S&P and Moody’s Put on the Defensive: Rating Agencies to Share Liability under New Bill

From Merriam-Webster:

Conflict of Interest
Date: 1843
: A conflict between the private interests and the official responsibilities of a person in a position of trust.

To most, AAA investments are as good as gold and function as a secure reference point with which to steer portfolios. However, they recently served as a false beacon, leading thousands onto the jagged rocks of financial peril, causing billions of dollars to be lost forever. The credit ratings agencies responsible for these guiding lights are supposed to have the interests of the investor and public aligned with their own but it is widely perceived that this is not so. Now under public pressure for accountability, congress is considering a bill that will force liability onto these agencies.

It is commonly known that credit rating agencies such as Moody’s, Standard and Poor’s, and Fitch make their money not from the public who uses their ratings but from the companies who pay to have their securities rated. This would seemingly create a conflict of interest, because the agencies would naturally be more eager to appease those who pay them than those who do not. Thus their official responsibilities (putting out accurate credit ratings) are in conflict with private interests (being paid by companies to rate them). Especially if that company is say, Lehman Brothers, whose financial viability rests upon the AAA ratings of their securities which they know to be worthless. A company in that position would undoubtedly be willing to fork over lots of cash to keep their self-sustaining illusion afloat. Likewise ratings agencies, faced with the proposition of losing business if they are not conciliatory, might be persuaded (through proper monetary investment) to help in that endeavor.

The ratings agencies response to their defaulted ratings is essentially “oops” because they are not liable for the ratings they put out. It is of course natural then that the public would want to strike back at these agencies and hold them accountable for their ratings, to ensure that no future “investment grade on Friday, bankrupt on Monday” ever occurs. But a regulation such as the one proposed is a tricky measure, in need of careful analysis before implementation.

For one, if those giving financial advice are suddenly made liable, to what extent and under what conditions can they be sued? It is possible something could evolve like what currently plagues the medical profession, a multitude of frivolous lawsuits which drive costs unnecessarily upward. Any investor could theoretically have a claim against these agencies, even if the market did take an unforeseen dip. Secondly, the regulation could come out looking like the widely criticized Sarbanes Oxley Act. An act which is generally hailed as being not only a hazardous maze of red tape but essentially a useless precaution. Finally, these agencies may not be liable but they cannot falsify their reports without reproach. Already there are pending law suits alleging major fraud, which could end up securing convictions, penalties or major settlements. These suits could bring about the accountability desired, making legislation unnecessary. Regulation is always more complex than it seems in principle; prudence requires us to be cautious, skeptical and thorough with regards to any proposal.

The net lease industry, like most others, depends upon the validity of credit ratings. One of its most appealing qualities is the promise of long-term viability. Discovering a portfolio of AAA properties is actually not even investment grade would simply be disastrous. Accurate ratings are without a doubt needed but legislation must be properly vetted to ensure it is not harmful, ineffective or unnecessary.