How the Government Helped Moody's Effort to Crash the Economy

James Surowiecki explains how the government contributed to the problem with the ratings agencies.

[O]ver the years the government has made the agencies an increasingly important part of the financial system. Rating agencies have been around for a century, and their ratings have been used by regulators since the thirties. But in the seventies the S.E.C. dubbed the three biggest agencies — S. & P., Moody’s, and Fitch — Nationally Recognized Statistical Rating Organizations, effectively making them official arbiters of financial soundness. The decision had a certain logic: it was supposed to make it easier for investors to know that the money in their pension or money-market funds was going into safe and secure investments. But the new regulations also turned the agencies from opinion-givers into indispensable gatekeepers. If you want to sell a corporate bond, or package a bunch of mortgages together into a security, you pretty much need a rating from one of the agencies. And though the agencies are private companies, their opinions can effectively have the force of law. The ratings often dictate what institutions like banks, insurance companies, and money-market funds can and can’t do: money-market funds can’t have more than five per cent of their assets in low-rated commercial paper, there are limits on the percentage of non-investment-grade assets that banks can own, and so on.

The conventional explanation of what’s wrong with the rating agencies focusses on the fact that most of them are paid by the very people whose financial products they rate. That problem needs to be fixed, and last week the S.E.C. proposed new rules to address conflicts of interest. But there’s a much bigger problem, which is that, even though nearly everyone knows that the agencies are compromised and exert too much influence, the system makes it impossible not to rely on them.

I have an interview with Barney Frank coming this weekend where he talks a bit about this. Suffice to say that even congressional liberals think it's time for the feds to stop giving these raters their support. And my understanding is that the ratings agencies are not big fans of being federally chartered. As Surowiecki says, the people who continue defending the arrangement are big investors:

Oddly, the ratings system, broken as it is, remains attractive to many investors who have been burned by it. For one thing, it provides an easily comprehensible standard: without it, we’d need to come up with new ways of measuring risk. More insidiously, the ratings system provides a ready-made excuse for failure: as long as you’re buying AAA-rated assets, you can say you’re being responsible.