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Just as Enron and WorldCom’s collapse precipitated a financial crisis in 2002, the recent turmoil in the securitized debt market, centered around mortgage-backed securities and similar collateralized debt obligations, has provoked a similar, if smaller, market meltdown, whose repercussions have already shut down the leveraged buyout boom and produced at least a short-term liquidity crisis. As always, financial panics encourage fingerpointing and a search for villains. In 2002, the obvious villains were the major accounting firms, which had seemingly acquiesced in pervasive irregularities, arguably in order to market consulting services to their auditing clients. As a result, auditors became the principal target of the Sarbanes-Oxley Act. This time, the obvious target will be the major credit-rating agencies, whose belated ratings downgrades of structured finance products precipitated a major sell-off in the debt securities market. At first glance, the similarities between these two episodes are striking. In both cases, the targeted professionals are gatekeepers performing a functionally identical role: Accountants serve shareholders, rating agencies serve debt investors. Both responded sluggishly, and when they took eventual action � by compelling financial statement restatements in the case of accountants and by downgrading their ratings in the case of the ratings agencies � it touched off a panic. Both industries are also heavily concentrated: four major auditing firms versus only three major ratings agencies. As a result, the competition among these professionals is muted at best, and conscious parallelism likely becomes the norm. Finally, both sets of gatekeepers were destabilized by a new development in their market. In the case of accountants, the explosive growth in consulting income in the 1990s induced them to use their auditing relationship as a “portal of entry” into the corporate client by which to seek more lucrative consulting work. Correspondingly, the credit-rating business was destabilized by the extraordinary growth and profitability of structured finance. Structured finance now accounts for the majority of the revenues of the major ratings agencies. More importantly, the investment banks that need investment grade ratings to market their securitizations are major clients controlling a high volume of business. Thus, while a corporation that wants its bonds rated represents only a trivial percentage of the rating agency’s business, the investment bank is a repeat player that accounts for a material share of the rating agency’s structured finance revenues and that could take that business elsewhere. Rating agencies catered to investment banks As a result, the relationship between the ratings agency and the investment bank becomes close to the point of incestuousness. If the ratings agency will not deliver the desired investment grade rating on the first request, the investment bank will ask what more must it do. Gradually, the securitized pool of assets is improved and “sweetened” until it just makes it over the “investment grade” line. All in all, this cozy relationship is much as if the rater for the Michelin Guide were taken to the chef’s kitchen, asked how the souffl� should be improved and then paid to test the revised recipe � over and over until the restaurant earned the desired extra star. Striking new evidence supports this claim that structured finance products have been the subject of rampant “grade inflation.” The economists Charles Calomiris and Joseph Mason have recently pointed out that a sharp disparity has arisen between the default rates on collateralized debt obligations (CDOs) rated investment grade by Moody’s and the default rates on corporate bonds given the same rating by Moody’s. See Calomiris and Mason, “Reclaim Power from the Ratings Agencies,” Financial Times, Aug. 24, 2007 at 11. Specifically, they report that corporate bonds rated Baa by Moody’s, which is that agency’s lowest investment grade, had an average 2.2% default rate over five-year periods from 1983 to 2005. Yet, from 1993 to 2005, CDOs given the same Baa rating by Moody’s had a corresponding default rate of 24% � more than 10 times higher. The only plausible conclusion is that grade inflation has occurred in one context, but not the other, and the economic motive for such grade inflation seems obvious. If the gatekeeper has been compromised, what is the appropriate policy response? This question has no simple or obvious answer. As this author has argued at length in a recent book, market failure is a recurrent and predictable problem in the case of gatekeepers. See John C. Coffee Jr., Gatekeepers: The Professions and Corporate Governance (2006). Normally, the market’s response to demonstrated failure by any service provider is to withdraw business from it. But that will not happen in the case of credit-rating agencies because they do not simply provide information. Rather, for decades, the major credit-rating agencies have been delegated a form of governmental power. A variety of financial intermediaries � banks, brokers, insurance companies and mutual funds � are effectively required by federal and state law to keep the bulk of their investment portfolios in securities rated investment grade by “Nationally Recognized Statistical Rating Organizations” (NRSROs). For example, Securities and Exchange Commission Rule 15c3-1 (the net capital rule) strongly encourages broker-dealers to invest in bonds rated investment grade by NRSROs. Thus, because the ratings agency has a de facto licensing power, the issuer needs its rating even if the market distrusts the rating’s informational value. If market-based remedies are inadequate, some will advocate a stronger litigation remedy. To date, the major ratings agencies have wholly escaped liability in securities litigation. Their claim is that their ratings are protected First Amendment speech � in effect, their letter grades are seen as the world’s shortest editorials. Even if one views this First Amendment claim as overbroad, litigation is still an imperfect remedy. A ratings downgrade may produce a market decline of several billion dollars (as WorldCom showed). To threaten rating agencies with Rule 10b-5 liability in this amount because they were allegedly slow to downgrade is to threaten them with a nuclear weapon. Over time, only scorched earth might be left. If market and litigation remedies will not alone work, others will suggest that the appropriate policy response is to encourage greater competition in the market for credit information. Indeed, Congress elected this approach last year when it enacted the Credit Rating Agency Reform Act of 2006, requiring such firms to register with the SEC. Clearly, greater competition is desirable, but it is no panacea. Federal Reserve studies suggest that new entrants into this market tend to be even more optimistically biased than the established firms. In truth, no one likes a tough, objective rater � not the issuer that pays for it, nor the institutions that hold portfolios of investment grade debt that will be devastated by a ratings downgrade. Because the ratings agency is paid at the front end for its rating, it earns no additional revenue from a downgrade, but does risk future business. Thus, the deeper problem with gatekeepers is that there is often no constituency that truly values the unvarnished truth. As a result, downgradings are tardy and represent less a prediction of the future than a formal obituary for developments that the market has already begun to recognize. So what might work? Calomiris and Mason proposed that ratings agencies be prohibited from issuing letter grades. Instead, financial intermediaries would be forced to make their own assessments, and the ratings agencies would simply provide analytic tools. Unfortunately, this proposal has two defects: First, if there is any merit in the ratings agencies’ First Amendment argument, this reform would clearly run afoul of it by prohibiting a form of speech. Second, the idea that every institution should perform its own credit analysis is no better than the idea that every individual should be his or her own doctor or lawyer. It makes sense to centralize professional expertise in specialized firms. Indeed, smaller institutions, such as pension funds, have thin staffs by necessity and could not afford to bring this expertise in-house. Realistically, the government cannot regulate how risk assessments are made by professionals. Any attempt to develop SEC regulations defining the term “investment grade” or specifying the review process necessary to issue such an opinion would produce only a bureaucratic nightmare and a book-long addition to the Code of Federal Regulations. Predictably, skilled corporate lawyers would find ways to outflank such regulations in a few days. Status could be based on agencies’ default experience But something sensible can be done! A credit-rating agency’s status as a NRSRO (and thus its ability to exercise delegated power) could be made to depend on the default experience of its credit ratings. Let’s assume that the “normal” five-year default rate on a debt obligation rated Baa (or the minimum level of investment grade) were 5%. If Moody’s experienced a 24% default rate over this period on its CDO ratings (as noted above), it should lose its official status as an NRSRO for this class of security. Thus, it could still issue ratings, but financial users could not rely on them to satisfy their own legal obligations. This disqualification sanction could be limited to a particular class of securities and a particular rating. Thus, on the foregoing facts, Moody’s could still issue higher ratings if its default rates for those ratings met applicable higher standards. The impact would be to make ratings agencies more conservative, particularly as their default rate began to rise, and thus create a countervailing pressure to the current incentives that produce grade inflation. Making market experience the ultimate test for the grader is the least intrusive and best answer to market failure. Live by your ratings and die by them. It would be tough, fair and efficient. John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia University Law School and director of its Center on Corporate Governance.

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