It's one thing to say that the credit rating agencies shouldn't be penalized if they just misjudged the severity of the housing market collapse. After all, just about everybody else did too. But if an agency realized it made a mistake in a rating, and then failed to fix it, should it be held accountable? The Securities and Exchange Commission decided Moody's shouldn't be -- but there's a technical reason why.

According to Zachary Goldfarb's Washington Post account, the SEC found that Moody's learned of a mistake it had made, but didn't fix it. It failed to do so due to the concern that downgrades would "negatively affect Moody's reputation." Well sure: they should. That's precisely what's supposed to happen if you make a mistake.

So why didn't the SEC take action? WaPo reports:

The SEC said it chose not to file suit because of "jurisdictional" limitations. The activities at the center of the SEC investigation took place in Europe, beyond the agency's reach at the time.

But the agency said it might have made a different decision under the terms of the legislation enacted this summer to overhaul financial regulations. The bill gave the SEC the power to sue credit-rating firms engaged in "otherwise extraterritorial fraudulent misconduct."

A technicality! But at least the SEC issued a report about the incident. Usually, when they don't rule against a firm, they just drop the case without mention. Clearly, the regulator was trying to send a message.

But the agencies have already heard it. Separately, Darrell Preston and Matthew Leising at Bloomberg report today that Moody's is now trying to require that taxpayers indemnify it against lawsuits if its ratings are challenged on municipal bonds, excluding situations of fraud and willful misconduct. As the excerpt above alludes to, the new financial regulation bill provides more flexibility to sue the agencies when they get ratings wrong. This has already been the source of a headache in securitization, when the industry halted in July due to the new rule.

It's easy to see both sides of the argument here on a broad level. The agencies can't predict the future any better than anyone else. So they don't want to be held accountable if unexpected things happen. Meanwhile, investors want to continue to rely on their ratings. The two sides should find a middle ground. Investors should take more responsibility for buying their investments based on their own analysis, but the agencies should take care not to make any terrible decisions that reflect gross negligence in the rating process -- like rating bonds backed by loans without documentation.

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