Congress failed to change the way the nation's credit rating agencies do business when it had a chance after the 2008 financial crisis. Now the folly of that failure is apparent again. Standard & Poor's, one of the big three credit rating agencies, is up to its old tricks, handing out higher ratings than its competitors to lure business. The financial incentives under the "issuer pays" model, where the agencies get paid by the bank packaging the security, always will be a problem. Congress should revisit the issue and reform the way the industry works.
It has been only five years since the financial sector's greed and irresponsibility brought the country to the brink of economic collapse and launched the Great Recession. A multitrillion-dollar bailout and recovery is still underway, and employment numbers have yet to fully rebound. The three big credit rating agencies — Moody's, Fitch and S&P — enabled the crisis by handing out gold-plated ratings indicative of the most secure investments to toxic mortgage-backed securities in exchange for fat fees.
After investors lost nearly everything, the credit rating agencies promised to reform. But S&P is handing out disproportionately high ratings on commercial mortgage securities and attracting a flow of business as a result, according to the New York Times.
S&P rejects any conclusions that suggest its ratings are influenced by a conflict of interest. But David Jacob, who ran the S&P division that rated securities after the financial crisis, told the New York Times that he witnessed employees altering criteria in response to business pressures. An independent analysis for the newspaper of certain mortgage-backed securities rated by S&P and its rivals found S&P doling out higher ratings. This has led to the ratings agency tripling its market share in the first half of 2013. S&P is also the only firm of the big three to face a multibillion-dollar government lawsuit that claims it relaxed standards to win business before the crisis.
The financial system still relies to a great extent on the ratings given by the big three agencies. Many institutional investors may only buy instruments that have been given a top AAA rating by one of those firms. The agencies have tightened their ratings standards since 2008, but with S&P becoming more generous, it's only a matter of time before the others follow suit, if only to maintain market share.
In 2010, when Congress passed the Dodd-Frank financial reform law, oversight of the agencies was strengthened. But the law didn't eliminate the inherent conflict of interest in the "issuer pays" model. The law also asked the Securities and Exchange Commission and the Government Accountability Office to study alternative payment schemes, but that hasn't led to needed reforms. There was a time when the buyer of bonds paid for the ratings information, resulting in unbiased, dependable, investor-friendly ratings. It's an idea worth exploring again.