Rating Agency "Reform" Cut to "Study"

When it comes to the post-crisis world of American finance, there’s one thing we can all agree on:

Something’s got to give when it comes to ratings agencies.

Over the past decade, we’ve all witnessed the “big three’s” role in the credit crisis. S&P, Moody’s and Fitch gave their famous AAA ratings to an array of troubled securities, companies and nations. Not only did they issue the wrong ratings – and correct those ratings far too late – but their dubious business model was put under the spotlight, too… ripe with conflict of interest and suspicious relationships with their Wall Street clients.

Thus, rating agency reform would appear to be a legislative home run…a slow moving softball pitched right into the sweetspot of financial reform.

Well, Congress just effectively whiffed.

Earlier this week, the House and Senate removed the one amendment in the coming financial reform bill that addressed the ratings agencies. In its place – really, you can’t make this stuff up – Congress will commission a two-year SEC study. The SEC, apparently not busy enough, will spend the next couple years poking and prodding the agencies and ultimately deliver Congress a report, which will announce whether a conflict of interest really does exist, and the Commission’s advice as to how to fix it.

Now, we will admit, the “reform” that this study will replace was a complicated mess. The brainchild of Senator Franken, it was a plan all too typical of Washington: The amendment would have empowered the SEC to set up a new agency with its own fun acronym (the Credit Rating Agency Board, or CRAB) which would in turn give the ratings agencies new sets of hoops to jump through and papers to file. In short, we don’t’ blame Congress for wanting a different solution.

But a commissioned study by the SEC? C’mon.

What Congress ought to do is act, not create a sub-panel, or a study, or punt this to the next class of congressmen (which is essentially what this study is doing). What’s needed is a tough decision – one that will have immediate consequences and send a message to the ratings world: Either get it right, or as Donald Trump would say, “you’re fired.”

We certainly don’t have a monopoly on all the right ideas, but why not start by stripping S&P, Moody’s and Fitch of their status as Nationally Recognized Statistical Ratings Organizations? The SEC bestows such a distinction. Basically, the biggest, best, most trusted raters in the world are given the NRSRO seal of approval, which is supposed to assure clients and investors that they’re trustworthy. It’s one of the central reasons why the “big three” have such a chokehold on the ratings universe. Only seven other firms – in the entire world – hold the distinction.

So, how do you get this SEC blessing? Read their explanation… and try not to snicker:

“The single most important factor in the Commission staff’s assessment of NRSRO status is whether the rating agency is ‘nationally recognized’ in the United States as an issuer of credible and reliable ratings by the predominant users of securities ratings.”

Are S&P, Moody’s and Fitch not “nationally recognized” fools, at best? Is there a living soul left that would consider their ratings “credible and reliable?” Here are some more SEC standards for the NRSRO privilege:

“The [SEC] staff also reviews the operational capability and reliability of each rating organization. Included within this assessment are… the rating organization’s independence from the companies it rates… the rating organization’s rating procedures (to determine whether it has systematic procedures designed to produce credible and accurate ratings)…”

Ha!

So, we ask the SEC and Congress: Why not remove the “big three” from this club? In fact, since the credit crisis has proved this NRSRO status to be largely useless, why not abolish the designation all together? It’s a rare situation in business legislation that a level playing field isn’t a good thing…and this doesn’t seem to be one of ’em.

And if it was, in fact, the SEC’s own NRSRO system that empowered the big three to make such awful mistakes, what faith should we have that this new study – to be conducted by the SEC – will be of any use?

In the meantime, we can’t help but wonder if shares of ratings agencies and their parent companies are a contrarian buy. Both the American free market and legislature has shown the will to reform and revolutionize this sector, but now more than ever, it appears no one will have the stones to do it. Thus, despite being so universally disliked, at this stage it’s hard to see the “big three” doing anything else but business as usual.

Ian Mathias
for The Daily Reckoning

P.S. As of this writing, ratings agency reform isn’t entirely dead in the water. One item in the financial reform bill, 436(g), alters the liability exception currently granted to the raters. In essence, it would allow investors and clients to sue the raters – if the plaintiffs can prove “knowing and reckless” conduct on the raters’ behalf.

In medical parlance, that’s really addressing a symptom, not the disease. And proving that any of these agencies were willfully out of conduct will be no small feat. We’d also expect Big Three lawyers and lobbyists to make damn sure that, if this provision becomes law, there won’t be any claw-back stipulations that would allow plaintiffs to sue for past digressions…like 2005-2008, the biggest ratings folly the world has ever known.