there's a reason that the best food critics dine in disguise.
if it were even perceived that they received favorable treatment-and, consequently, an ulterior motive-to pen a positive review, they would be out of business.
so why do we tolerate such dubious behavior on the part of our credit rating agencies and their assignment of risk to securities? their conduct in this exact fashion contributed to the meltdown of the financial sector. now, their very existence is in jeopardy.
but to restore investor trust and maintain the efficiency of our free markets, ratings firms simply need to be reformed in three critical ways: 1) removing the incentives that pair their interests with those of banks; 2) injecting more accountability into the ratings process; and 3) adding more transparency to their decisions.
first, let's recall how credit rating agencies are supposed to function. they use models to evaluate the risks of bonds or other debt-like securities. investors then rely on these evaluations when deciding whether to buy, sell or hold. by disseminating information via an easy-to-understand grading system, the agencies bring fairness to the capital markets and open them to a wider investor pool. only that's not how it worked.
not only did moody's, standard and poor's and fitch use models that were seriously flawed (all three listed bear stearns as investment grade on the day it collapsed), they did a healthy business consulting investment banks on how to engineer shaky securities so they'd win favorable ratings.
in other words, they got paid to tell folks how to obtain their seal of approval. this practice proved lucrative-almost half of moody's 2006 revenue came from its structured finance activities. but with the structured finance market essentially dead, now is an easy time to take the first step toward reform and shut down these suspect consulting services.
on the issue of accountability, the ratings agencies have legal immunity from investors because courts view their evaluations as something like newspaper editorials. this makes it almost impossible to sue them. supporters claim that legal liability would result in the agencies getting sued out of business. still, stripping rating agencies of their legal protections need only go so far. new york state could establish a strict liability standard, such as recklessness, and cap damages at a reasonable limit.
as for transparency, firms are currently not obligated to release reports on securities if the issuers don't like the ratings. so banks cancel unwelcome evaluations and effectively manipulate the securities until they get the grade they want-like a student seeking out a more lenient teacher after failing a class. fortunately, new york state attorney general andrew cuomo struck a deal to curtail "ratings shopping" by ensuring agencies get paid up front, regardless of whether they are selected by issuers to assign a grade.
but it is still the case that non-disclosure of initial ratings reports leaves investors in the blind. this is the antithesis of transparency. in their deal with cuomo, the agencies did agree to pursue further reforms. the next one should be to mandate the release of all rating reports ever written on any given security.
nationalization may be a tempting alternative. but most americans prefer free markets-while demanding accountability and transparency. so adopting these reforms is the right place to start. only then can we expect americans to trust their savings to a resurgent and stable financial system. -- melinda r. katz is a new york city council member and is a democratic candidate for comptroller in 2009.