Would Rating Agency Liability Make for a Healthier Market?

By now, most people understand that the credit rating agencies got quite a few things wrong prior to the financial crisis. They gave a large number of real estate-related securities high ratings, only to downgrade them once the bubble burst. This has resulted in some very legitimate calls for reform. One recommendation is to require expert liability. Would this have really helped?

First, let's take a step back. The agencies have long argued that their ratings are opinions and protected by the First Amendment. Courts have generally agreed. The Dodd-Frank financial regulation bill passed last summer attempted to thrust expert liability on the agencies. Shortly thereafter, the agencies said that they would no longer provide ratings on registered securities, because they did not want to be held accountable. The market seized, and the SEC stepped in to strike the new rule, indefinitely.

Gretchen Morgenson of the New York Times does not find this move amusing. She understands that the SEC is attempting to take the agency ratings out of federal statues and regulation, but says that's not enough:

IT is certainly important that the S.E.C. work to eliminate references to ratings in the investment arena, and to reduce investor reliance on them. But Congress couldn't have been clearer in its intent of holding the agencies accountable. That the S.E.C. is undermining that goal is absurd in the extreme.

Is it? In her same article, she explains why the SEC took this route:

Meredith Cross, director of the S.E.C.'s division of corporation finance, explained the agency's decision to stand down on the issue: "If we didn't provide the no-action relief to issuers, then they would do their transactions in the unregistered market," she said. "You would impede investor protection. We thought, notwithstanding the grief we would take, that it would be better to have these securities done in the registered market."

For those who haven't worked on Wall Street, there a security can be offered in roughly two ways: publicly or privately. If it's offered publicly, then it has to conform to a whole slew of regulations. If it's offered privately, then substantially fewer rules apply. When Dodd-Frank passed, the agencies said that they would no longer provide their ratings on publicly offered securities, because they did not want to face liability. As a result, the entire mortgage- and asset-backed securities market would have gone private, which means transparency would have been reduced and regulators would have had even less control over a market that was largely responsible for the financial crisis.

If that sounds like a good idea to you, then maybe you should re-read the last paragraph. The last thing regulators want to do is create a market with less transparency and more secrecy. Indeed, that's precisely one of the things the financial crisis has taught us can be very harmful. The SEC nullified agency liability to avoid that problem.

But the liability requirement also doesn't really make sense to begin with for a few reasons. First, it's somewhat crazy to hold someone accountable for their prediction of the future. What if every time the weatherman got the forecast wrong, you could sue? There wouldn't be many weathermen left. If the agencies had liability prior to the financial crisis, it's likely they would have made most or all of the same mistakes, since just about the entire market made the same miscalculations. As a result, they would have all been sued into oblivion, and we would have no rating agencies at all. That have would seriously screwed up the market, because it would have needed to adjust to a market without ratings very quickly. The agencies probably would have been bailed out.

In fact, a liability standard for the agencies would simply cause investors to be even more reliant on ratings. There would be no purpose in doing their own due diligence: if an investment they buy goes bad, they could just sue the agency for damages. Investment management would become mindless and robotic, as analysts could just look at ratings nod, and move on.

That isn't a healthy market. Regulators should encourage as many parties as they can to develop theories and assumptions about securities that challenge one another. If more people had been analyzing the residential real estate market during the housing bubble instead of blindly trusting the rating agencies, then perhaps the market would have caught on sooner. Instead, they dumbly scooped up AAA-rated securities and then complained when they realized their investment was toxic. But the buck should stop with the investors. Investors buy securities of their own free will, so investors should be responsible if they go bad.