Triple-A Trouble

By Justin Fox

Correction Appended: March 14, 2008

The People at Moody's and Standard & Poor's are used to catching flak when debt markets blow up. Why didn't they see the bankruptcy of California's Orange County coming in 1994? Why did they fail to account for the currency risks brewing in Thailand and Indonesia and South Korea in 1997? And how was it that they were still rating Enron's debt as investment grade four days before the company went belly-up in 2001?

The furor over such missteps usually fades quickly. After a congressional hearing or two, the ratings agencies have always been allowed to go their merry and profitable way. And why not? Inability to see into the future isn't a crime, plus there has usually been someone else available to take the fall--like Arthur Andersen in the Enron case.

This time around, though, the ratings agencies didn't just fail to see a financial calamity coming. They helped cause it. Why did collateralized debt obligations (CDOs) based partly on risky subprime mortgages lead to so much trouble? Because Moody's and S&P awarded them dubiously generous letter grades. It's the same story for the mostly incomprehensible tizzy over bond insurance.

What can we do about this? There's actually a simple answer: just declare our independence from bond ratings.

The practice of giving letter grades to bonds to reflect their riskiness was pioneered by John Moody in 1909. But the industry took its current form only in the early 1970s. That's when Moody's and its competitors switched from selling research to investors to charging bond issuers to rate their goods. This approach wasn't unheard of: you have to advertise in Good Housekeeping to get the Good Housekeeping Seal of Approval. What made it problematic was that at about the same time, the Securities and Exchange Commission (SEC) exalted the status of the ratings by writing them into the rules governing securities firms' capital holdings. Since then, the use of bond ratings in regulation has only grown. Many institutional investors are banned from owning non-investment-grade bonds. Bank-capital requirements--the cash and equivalents banks need to keep on hand--give more weight to highly graded securities. And this is increasingly the case not just in the U.S. but around the world.

What all this amounts to, argues Frank Partnoy, a derivatives salesman turned University of San Diego law professor, who is one of the sharpest critics of the ratings status quo, is a "regulatory license" for the ratings agencies. It's certainly a license to print money. Moody's, the lone ratings firm for which data are available, made $702 million in after-tax profit last year, up from $289 million just five years before. Its operating profit margin was a stunning 50% of revenue. By comparison, Google's was 30%.

To keep that profit machine going, Moody's and S&P have to keep finding new things to rate. And they're under intense pressure from issuers and investors alike to get as many securities as possible into the top ratings categories. The result is grade inflation, especially in new products like CDOs. That's how banks and investors around the world ended up owning billions of dollars in triple-A mortgage junk. It also helps explain the growth of bond insurers, companies that used their own triple-A ratings to bump ever more bond issues into the top categories--even as their businesses ceased to be triple-A safe.

One way to combat these tendencies would be to subject the raters to tight regulation by the sec. But that understaffed agency is unlikely to be up to the task, especially since it's not clear what exactly the task would be.

Which leaves the alternative suggested by Partnoy and several economists: cleansing the federal code of its reliance on bond ratings. Among the simplest fixes would be removing the ban on pension funds' holding debt securities rated lower than BBB. The funds can make far riskier investments in stocks and hedge funds, after all. Bank-capital requirements do have to take into account the quality of securities, but there are market-based measures that could at least partly replace ratings.

"The experiment we ran with government relying on the ratings agencies to do its job has failed," Partnoy says. Time for a new experiment.

More Money To read Justin Fox's daily take on business and the economy, go to time.com/curiouscapitalist

The original version of this article said Moody's made $702 billion in after-tax profit last year. The correct figure is $702 million.