Reining In Moral Hazard on Wall Street

Wall StreetBy Eric Ramoutar.

Getting a company to willingly admit wrongdoing is a tall order. Getting a Wall Street mainstay to do so is nearly impossible. That is what makes last week’s settlement between Standard and Poor’s (S&P), a massive credit rating agency, and the Securities and Exchange Commission (SEC) all the more impressive. S&P agreed to pay $77 million in fines and stop rating certain assets for a year as compensation for what the SEC alleges was intentional misinformation about how the firm rates certain investments.

Win, Win, Lose

The services of S&P and other rating agencies are as integral to Wall Street as investment banks or insurance companies. S&P provides a credit rating on the debt of companies and governments, essentially telling investors how safe a certain investment is on a scale from D (likely to default) to AAA (very safe). S&P and its two largest competitors, Moody’s and Fitch, account for about 95% of all credit ratings worldwide, and their predictions are used by ordinary investors and huge investment banks alike.

The problem, the government claims, is that S&P’s business model creates an unavoidable conflict of interest. Instead of charging users to access its ratings, S&P charges businesses to have their debts rated. That provides a powerful incentive for S&P to relax some of its more rigid evaluation standards to produce more optimistic outcomes. If everyone gets a AAA, everyone wins. The company has an investment that now looks attractive, and the rating agency has pleased its client.

But when S&P gives out AAA ratings to increase its own profits rather than recognize stable companies, the duped investor shoulders all of the risk. Certainly nobody will shed a tear for Goldman Sachs, but as New York Attorney General Eric Schneiderman, put it, S&P has been “lying to investors. 

Don’t Just Trust Us

S&P’s response to the accusations was to cry free speech. According to the firm, credit ratings are merely public commentary akin to political critique, and therefore immune to standards of criminal fraud. They were also quick to point out that rating agencies are just one side of the equation, and that buyers are the ones who ultimately make the decision to invest.

Even those who harbor strong disdain for financial institutions after the 2008 collapse should concede that S&P’s free speech argument makes some sense. After all, rating investments on their future stability is an inherently predictive exercise, and few would suggest that S&P should be dragged into court every time their model turns out to be inaccurate.

But arguing that free speech protects the work of S&P does not make that work any more savory, and in many ways, credit rating is the poster child for moral hazard on Wall Street. For years, the corrupted ratings process was ignored because we had yet to be burned. But in 2008, S&P issued highly favorable ratings for the same insolvent, mortgage-backed investments that brought our financial system to its knees.

Leave it to the People

One obvious way to temper this corruption is to simply stop trusting ratings agencies, but some instructive history makes that seem very unlikely. After the financial crisis, S&P barely missed a beat. Since 2009, McGraw Hill Financial, S&P’s owner, has seen revenue increase by $1.4 billion and year-end share prices grow by 133%. The public may be more conscious of the cozy relationship between rating firms and debt sellers than they were before the collapse, but that has hardly affected their reliance on these firms.

We may hate it, but continuing to use these rating agencies is completely rational. Neither large investment organs nor individuals investors have the resources or technical expertise to rate these investments themselves. In the absence of some third-party service, investors can either stop investing or start taking random guesses about which ventures are likely to profit. Nobody has any desire to go back to the days when smart investing required heaps of research or decades of experience, so, for now, most are content to accept a crooked model when the alternative is no model at all.

Time for an Intervention

Ideally, S&P would recognize their own ubiquity in our financial system and purify their ratings process for the greater good. But the current model has been enormously profitable, and there are few tasks more difficult than convincing a financial institution that there are worthy goals other than profit margin. Even if S&P’s legal team is ultimately able to prove that their work is safeguarded by free speech protections, it does not mean that we should accept a monopoly of the corrupt. Instead, we should start asking governments to fill the void. 

To inform investors which ratings are likely to be the most tainted, regulators should force rating agencies to disclose which companies pay the heftiest sums for their rating. Perhaps then investors will become wary of investing in companies that paid handsomely for ratings, incentivizing companies to stop implicitly paying for AAAs.

In cases when the conflict of interest is particularly pernicious, governments should provide an objective rating that cannot be bought. If corrupted ratings are all that is available, then it is corrupted ratings that will be used by investors. Offering some diversity of opinion will certainly shrink the influence of improper ratings.

Rating agencies are severely flawed institutions, but they are here to stay. The task now is to deal with their imperfections. Checks on their incredible influence can and should be erected, and inaction may just set the stage for another 2008.

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