Washington: We See The Problem

After reading my Sunday New York Times, it appears that the new administration is moving in the right direction. The headline on the front page reads “Obama Plans Fast Action To Tighten Financial Rules” “New Scrutiny for Hedge Funds, Derivatives Market and Credit Rating Agencies.”

It does not appear that this administration is ready to scrap the credit rating companies and take the responsibility and put it with the Federal Reserve Bank or the Securities & Exchange Commission. In the real world this kind of drastic action will only be taken if all else fails, I guess. This is what the Times had to say,

“Some of these actions will require legislation, while others should be achievable through regulations adopted by several federal agencies.
Officials said they want rules to eliminate conflicts of interest at credit rating agencies that gave top investment grades to the exotic and ultimately shaky financial instruments that have been a source of market turmoil. The core problem, they said, is that the agencies are paid by companies to help them structure financial instruments, which the agencies then grade. Until we deal with the compensation model, we're not going to deal with the conflict of interest, and people are not going to have confidence that the ratings are worth relying on, worth the paper they’re printed on,”(said) Mary L. Shapiro, who testified earlier this month before being confirmed by the Senate to head the Securities & Exchange Commission.”

It does not take an Einstein to know that if the credit rating agencies are being paid by the investment bankers, who underwrite the structured financial instruments, that unless the underwriters get the AAA rating they are looking for, that they will then “shop” for another credit rating agency that will give them the AAA rating. Because these companies, the credit rating agencies, are corporations that are publicly traded with quarterly earnings reports, and CEOs, whose salary and bonus are usually tied to the growth in earnings of their corporation, the greed factor is alive, well and at work. Figuring out how to remove this major conflict of interest that the rating agencies have with their clients, the investment banks on "Wall Street", is at the heart of the matter. Without this conflict of interest worked out of the equation, it will be business as usual. Greed trumps all cards.

The article goes on to say,

“They are considering proposals to have the S.E.C. become more involved in supervising the underwriting standards of securities that are backed by mortgages.”

That sounds good, but they do not say how they are going to eliminate the conflict of interest. I happen to know a person that owns a company that writes mathematical models for structured finance. I also know that the credit rating agencies declined their offer to help them with their task of rating mortgaged-backed bonds. Had the credit rating agencies used the models offered to them, they would not have been able to give many of these mortgaged-backed bonds their AAA rating.

The real story is that the credit rating agencies really did not want to know that they should not be passing out their AAA rating like candy to children on Halloween.

Unless the conflict of interest problem is resolved, and it will take some tough and comprehensive regulations and oversight to do that, the problem of confidence in structured financial instruments will remain. The way out of the recession has many avenues, but the credit rating agencies solution is, in my opinion, directly tied to the speed of the economic recovery.

Stay tuned.