SEC’s S&P solution is poor

Ratings agency Standard & Poors (S&P) revealed in a financial filing yesterday that the SEC had begun an investigation into its collateralized debt obligation (CDO) rating practices during the housing bubble.  If the investigation reveals improprieties in the way that S&P rated the Delphinus 2007-1 CDO (the specific CDO cited in this investigation), the SEC could levy fines, injunctions or other penalties on S&P.  Presumably, if the investigation turns up evidence of misconduct in this rating, the SEC could turn its attention to the thousands of other CDO’s S&P rated, levying penalties for each transgression.

The other two major rating agencies, Moody’s and Fitch’s, hardly performed better and one has to wonder if the choice to go after S&P first isn’t at least a little influenced by its downgrade of the US’s credit rating in August.

Unfortunately, these punitive measures miss the point, even if they might provide some much needed catharsis.  If the only action by the government is levying fines on the ratings agencies, then there will be no structural protections from the next bubble.  S&P rated so many CDO’s as AAA (the highest investment grade) because the incentives were aligned for them not to ask any questions. The sellers of securities pay for ratings and can choose between three different ratings agencies.  Clearly, most of the business is going to go to the agency with the most lenient rating models or the one that asked the fewest questions.

The SEC investigation won’t really serve as a strong deterrent either.  It’s unlikely that S&P was maliciously cooking the numbers: the incentives were just there for them to take the (cooked) numbers from the issuers and not be too critical.  Maybe the issuers just flocked to the agency whose model gave them the best rating and that agency decided not to mess with what had made them the market leader.  The hallmark of a bubble is that the people involved don’t actually think that there’s a bubble.  The next time credit ratings so strongly influence the market, the ratings agencies won’t be thinking about their potential SEC liability because they won’t think that they could be doing anything wrong.  Beyond that, SEC fines are usually small potatoes compared to the wrath of people whose money is actually on the line. For example, a stock price claim that Bank of America settled with the SEC for $150 million has also spawned a $50 billion class action in the Southern District of New York.  Aggrieved shareholders can take care of the monetary penalty side of things just fine; the SEC should focus on regulation to make sure that the problems don’t happen in the first place.

The only way to do this is to change the way rating agencies work.

The best option is to have the SEC or another of the alphabet soup of financial regulatory agencies do the ratings itself and require the rated securities to pay the costs involved in the ratings. Nor should the government skimp on the salaries for the people doing the ratings. One of the big disadvantages for S&P is that its employees are often people who wanted to work for the investment banks but couldn’t quite hack it.  If the government wants to change the script, attracting talented people will be key.  Working for the SEC will certainly attract people looking to do their duty, but extra money never hurts either.  If the government isn’t willing to take on this responsibility it should require that securities be rated only by one randomly selected ratings agency.  The probability of an agency getting a rating could be set to some metric of accuracy, which would align the ratings agency’s incentives properly.  What’s clear is that fining S&P and deciding that it will fix the problem is a recipe for repetition.