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Heads have rolled, huge write-downs have been taken, but still equilibrium has not returned to the debt markets. Unless the credit meltdown can be halted, a recession looms. Consumer spending has been recently responsible for roughly 70% of U.S. gross domestic product, and it is, in turn, financed today primarily through securitizations. Thus, destabilize the financing of consumer spending and the economy falters. So far, the response of policymakers has largely been to fashion accommodative monetary policies that will either bail out imperiled financial institutions or relieve overextended homeowners. Such policies may alleviate the symptoms, but they will not cure the liquidity crisis that is paralyzing the debt markets. By definition in a liquidity crisis, trading slows and prices become deeply discounted because most investors cannot determine the real value of the affected assets. Normally, the crisis ends only when the “smart money” offers deeply discounted prices at which risk-averse holders are willing to sell their gridlocked securities. But little movement in this direction has been visible. Informational asymmetry persists for several reasons Why not? At bottom, the informational asymmetry that fuels a liquidity crisis has persisted. Explaining why it has continued clarifies in turn what reforms could bring transparency to this critical market. Most recent accounts tell a story in which greedy, fee-driven bankers packaged risky subprime mortgages into collateralized debt obligations (CDOs), ignoring credit problems, because they did not expect to hold these securities for long. True, bankers no longer resemble Jimmy Stewart in It’s A Wonderful Life, but these “market bubble” stories do not adequately explain why transparency has not been restored to the debt markets. A fuller, richer story must explain not only the dubious motives of bankers, but also why corporate bonds trade smoothly today in deep and liquid markets, while structured finance remains paralyzed. The fuller answer must begin with the critical gatekeeper for debt markets: the debt ratings agencies. Rating agencies provide two different and potentially conflicting services: They provide information about credit risk to investors, and they dispense regulatory licenses without which issuers could not sell their debt securities to most institutional investors. Because the regulatory agencies that supervise banks, insurance companies, mutual funds and pension funds lack the ability or manpower to appraise credit risk of issuers, they long ago delegated this function to those debt-rating agencies that are recognized by the Securities and Exchange Commission (SEC) as “Nationally Recognized Statistical Rating Organizations” (NRSROs). Unless debt securities are rated “investment grade” by an NRSRO, they are basically off limits for most institutional investors. This need for an investment-grade rating creates a strong incentive for grade inflation, as the issuer and sometimes even the institutions lobby the rater for liberal grades. It also probably explains why the fees of the dominant NRSROs � Moody’s, Standard & Poor’s and Fitch � are paid by the issuer, not by the users of this information. Still, although issuer-paid ratings creates an obvious conflict of interest, it does not appear to have adversely affected the market for corporate bonds, where high investment ratings do in fact correlate with low default rates. But the reverse has been true in structured finance, where the five-year default rate on CDOs for Moody’s lowest investment-grade rating (BAA) has recently ranged as high as 24%. This sharp disparity between bonds and CDOs may seem puzzling, but some basic differences between the two markets explain it. First, the conflict of interest is greater in the structured-finance setting. While the public corporation represents only a trivial percentage of a ratings agency’s business, the investment banks that package securitizations are repeat players that, in a frothy market, may seek ratings continuously and thus have greater market power and leverage. Second, rating structured-finance products is far more difficult than rating the bonds of public corporations. The latter disclose their financial history and projections to the market, and even an amateur can estimate the risk of default. But structured-finance products are far more opaque. Residential mortgage backed securities (RMBS) consist, for example, of a static pool of mortgages that were packaged in a given year. Could the borrowers in the 2005 cohort differ significantly from those in the 2006 cohort? The amateur cannot tell, and even sophisticated analysts believe that a process of “seasoning” is necessary, which may take three years, before differences between the two cohort groups will surface and enable valid risk assessments to be made. Third, rating agencies assess risk at the time of issuance and devote little resources to continuing surveillance of the issuer. Economically, this is a corollary of issuer-funded ratings, because the issuer will hardly pay for a downgrade. Since downgrades cost the ratings agency future business, they are uncommon. Overall, the absence of continuing monitoring has less impact on the corporate bond market, where information about the issuer is publicly available and the issuer is also subject to the continuing review of securities analysts. But this absence has far more significance for structured finance, where the “true” risk level typically becomes apparent only after a “seasoning” period. Ironically, the agencies exploit this limitation by selling software to institutions to help them evaluate the risk of rated debt securities in light of new information that emerges after issuance. Thus, they may profit more than if they updated their ratings and kept the market transparent. Finally, ratings agencies do not perform meaningful due diligence. In fact, they proclaim as much. Moody’s Code of Professional Conduct states that: “Moody’s has no obligation to perform, and does not perform, due diligence with respect to the accuracy of the information it receives or obtains in connection with the ratings process.” See Moody’s Investor Service, Code of Professional Conduct 6 (June 2005). This failure distinguishes debt-ratings agencies from other traditional gatekeepers, such as accountants, lawyers, investment bankers and even securities analysts. Economizing on due diligence has greater impact on the accuracy of structured-finance ratings because the issuer can more easily manipulate the agency’s credit risk model, whereas the public corporation’s books and projections are audited and reviewed by other gatekeepers. Against this backdrop, recent developments come into sharper focus. Although mass ratings downgrades had been virtually unknown, two major waves of downgrades swept over the markets in June and July, but were largely limited to the still “unseasoned” pools of mortgages packaged in 2006. These downgrades appear to have been motivated by the soaring default rates on these securities, which could no longer be ignored. A recent Morgan Stanley study focused on all sub-prime RMBS pools that were packaged in 2006, and found that of the 6,431 such pools rated by Moody’s in this 2006 “vintage,” Moody’s had already downgraded the ratings on 3,225, or 50.1%. This 50.1% figure compares with the historical risk of a downgrade on RMBS offerings of only 0.3% � a dramatic discontinuity! Indeed, 97% of the RMBS issuances rated A or below in 2006 by Moody’s had already been downgraded. See Morgan Stanley Fixed Income Research, “Standing on the Razor’s Edge” (November 2007). Clearly, this unprecedented level of downgradings traumatized the debt market. But, even worse, it is not over. The major ratings agencies are still reviewing their ratings on structured-finance products and may have been slowed by the intensity of the market’s reaction. Steps to make the process more predictable In effect, downgrades that in a more transparent market would have occurred more evenly were telescoped into one brief burst of downgradings. To restore transparency, this process must be made more predictable and constant. Nothing will work overnight, but the following steps could restore investor confidence: • Require NRSROs to review and republish their ratings at least annually. Securities analysts update their research regularly, and public companies file periodic reports with the SEC at least quarterly. Only the ratings agencies claim the right to opine and forget. This absence of periodic re-ratings is particularly troubling in the case of structured finance, where the need for “seasoning” often renders the original rating premature. The rating agencies will predictably respond that they have a First Amendment right to publish their opinions only when they want. That may be true in general, but there is no constitutional right to be an NRSRO. If a ratings agency wants to possess the right to sell regulatory permissions to issuers and institutional investors, it should be required to update its ratings regularly. • Encourage competition by reducing the rating agencies’ exemption under Regulation FD. Today, Regulation FD exempts ratings agencies from its prohibition on selective disclosure. The consequence is that an issuer can disclose confidential information to one agency, but not to the public or other agencies. As the result of 2006 legislation, the SEC has finally admitted new members to the NRSRO club, but issuers continue to release information only to the agency that they have hired to rate them. New agencies are increasingly subscriber-funded and thus are potentially more independent. To make them effective watchdogs of the dominant agencies, they should receive access to the same information that the issuer gives its “hired gun” rater. • Mandate due diligence. It’s a great business when you can state your opinion for a lucrative fee and have no liability for its inaccuracy, no obligation to review or update it and no duty to perform minimum due diligence. This state of affairs largely explains why the credibility of ratings remains under a cloud. John C. Coffee Jr. is the Adolf A. Berle Professor of Law at Columbia Law School and director of its Center on Corporate Governance.

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