In Defense -- Yes, Defense! -- Of The Rating Agencies

A lot of people, including me, say that the credit rating agencies played a huge role in the financial crisis. Investors relied on their flawed ratings for hundreds of billions of dollars in securities that become known as "toxic." These bad assets consequently clouded banks' balance sheets and forced them to take obscenely large write-offs for the past few years.

The story, of course, changes if rating agencies had gotten it right. Indeed, the housing bubble itself might not have inflated if the mortgage-backed security market hadn't been allowed to expand so greatly through the sale of so many incorrectly rated bonds that the rating agencies graded as safe. So reform is absolutely called for, but in an article on The Big Money, I think Chris Thompson gets a little carried away.

Just like in virtually every industry, there were those who worked at the rating agencies who probably weren't the best human beings. Some communications within some agencies have brought to light that some analysts might not have believed the ratings they were handing out. But having worked with the rating agencies myself, I think these individuals were more the exception than the rule. Most of them, I think, just got it wrong -- just like pretty much everybody else.

Was there negligence? Probably. Was there fraud or criminal intent? I think only in quite rare situations. But in evaluating some proposed rating agency reforms making their way through Congress, Thompson concludes:

Once again, Congress passed on the opportunity to add criminal penalties against the rating agencies. If the Big Three defraud investors on a historic scale, lie to millions of people about the creditworthiness of junk mortgage tranches, and cash their checks while another market collapses, they might someday pay a little money in civil court. But no one will ever go to prison. As rackets go, that ain't bad.

Now, if it's true that fraud could be proven, and the rating agencies were not held accountable, then I completely agree with Thompson. But I'm pretty sure that the issue here is that it's quite difficult to prove widespread fraud at the rating agencies -- because there wasn't any. There were just very poor assumptions about the mortgage market.

And frankly, there's another reason why the rating agencies shouldn't be held to a very high standard: at the end of the day, their ratings are merely opinions. The real problem with the system here wasn't that they got it wrong -- it was that investors cared so much about ratings.

But that's how the market functioned. Investors generally didn't have the same data available to them to perform as in-depth analysis as the agencies. So when they rated something as AAA, investors nodded and traded it with the assumption that it was probably very, very safe.

Now imagine that there were no rating agencies, but that investors bought these same securities based on their own assessments of the risk involved. And imagine that their assumptions were just as flawed as the agencies' ratings were -- and they probably would have been, because virtually no one expected the real estate market to tank to the extent that it did.

Then, I think all you get is a shrug. It was the investors' money to lose. So if they made poor investments, then that's too bad for them, but that's the game they play. Being an investor means trying to make bets about what the future holds. Sometimes you win; sometimes you lose.

Instead, in this market, there's a middle man -- the rating agencies -- who screwed up, so investors have someone to blame instead of themselves. And given the current framework, they have some standing to do so. After all, the rating agencies are highly regulated by the U.S. government, so their trusted advice means something.

But it shouldn't. Rating analysts are not dumb people, but they're also not gods. Investors don't have crystal balls to see the future, and neither do the rating agencies. But when investors make a mistake, it's at their own peril. When agencies screw up, others pay. Until the system changes, we'll continue having this disparity. That's why the solution is not to penalize the rating agencies further for not knowing the future; it's to place the responsibility on investors to evaluate the risk themselves.