The chilling realization that some things in high finance will never change, notwithstanding the current crisis, came to me the other day when I discovered that the Federal Reserve would accept only AAA-rated securities as collateral for its new program to finance consumer loans.
On the surface this seems only prudent -- after all, what could be more gilt-edged than paper given a top investment grade by two of the three most-recognized credit rating agencies, as the Fed demands?
But the problem isn't the ratings. It's the raters. If the mortgage meltdown teaches us anything, it's that the work of the credit rating companies isn't worth the paper it's scribbled on.
The slipshod performance of these firms -- Moody's Investors Service and Standard & Poor's Ratings Services are the largest by far -- was a major contributing factor to the crisis. Yet the raters are so deeply embedded in the financial system that eradicating their pernicious influence may be the toughest regulatory challenge we face.
"They're like a cancer that's spread throughout our law, our banking regulations, our securities regulations, our insurance regulations," Frank Partnoy, who dealt with derivatives as an investment banker and now teaches law at the University of San Diego, told me this week.
By order of the Securities and Exchange Commission, for example, money market funds can't invest in paper below a certain rating. Institutional investors such as pension funds are often barred from buying bonds below a certain grade.
That means a rating firm's word can determine whether the market for a bond is huge or minuscule. For corporate issuers, a top credit rating is money in the bank because it means lower borrowing costs.
For investment managers, the ratings provide cover for half-baked decisions: If you blow a billion for a pension fund on a bad bond issue, you can always point to the AAA grade it got from Moody's or S&P (or both) and say, "Don't blame me."
Yet the rating process is shot through with conflicts of interest. The agencies get almost all of their income from fees for rating securities, and those fees are paid by the issuers of those securities. As a result, the raters are wary of giving low grades, fearing customers will get ticked off and take their business to a competitor that might be more, shall we say, flexible.
