How Not to Regulate the Credit Rating Agencies

The credit rating agencies are in something of a pickle these days. It's their business to provide expertise on credit risk, yet their epic failure to sense the housing bubble got them into trouble. In order to shield themselves from lawsuits for their bad judgment, they relied on a court precedent indicating that their ratings were mere opinions and protected by the First Amendment. Of course, even though they shouldn't, investors treat credit ratings as far more than just opinions, as they have traditionally been an essential metric for pricing bonds. But the financial regulation bill made things even more cumbersome for the agencies.

The Wall Street Journal reports:

Once the bill is signed into law, advice by the services will be considered "expert" if used in formal documents filed with the Securities and Exchange Commission. That definition would make them legally liable for their work, meaning that it will be easier to sue an (sic) firm if a bond doesn't perform up to the stated rating.

That is a change from the current law, which considers ratings merely an opinion, protected like any other media such as a newspaper.

According to the article, this has halted the asset-backed securities market this week, as the raters assess their options. Agencies don't want their ratings included in marketing materials, because they don't want to be liable. Of course, without those ratings, investors don't know what to pay for the bonds, because they haven't done enough analysis themselves to determine what the securities should be worth.

This provision of the bill is senseless. The raters' response to the regulation shows its uselessness. After all, it isn't like the agencies are going to withdraw their ratings entirely. That can't happen if they hope to stay in business. Meanwhile, even if forbidden in marketing materials, these ratings will still exist, and investors can still rely on them. Ultimately, investors will just have to go to a source other than the official marketing materials for bond ratings. This regulation accomplishes nothing.

Think about how silly this is. It's like saying that a CEO is liable for his statements about his company's performance only if in an official SEC document. So if he goes on CNBC and assures viewers that there's no chance his company can go bankrupt, but it does the following day, he can't be held liable. But if he did the same thing in an earnings report, then he could be sued. How is this different from a bad AAA-rating? Either experts should be liable for their opinion, or they shouldn't be, regardless of the medium through which it is expressed.

It will be interesting to see how this new regulation evolves. In its current form, it's useless and just creates a less efficient market, where investors will need to go through a third party source to obtain ratings information. Of course, the formulation of the law is flawed to begin with, as the burden of understanding securities should exist on the part of investors to know what they're buying and not merely rely on ratings. The law won't change that; it will just make investors jump through an additional hoop.