When Standard & Poor's, the bond-rating agency, lowered General Electric's rating to AA+ from AAA last week, many were shocked at the tarnishing of one of America's most revered corporations. But the real scandal is how long it took S&P to make that minor change — and that the other major ratings firm, Moody's, still hasn't — even though GE's dividend has been slashed by two-thirds and its stock price had fallen below $7, from nearly $40 a year ago.
Why, more than a year into the crisis, do regulators and investors continue to rely on ratings? No one has been more wrong than Moody's and S&P. Less than a year ago both gave high ratings to 11 of the largest distressed financial institutions. They put the insurance giant American International Group in the AA category. They rated Lehman Brothers an A just a month before it collapsed. Until recently, the agencies maintained AAA ratings on thousands of nearly worthless subprime-related securities.
The reason for this continued reliance on ratings is simple: bad regulation. We have seen up close how legal rules that depend on ratings pervert the process. One of us worked at Moody's and was a frequent in-house critic of how the agencies put troubled companies on artificial "watch lists" while they maintained overly optimistic letter ratings. The other of us worked in Morgan Stanley's derivatives group, which designed risky structured products that nevertheless obtained high ratings. These deals were the ancestors of the highly rated subprime mortgage derivatives at the center of the crisis.
The trip down the dysfunctional regulatory path began after the 1929 crash, when Gustav Osterhus, an examiner at the Federal Reserve Bank of New York, proposed a system for weighting the value of a bank's portfolio. He felt regulators needed to be able to express a portfolio's "safety" with letter symbols.
Since then, the number of financial regulations based on ratings has skyrocketed. Money market funds can buy only bonds rated in the top two categories. Banks' capital requirements are lower for highly rated securities. Even federal highway financing depends on credit ratings.
Over time, ratings became valuable not because of their accuracy but because they "unlock" markets; that is, they are a sort of regulatory license that allows money to flow. Moreover, institutional investors came to rely on ratings for contracts that don't even need regulatory approval. Trillions of dollars of derivatives payments depend on ratings. Much of the panic at AIG stemmed from ratings "triggers" embedded in credit default swaps, in which billions of dollars of payments depended on how Moody's and S&P labeled AIG's credit risk.
This has left us in a ratings trap. As more regulators and institutions rely on ratings, the agencies have become increasingly reluctant to downgrade. Even a one-notch downgrade of AIG before it hit the shoals would have saddled it with an extra $8 billion of obligations. It is no coincidence that when government officials were debating the fourth round of AIG bailouts this month, they quietly called on the rating agencies to ensure that they would not downgrade the insurer. In a crisis, downgrading debt can be like firing a bullet into a company's heart.
The system is rife with conflicts of interest. The ratings agencies get a fortune from corporations to evaluate their bonds and naturally don't want to bite the hand that feeds them. Nor do they want to admit a mistake or antagonize investors who might have to sell after a downgrade.
The only way out of the trap is to reduce reliance on ratings. First, regulators should undo the regulation web they began creating during the 1930s. The Securities and Exchange Commission has called for eliminating reliance on ratings, but that proposal has stalled in the face of intense lobbying.
For their part, investors should stop putting ratings-related language into financial contracts. The terms of credit default swaps and other derivatives should be free of ratings-based triggers. Banking supervisors should insist that loan contracts not refer to ratings. Fund sponsors, pension plan administrators and insurance regulators should remove ratings-based criteria.
The financial markets can function without letter ratings. Instead of relying on arbitrary letters, regulators and investors should consider all of the information available about an investment, including market prices.
Finally, regulators and investors should return to the tool they used to assess credit risk before they began delegating responsibility to the credit rating agencies. That tool is called judgment.
Jerome S. Fons is a consultant and former managing director at Moody's. Frank Partnoy is a law professor at the University of San Diego.