Credit-rating firms have come under much deserved criticism for their contributions to the financial market crisis. Their ratings methodologies totally missed the toxic nature of many mortgage-backed securities and collateralized debt obligations.
Many observers believe the rating agencies became too close to the investment banks paying for the ratings and catered to their wishes.
However, many institutional investors deserve criticism, too, for their complacency in accepting the ratings without doing independent credit research for confirmation. The Securities and Exchange Commission should take some blame also for relying on credit ratings in some of its own investment rules.
An Obama administration proposal takes a step in the right direction to improve the credit-rating process by strengthening oversight as part of the proposed financial market overhaul it unveiled June 17, but details are lacking. Now is the time for investment groups to come forth with specific ideas to fill in the details.
The Council of Institutional Investors already has produced a white paper, released in April, containing proposals for tightening oversight of credit-rating firms that should be part of a regulatory overhaul.
The paper Rethinking Regulation of Credit Rating Agencies: An Institutional Investor Perspective, written by Frank Partnoy, professor of law and finance at the University of San Diego School of Law, and director of its Center on Corporate and Securities Law, calls for better oversight of credit-rating firms, either through a separate board created by Congress, or within the SEC.
The board would provide stronger oversight of disclosure, conflicts of interest and rating methodologies, and could seek to reduce reliance on ratings by investors.
Other recommendations include ending the firms' exemptions from liability, making them subject to civil lawsuits under the anti-fraud provision of securities laws. The threat of such civil action would do much to focus the firms' attention on their rating processes and procedures. However, the repeal of the exemption must be written so as not to invite suits over ratings that turned out wrong despite following appropriate research.
Credit-rating firms play a powerful role in the financial markets. As Mr. Partnoy wrote, Ratings dictate the net capital requirements of banks and broker-dealers, the securities money market funds may hold, and the investment options of pension funds. As legal requirements for ratings have proliferated, the rating agencies have evolved from information providers to purveyors of "regulatory licenses.'
The SEC should reduce some of the importance placed on credit ratings in its own regulations, such as those determining minimum risk levels and acceptable securities for investment portfolios such as money market funds. Such regulation has led some investment managers to rely too much on credit ratings. An SEC proposed rule on the subject, issued last July, is still pending.
Many investors have supported the proposed change, while others have opposed it to varying degrees. According to its comment letter to the SEC in September, the Securities Industry and Financial Markets Association's credit-rating agency task force has not found that the possibility of undue reliance on credit ratings supports the deletion of references to, and use of, credit ratings in regulations.
But as Dan Waters, asset management sector leader at the U.K. Financial Services Authority, said in a speech addressing credit-rating firms in general in March: It remains the responsibility of investors (and fund managers as their agents) to perform their own due diligence and research when making investment decisions, and to use credit ratings responsibly. This is another illustration of the perennial truth that if you do not understand something, you should not invest in it.
In the end, whatever the outcome of the Obama administration's financial overhaul, or the SEC's almost year-old proposed rule, executives at pension funds and other fund sponsors have to ensure their money managers have independent credit research to back up any credit rating used to screen securities for portfolios.