Don’t support a conflict of interest

Marketplace Staff Oct 24, 2007


Scott Jagow: I mentioned Merrill Lynch earlier.
It’s one of several Wall Street banks paying for their sins in the mortgage market.
Congress and several government agencies wanna know something from the credit-rating agencies, like Standard & Poors, Moody’s and Fitch. Why did they give high ratings to securities backed by subprime mortgages, when it was quite obvious they were junk, and that a lot of people wouldn’t be able to pay back those loans when interest rates went up?

Commentator Robert Reich says the answer to that question is pretty clear, too.

Robert Reich: The answer has to do with the one simple fact: Credit-rating agencies are paid by the same institutions that package and sell the securities the agencies are rating. If an investment bank doesn’t like the rating, it doesn’t have to pay for it. And even if it likes the rating, it pays only after the security is sold.

Get it? It’s as if movie studios hired film critics to review their movies, and paid them only if the reviews were positive enough to get lots of people to see the movie.

Until the collapse, the result was great for credit-rating agencies. Profits at Moody’s more than doubled between 2002 and 2006. And it was a great ride for the issuers of mortgage-backed securities. Demand soared because the high ratings had expanded the market.

Traders didn’t examine anything except the ratings. It was actually a market in credit ratings — a multibillion-dollar game of musical chairs. And then the music stopped.

So why is the result such a mystery? What exactly are the SEC and Treasury and Congress investigating? It’s obviously a giant conflict of interest.

It’s just like stock analysts who, before the dot-com bubble burst, advised clients to buy stocks their own investment banks were issuing. The remedy for that was to split the two functions — analysis from investment banking.

The remedy here is to do much the same — barring issuers from paying credit-rating agencies. If investors want credit ratings, they or the pension or mutual funds they invest through can subscribe for the service — just as movie-goers subscribe to publications where reviews appear.

Jagow: Robert Reich’s latest book is called “Supercapitalism.” He was labor secretary under President Clinton.

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