Time to Downgrade Ratings Agencies

WARREN BUFFETT may be the Oracle of Omaha, but even he is hamstrung by credit ratings agencies. Appearing on Wednesday before the Financial Crisis Inquiry Commission, he said that as the chairman of Berkshire Hathaway, he has “no negotiating power” with Moody’s and Standard & Poor’s, the two major agencies, because ratings were “required in many cases by the rules.”

This wouldn’t be so bad if the agencies had performed well in the financial crisis. Instead, by giving undeservedly high ratings, they helped create it.

If the government outsourced drivers’ licenses, and the roads filled with accidents caused by bad drivers, it would stop using those companies. Congress should do the same with the credit ratings agencies.

From our different perspectives, as a law professor writing about financial markets and a commissioner of the Securities and Exchange Commission (whose views are her own and not those of the commission), we see such a move as the single most important piece of the reform puzzle, removing many of the incentives that led banks and ratings agencies to create thousands of dubious AAA-rated, subprime-mortgage-backed securities.

Reliance on ratings has grown significantly since the 1970s, when the S.E.C. first referenced them in a rule governing brokerage firms. Instead of assessing the safety of brokers itself, the commission deferred to the ratings agencies. Other regulators followed suit, and within a few decades the government had essentially outsourced its oversight role.

But as the reliance on ratings has spread, their reliability has plummeted. A continuous thread runs through the collapse of Orange County, Enron, Bear Stearns and the issuers of collateralized debt obligations: All received high ratings and then promptly collapsed.

The crisis hasn’t changed a thing. In fact, more than two years since it began, there are still nearly 2,000 references to credit ratings in the Federal Register. At the height of the crisis, the Federal Reserve instituted the Term Asset-Backed Securities Loan Facility, a huge program to encourage lending, but the borrowers could buy only AAA-rated investments.

Just this year, the S.E.C. endorsed ratings in regulations governing money market funds, even after it removed references to ratings in other rules. Meanwhile the Department of Labor has exempted pension funds from some rules if they trade securities with high ratings.

Government reliance on credit ratings explains why they retain such power in the market. Just as people must obtain a driver’s license before driving a car, borrowers must obtain a regulatory license before borrowing money. This is why Mr. Buffett feels powerless.

Mr. Buffett’s testimony comes at a crucial time, with the House and Senate working to reconcile more than 3,000 pages of financial reform legislation, including a short, simple provision to remove credit ratings requirements and force regulators and institutional investors to find substitutes. But it’s not guaranteed — the chambers have approved different versions of this approach, and some regulators and investors oppose the change, claiming it will be disruptive.

Perhaps, but we believe any disruption would be worth it. Surprisingly, so do the credit ratings agencies, which understand better than anyone the system-wide dangers that arise from over-reliance on their ratings. Because so many funds are required to hold highly rated assets, a downgrade can set off a financial collapse by forcing investors to sell. The ratings agencies would rather play a less important, albeit a less profitable, role.

Some institutional investors and regulators worry that they will not be able to make sufficient judgments about credit quality themselves. But under the proposed reform in Congress, ratings wouldn’t be banned, just not required.

Ratings will continue to play an important role in the financial markets, and investors should continue looking to them in making their credit quality judgments. But using them should be an option, not a mandate to follow a government-enshrined oligopoly.

Kathleen Casey is a commissioner with the Securities and Exchange Commission. Frank Partnoy is a law professor at the University of San Diego.

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