Last Friday, Carl Levin, chair of the Senate Permanent Subcommittee On Investigations rang the alarm. Congress has aimed a spotlight on critical issues such as moral hazard engendered by a “too big to fail policy.” The ability of large financial institutions to employ products or strategies that recklessly or intentionally create excessive risk is a national and arguably global concern. Senator Levin warned, however, that effective reform of financial markets will also require addressing the role of secondary actors, like credit rating agencies. (See here.)
Between 2002 and 2007, each of the three largest credit rating agencies earned more than $6 billion a year, double their annual revenues for years past. (See here.) The increased revenues came largely from rating complex credit derivative instruments. While testimony continues to emerge from various legislative committees, few contest the need to address the central and critical role that credit rating agencies played in the most recent financial crisis. The creation of collateralized debt obligation (CDO) introduced a nascent industry centered on pooling and packaging home mortgage debt. The CDOs offered rights to receive periodic payments from the cash flows associated with specified bundles of home mortgages. Each CDO received a rating from two nationally recognized credit rating agencies. Investors viewed credit rating agencies as gatekeepers who issued independent, fair and accurate assessments of the value of these instruments. Last Friday’s hearing charged credit rating agencies with recklessly assigning ratings. Some have alleged collaboration with the banks that packaged and sold the bonds.
The current financial reform bills in the House and the Senate do address some of these concerns – requiring credit rating agencies to register with the SEC and to offer greater transparency regarding their rating methodologies. There is also a call to adopt an express private right of action to allow investors to sue credit rating agencies – a path that had been closed by judicial decisions protecting credit ratings under the First Amendment.
Ultimately, however, it seems that the stickiest issue underlying the role of the credit rating agencies in the crisis may be the conflict of interest inherent in the issuer pay model. Bond issuers pay credit rating agencies for the ratings issued on the bonds that the issuers hope to distribute. When dissatisfied with the ratings, issuers may shop for a different opinion.
Failing to address the conflict of interest created by the issuer pay model creates an opportunity for continued market manipulation. Arguing that we cannot adopt legislation unless we can contemporaneously fix every open issue may undermine reform because legislators lack the crystal ball required to predict the antecedents of all future crises. Reform should, however, address identified and correctable issues from a comprehensive perspective, or else we will find ourselves reacting to the next crisis or running to shove our fingers and toes into each new hole in the buckling dam of financial markets regulation.