Watchdogs drooling

Ratings agencies were paid by the same companies they oversaw.

Though subprime loans, securitized derivatives and sleeping regulators have rightfully drawn public ire for their roles in the 2008 financial collapse, it is private debt-rating agencies that most facilitated underlying market imbalances. These firms exist to act as honest, private arbiters of an investmentâÄôs quality by giving each a grade based on its perceived level of risk. However, enraptured by hefty fees from Wall Street, these firms turned a blind eye to complex deals with hidden layers of risk, allowing unscrupulous financiers to dupe unsuspecting investors. E-mails revealed by a Senate committee last Friday show that agencies regularly worked with clients to massage ratings in their favor. Individual deals could be worth upward of $1 million. The perverse incentive of loan issuers paying ratings agencies is the financial equivalent of allowing pitchers to choose their umpires. Plus, with only three firms dominating the ratings market, once one umpire relaxes standards the others are quickly compelled to follow. With the benefit of hindsight, the extent of ratings agenciesâÄô failure is breathtaking; approximately 90 percent of the top-rated securities in 2006 and 2007 have since been downgraded to below investment grade. Conservative, sober investors who thought they were getting a safe return have instead lost billions. Unfortunately, proposed financial reform legislation will do little to curb these practices. Much more must be done to eliminate backward incentives. Shifting payment for ratings from sellers to buyers would be an excellent start, though the removal of regulatory barriers to entry into the ratings industry would give a necessary boost to competition in this sector.