Why Ratings Are Failing Us

Several months ago, I received a call from an investment officer of a French insurance firm who was spitting mad about his experience in the U.S. credit market. This guy had been told by his investment committee to purchase only high-quality bonds in the U.S. for his portfolio. So he invested in AAA-rated securities offered by major investment banks.

Unfortunately, he invested in the wrong AAAs—his were cut to D in only two days during the height of the credit crunch. He thought he was going to get back his investment and a little tip (that is, about 3 percent). Instead, he was told he would receive absolutely nothing. That is where the spitting-mad part comes in—"highway robbery," "fraud," "corrupt investment banks," "corrupt rating firms" and "corrupt regulators" were a few of the phrases he threw out in the course of the phone call. The sentiments of this gentleman are felt by many others, and I suspect we will not move beyond this credit crisis, the worst we've seen since the 1930s, until some structural problems within our credit-rating system are fixed.

The rating industry has been under fire—and rightly so—because so many securities that were rated at or near AAA later experienced massive losses, thereby causing widespread market disruptions. AIG, MBIA, Ambac and a slew of lesser-known AAAs have lost their coveted top-tier ratings. To better understand the problem, a little history is helpful. From the early 1900s until the mid-1970s, S&P and Moody's were paid by investors; if the raters assigned inaccurate ratings, they lost revenues. This time-tested system unfortunately morphed as bonds became a primary means for funding corporations, and various regulations and investment guidelines required ratings. Issuers of debt now provide 90 percent of the revenues for rating agencies. Naturally, they want the highest rating possible to reduce the cost of issuing debt. So, with the help of investment bankers, companies now go shopping to obtain the highest rating. Whether it's Moody's, S&P or Fitch, they simply select whichever firm gives them the rating they like best.

In this system, a conservative rating firm would turn out to be an underemployed rating firm—or, worse yet, it would be threatened with litigation. MBIA—an insurance firm that provided guarantees on some of the most toxic assets, such as mortgage-backed securities and collateralized debt offerings during the course of this financial crisis —has seen its shares plunge from $80 to less than $5 over the past 18 months. Yet prior to the implosion, MBIA threatened to sue independent firms like mine, which warned about its problems, claiming that we weren't privy to the same level of information as S&P, Moody's or Fitch.

The fact that rating firms (unlike Arthur Andersen in the Enron situation) are protected from liability for malfeasance because ratings are deemed "speech" protected by the First Amendment actually adds more fuel to the fire. Firms can knowingly give a security a higher-than-deserved grade, safe in the knowledge that they can't be prosecuted for their "opinions." All this has led inevitably to a disastrous failure of due diligence.

What's the solution? Some market observers have argued for banning the rating firms. Yet investors must have some efficient means to assess the multitude of securities in the market; they simply can't do all the legwork themselves. Meanwhile, the Fed continues to support agencies paid by issuers—despite their repeated failure to warn about problems. The only way out is to ban payments by issuers to rating agencies; this would force institutional investors to pick up the tab. They are the ones who need credible ratings in order to make smart investment decisions.

Until some meaningful steps are taken to restore checks and balances, reinstate trust in the rating system and thus reestablish the flow of capital, the economic-stimulus programs and various bailouts are likely to fall far short of the mark. The economy can't recover until people trust that AAA means AAA.