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The American Prospect: Financial Reform's Triple "F" Rating

In current practice, banks pay agencies to assess their financial products favorably. Why hasn't this system of kickbacks been eliminated?

-By David Dayen

February 21, 2013- Earlier this month, the Justice Department and 16 state attorneys general sued the Standard and Poor’s (S&P) credit-rating agency, accusing the company of improperly inflating the ratings of 40 collateralized debt obligations (CDOs)—essentially, securities made up of other mortgage-backed securities—at the height of the housing bubble. According to the suit, S&P misled investors by rating the risky securities as "triple-A," super-safe investments. But the purchases turned into massive investor losses when the bonds failed after the bubble collapsed. Using emails and other communications, state, and federal prosecutors will seek to prove that S&P knew the securities were junk but rated them highly for the most obvious of reasons: to make more money.

The lawsuit gets at a major problem at the heart of the credit-rating business: Rather than investors paying rating agencies to assess the value of securities it is the issuers of the securities themselves who pick up the tab. It is naturally in the interest of issuers—typically big banks—for rating agencies to rate their products highly, which increases the chances investors will buy them. Under this "issuer-pays" model, the largest credit-rating agencies then have a strong incentive to highly rate securities for issuers who can give them more business in the future. This is said to be part of the reason rating agencies ignored the risks from the highly complex securities and simply let everything pass; in one communication revealed in the filing, an S&P employee boasted, "It could be structured by cows and we would rate it."

The case against S&P is largely consistent with reports from the Senate Permanent Subcommittee on Investigations and the Financial Crisis Inquiry Commission, which showed that the promise of future profits drove credit-rating agencies to rate toxic securities highly. As Reuters financial reporter Bethany McLean points out, the other big rating-agencies, Fitch and Moody’s, engaged in similar conduct. "The argument can be made that the case against S&P is an indictment of the entire rating agency business model," said Jeffrey Manns, Associate Professor of the George Washington University Law School.

This leads to an obvious question: If the rating agencies have an inherent conflict of interest—something even the Justice Department, which is notoriously averse to prosecuting financial crisis-era cases, sees as illegal activity—why has the government not yet overhauled the way rating agencies get paid? As it turns out, the Dodd-Frank financial-reform law started a process to replace the current payment, but the Securities and Exchange Commission (SEC), which is tasked with writing the final rule, has yet to take action. The sponsors of the overhaul want to pressure regulators to finalize the rule, and eliminate this conflict of interest lurking in the heart of the financial system.



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