Rating system needs overhaul

By Edgar Ortiz

For the AJC

Credit rating agencies are paid by the companies whose debt they analyze and grade. This practice creates an inherent conflict of interest that puts profits before quality. It is time to shelve this old practice. The market can be better served with a process that emphasizes greater transparency and objectivity in the debt rating process.

Between 2000-07 total revenue for the big-three (Standard and Poor's, Moody's and Fitch) grew from $3 billion to $6 billion.

While credit rating agencies reaped a bonanza working with financial firms to structure collateralized debt obligations (CDOs) that held a questionable mix of financial products (subprime mortgage, auto-loans and junk-rated debt), markets and the economy experienced one of their worst periods in history.

Ratings provided by credit rating agencies are at the core of the global financial meltdown. Faulty ratings helped banks package over $3.2 trillion of subprime mortgage securities, 75 percent of which had been assigned a triple-A, their "highest-grade, " indicating safe investments with remote risk of default.

The downward spiral of real estate prices and financial losses in 401(K) retirement accounts are a daily reminder of how badly their highly recommended, low risk securities performed. We know too well the fate of Lehman Brothers, that venerable investment bank that on the same day it filed for bankruptcy protection, S&P had rated it "A"; reassuring us it was an investment of very low risk with strong financials. AIG, another highly rated institution is now on life support at tax payers' expense.

The daily news constantly reminds us of the damage caused to individuals, families, communities, municipalities, states, regions, the nation and the world economy from a lack of regulation and oversight that for too long has put self-interest and profits before quality. The painful consequences of faulty ratings are all around us:

• By the time the financial crisis is over, losses in the U.S., Western Europe and Japan will exceed $4.1 trillion.

• Losses over $2 trillion in retirement accounts in the last 15 months, a financial tsunami that has wiped out about 25 percent of their value, a devastating financial blow to the millions of Americans in or near retirement.

• A decline of over $4 trillion in home equity values, a heavy financial loss to millions.

Financial markets worldwide are experiencing a crisis of confidence. The market failure of top-rated, low risk structured financial products should serve as a reminder of how quickly distortions caused by lack of regulation and oversight in our markets can propagate and adversely impact the rest of the financial world. The U.S. needs to exert its leadership and help restore confidence and integrity in these markets. The SEC could start by:

• Introducing regulation to eliminate conflict of interest at credit rating agencies, which are financed and rewarded by the very institutions they rate.

• Establishing a rating agency funded and managed by investors having the authority to analyze and make parallel rating recommendations to those issued by the big Wall Street agencies paid by companies.

• Reducing the over reliance in market performance data and incorporating operational data into the rating process. As history shows, market euphoria contributes to inflated prices and ultimately to bubbles.

• Establishing "best-practices" and "observational periods" to monitor and assess the reliability of new financial instruments prior to their use in the market.

While our legislators debate the issue, the European Parliament has adopted regulation and transparency rules that rating agencies must abide by starting in 2010. Facing a leadership vacuum, other countries and regions are likely to follow. This proliferation of rating rules can be damaging to the U.S. economy and dampen the prospects for a sustained recovery. The U.S. needs to take the lead to ensure there's a "global message" on ratings to restore confidence in our financial markets and prevent the distorting impact of regulatory arbitrage opportunities across markets and borders.

Risk is part of life and will always be with us. Companies and nations flourish not by avoiding risk, but by taking risk. Now is the right time for the US and the SEC to set a new course and put our financial markets on the path to a "recovery of confidence."