at the height of the housing bubble. According to the suit, S&P misled investors by rating the risky securities as "triple-A," super-safe investments. But the purchases turned into massive investor losses when the bonds failed after the bubble collapsed. Using emails and other communications, state, and federal prosecutors will seek to prove that S&P knew the securities were junk but rated them highly for the most obvious of reasons: to make more money.
The lawsuit gets at a major problem at the heart of the credit-rating business: Rather than investors paying rating agencies to assess the value of securities it is the issuers of the securities themselves who pick up the tab. It is naturally in the interest of issuers—typically big banks—for rating agencies to rate their products highly, which increases the chances investors will buy them. Under this "issuer-pays" model, the largest credit-rating agencies then have a strong incentive to highly rate securities for issuers who can give them more business in the future. This is said to be part of the reason rating agencies ignored the risks from the highly complex securities and simply let everything pass; in one communication revealed in the filing, an S&P employee boasted, "It could be structured by cows and we would rate it."
The case against S&P is largely consistent with reports from the Senate Permanent Subcommittee on Investigations and the Financial Crisis Inquiry Commission, which showed that the promise of future profits drove credit-rating agencies to rate toxic securities highly. As Reuters financial reporter Bethany McLean points out, the other big rating-agencies, Fitch and Moody’s, engaged in similar conduct. "The argument can be made that the case against S&P is an indictment of the entire rating agency business model," said Jeffrey Manns, Associate Professor of the George Washington University Law School.
This leads to an obvious question: If the rating agencies have an inherent conflict of interest—something even the Justice Department, which is notoriously averse to prosecuting financial crisis-era cases, sees as illegal activity—why has the government not yet overhauled the way rating agencies get paid? As it turns out, the Dodd-Frank financial-reform law started a process to replace the current payment, but the Securities and Exchange Commission (SEC), which is tasked with writing the final rule, has yet to take action. The sponsors of the overhaul want to pressure regulators to finalize the rule, and eliminate this conflict of interest lurking in the heart of the financial system.
An alternative to the "issuer-pays" model for compensating rating agencies has already been crafted. During the Dodd-Frank debate, Senators Al Franken and Roger Wicker led a bipartisan effort to replace the issuer-pays model. Under the Franken-Wicker proposal, the SEC would create a self-regulating organization comprising various stakeholders that included investors. This new organization would then randomly assign securities to rating agencies. Performance and accuracy would then determine which agencies got more work in the future. Instead of a rating agency having to cater to the whims of the big banks to increase their profits, they would simply have to do their job well.
The Franken-Wicker plan passed with 64 votes in the Senate. But in the Dodd-Frank conference committee, it got watered down. In the final bill, the Government Accountability Office and the SEC were tasked with conducting studies of the current issuer-pays model and its potential alternatives. Under the statute, the SEC must implement either the Franken-Wicker random assignment model or some other solution that it deems more feasible. This gives the SEC significant wiggle-room—the easiest thing to do would be to maintain the status quo, after all.
Nearly two and a half years after the passage of Dodd-Frank, the SEC finally released their study, six months past the deadline. The study, based mostly on public comments solicited by the SEC, suggested that inherent conflicts of interest exist in the issuer-pays model but took no position on what should be done to address the problem; it merely offered a number of alternatives—seven in all—and listed the pros and cons of each according to various individuals and organizations who sent public comments, including the rating agencies themselves. Not surprisingly, most of the comments critical of changing the issuer-pays model came from the industry. In the end, the only firm commitment the SEC made in the study was to do additional study. "The staff recommends that the commission, as a next step, convene a roundtable at which proponents and critics of the… courses of action are invited to discuss the study and its findings," says the report.
This strikes many observers as an effort by the SEC to move the timeline for changes further and further out, and perhaps eventually kill them through delay. As law professor Jeffrey Manns, who submitted one of the public comments to the commission, put it, "They embraced the classic D.C. strategy of kicking the can down the road." He acknowledges the need to be deliberative and careful about what would result in a significant overhaul of the credit rating agencies. "But the SEC has now had two and a half years to think about this," he added. "The concern would be that the longer the SEC takes, the less political will there would be to see this through. The sense of urgency is not as pronounced as it has been."
That’s what Franken and Wicker want to prevent. Last week, they urged the SEC to convene the roundtable, the next step in the process, within the next three months. And they want a written timeline, complete with quarterly updates, for additional steps, including the promulgation of new rules on compensation. "Millions of investors are still reliant on credit ratings that we simply can’t trust," said Franken.
Franken and Wicker got Chuck Schumer, a member of the Democratic leadership, to sign on to their letter to the SEC, giving it additional muscle. "In my time in Washington, I’m struck by how much weight a letter like this carries," said Wicker. "I expect them to follow our model. If they don’t, there are many avenues for enators to take."
Part of the delay, Franken believes, stems from the lack of a fully staffed SEC. The departure of Chairman Mary Schapiro in December put them one commissioner down, and with the subsequent 2-2 deadlock between Democrats and Republicans, no big rules changes have proceeded. But Franken intimated that this offered an opportunity for him and Wicker to exercise more pressure. "We have spoken to all the current commissioners, and we will be speaking to Mary Jo White," Franken said, referring to President Obama’s nominee for chair. "There will be confirmation hearings, chances to talk to her." This wasn’t a sure statement that White’s confirmation could be made smoother with a firm commitment to move forward on an overhaul of the rating agency compensation model, but it was certainly close.
With private securitizations for mortgages nearly non-existent, and the market for asset-backed securities down significantly from its peak in 2006, continued rating agency malfeasance may have less of an impact right now than it did right before the financial crisis. But "the further the crisis retreats,” warns Jeffrey Manns, “the more likely market participants will return to similar patterns."