Free the Ratings Agencies

The Financial Crisis Inquire Commission was focused on the ratings agencies today. This comes at a timely moment, given that Congress (well, at least the democrats in both the House and Senate) is about to convene a conference to determine what to keep from the bills passed by both legislative chambers on changing Wall Street rules… including rating agency reform.

There are two different approaches to rating agency reform in the bills. One removes the government from rating agency approval. The other digs federal talons deeper into the rating agency game. As I discussed in an article on this a few weeks ago,

The Franken amendment would attempt to remedy this situation by allowing the SEC to assign rating agencies to certain securities. But this completely misses the point of why the current rating agency regime is failing and so convoluted: government sponsorship distorts market signals. The Franken amendment will take the current distortion and expand it, meaning credit rating agencies will carry an even stronger stamp of approval.

Today, The Wall Street Journal pointed out another piece in this rating agency reform debate.

The political problem now is that the mutual fund industry is lobbying to maintain the cartel. Both regulators and fund managers have figured out that doing their own analysis to decide what constitutes an “investment-grade” bond is hard work. But if some third party (such as Moody’s) has deemed a bond safe, no one can second-guess the mutual fund for owning it.

To put a finer point on it, the raters give mutual funds a shield from lawsuits if their investments go sour. All the more so because the Senate and House reform bills contain provisions that will make it much easier for plaintiffs attorneys to sue the credit raters. As long as the cartel remains, everyone is covered—except the individual investor, who loses money when the cartel members rate the next Enron as highly as they rated the last one.

See the whole WSJ op-ed here.

See my commentary on ratings agencies here.