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Unleash the investment risk watchdogs

- The Washington Times - Thursday, November 27, 2008

ANALYSIS/OPINION:

Washington has already spent $350 billion trying to stabilize the housing and financial markets, and it's still trying to figure out how on earth we got into this mess in the first place. One of the biggest puzzles is why the credit-rating agencies were apparently asleep at the switch.

These private agencies, with household names like Moody's and Standard & Poor's, issue ratings for bonds and similar investments issued by corporations and even governments. They are supposed to give investors a yardstick for measuring the soundness of bonds and securities.

They certainly failed to spot the subprime market fiasco and resulting meltdown. But it turns out that they have a history of failing to give investors adequate warning. They only gave a few days warning, for instance, that Enron was headed for bankruptcy.

Why? To be fair, the exotic complexity of housing-related securities made it impossible for almost anyone to figure out what was really going on and what assets were really worth.

But some researchers argue that the whole business model of the rating agencies is flawed, the result in significant part of federal regulations. And they have proposals to fix that business model so that the agencies would be far better watchdogs in the future.

One of those who have been sounding the alarm is Alex Pollock at the Washington-based American Enterprise Institute for Public Policy Research.

More than three years ago, Mr. Pollock pointed out that the federal Securities and Exchange Commission (SEC) has created an oligopoly, in which Moody's and Standard & Poor's control about 80 percent of the rating market. Add in the distant No. 3 rating service — Fitch — and you've encompassed about 95 percent of the market.

The SEC encouraged this cozy cartel by instituting a government seal of approval. It designates certain rating firms as "nationally recognized statistical rating organizations" (NRSRO). But to get this SEC seal it must already be one of the largest, well-known rating firms. Because companies issuing bonds and securities typically get two ratings to bolster sales, the three big government-approved rating firms really don't have to compete with each other.

There's another problem with this sweetheart situation. As my Heritage Foundation colleague David John points out, the larger rating firms actually get paid by the very companies that issue the bonds or securities they rate.

Just imagine if Consumer Reports financed itself by accepting payments from car companies or TV makers to rate their products.

This good-ol'-boy system needs an overhaul — one that will restore investor confidence and improve the quality of ratings by making the process more competitive. True competition would give rating firms more incentive to take a much closer look at bonds and securities in the future.

At the very least, says Mr. Pollock, the government should make clear that NRSRO status merely means you have met the government's requirements, not that you have a great track record at spotting the stars and the dogs. The SEC should widen competition by dropping its anti-competitive NRSRO requirement that a rating firm must already be one of the biggest players in the market.

Moreover, Mr. John calls on the SEC to "rate the raters," supplying data on the track record of each rating firm. Even more important, he says, it's time to end the pay-for-my-rating business model that is such a conflict of interest.

Investors — not issuers of bonds and securities — should pay for rating services. Before 1970, the ratings agencies charged investors - pension funds, mutual funds, banks, etc. - for providing their assessments. Those commercial customers buy the vast majority of securities. It's time to return to that way of doing business.

There's plenty of blame to go around for the failure to anticipate the crash that has cost millions of Americans much of their savings. Government pressure on mortgage companies to lend to risky borrowers helped trigger the initial collapse. Incompetent and frankly corrupt congressional oversight made it worse.

But the government has also fostered a cozy rating system with poor incentives. Competition and reform would help rouse from their stupor rating services that should function as watchdogs for investors, not lapdogs of the sellers.

Stuart Butler is vice president for domestic policy issues for the Heritage Foundation (heritage.org).