Proposed Credit Rating Agency Measures Don't Address the Core Problem, According to New Demos Study

As Congress Takes Up Sweeping Financial Reform, Report Urges Fundamental Change of Ratings Agency Model

Washington, DC — With the House of Representatives and a key Senate committee poised to vote on sweeping financial industry reforms, a new report by Demos finds that the proposed remedies fail to fully address the problems that led the credit rating agencies to become key enablers of the housing bubble and Wall Street meltdown.

In Reforming the Ratings Agencies: A Solution that Fits the Problem, Demos senior policy analyst James Lardner traces their errors to the built-in conflict of interest created by a business model in which securities issuers choose and pay the rating agencies directly. Leading figures in the House, the Senate, and the administration (including Securities and Exchange chair Mary Schapiro) have been harshly critical of the rating agencies, and especially of their financial dependence on the securities industry. "Yet the reforms so far proposed by the White House, the SEC, and committee leaders in the House and Senate," the report observes, "would not fundamentally alter the current business model-one that Sen. Charles Schumer (D-NY) has compared to ‘allowing students to pay for their grades.'"

Bills pending in the House and Senate mandate more transparency and legal accountability as well as closer SEC oversight of the rating agencies. "These steps are sensible and needed," the report observes, "but they should be ancillary. The first imperative of reform is to end the practice of letting securities issuers pick their raters."

The report calls for the creation of an independent office to act both as a ratings watchdog and as a clearinghouse, assigning securities offerings to ratings agencies at random. Some legislators portray such a remedy as overly intrusive; yet their reluctance to support wholesale reform leads them toward solutions that might have to be far more intrusive — in order to be effective.

"As long as the current business model is left intact, the rating agencies will be tempted to give security issuers the high ratings they want, and preventing that will be a matter of trying to anticipate, and regulate against, a whole host of specific abuses," Lardner writes.

"Thus, the rating-agency reforms initially put forward in both the House and Senate involve compliance officers, director independence, systems for ‘managing' conflicts of interest, liability reform, and tighter SEC oversight. Compared to the long list of proposed sanctions and safeguards in these measures, the clearinghouse idea offers a relatively straightforward and fairly gentle way to achieve the kind of decisive change that is needed."

Other key findings of the report include:

During the boom years of 2004 to ‘06, S&P and Moody's engaged in what S&P director Richard Gugliada recalled as a "market share war where criteria were relaxed." In August 2004, Moody's made methodology changes that led to higher ratings on subprime mortgage-backed securities. A week later, S&P altered its standards at the urging of an executive who spoke of the ‘threat of losing deals.' "

Between 2002 and 2007, Moody's, Standard & Poors, and Fitch gave Triple A ratings to the vast majority of the roughly $3.2 trillion in mortgage-backed bonds put on the market. Institutional investors around the world "were seduced into buying these high-risk securities by credit ratings that made them out to be as safe as the most conventional corporate and municipal bonds."

During that same period, the profits of the big 3 rating agencies rose from a combined $3 billion in 2002 to more than $6 billion, while their CEOs collected $80 million. For five of those six years, Moody's had the highest profit margins of any publicly held U.S. company.

"The secret of the industry's fabulous success," says Lardner, was "the ability to dispense something precious — an investment-grade rating — without a sense of duty to properly investigate, or even fully understand, the securities involved."

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