Credit rating agency rules to tighten

When money managers make good investments, they are happy to take credit for brilliance. When they make bad investments, they would rather the blame go elsewhere.

The Senate Banking Committee held a hearing last week to beat up on the credit rating agencies and to push the Securities and Exchange Commission to impose tough regulations on them as quickly as possible.

Many of the new rules the SEC is likely to consider are good ideas, but the responsibility for this debacle goes far beyond the rating agencies.

When the dust settles, it is probable that there will be SEC rules mandating that a company giving information to one rating agency be required to give it to any agency. It is not clear if the information will have to be made public. If not, there could be questions of trading on inside information, particularly since some new rating agencies will finance their work by releasing opinions only to the investors who hire them.

There will also be rules aimed at forcing the agencies to do a better job of checking the information they are given. The agencies now complain that those who manufactured mortgage-backed securities lied to them. But a committee of the International Organization of Securities Commissions, known as IOSCO, concluded that in some cases the agencies should have realized the information failed to pass a "sniff test."

There are also likely to be rules to make the agencies do a better job of keeping their ratings up to date. That could prove costly if the market for structured finance products remains moribund. With little income coming in from new ratings and more money going out to monitor old ratings, profits could be under severe pressure.

Finally, there is likely to be some kind of database to make it easier to see how accurate the ratings turned out to be.

If anything, anger at the rating agencies appears to be greater in Europe than in the United States, and pressure for tough rules is especially strong in Germany, where the banks would like to blame Moody's, Standard & Poor's and Fitch -- all hailing from America -- for the bad investments they made.

A few years ago, some European companies, angry at what they saw as unduly tough ratings, mounted a campaign for more regulation of the credit agencies. That led to international efforts to force the agencies to disclose their rating criteria. Those disclosures probably made it easier for Wall Street to tailor structured finance products to get desired ratings.

At the Senate hearing, there were only limited indications that anyone other than the rating agencies was responsible for the current crisis. There was a brief discussion regarding the need for an investigation into the way investment banks put together the structured finance products that the rating agencies misrated. But there was no talk about the decisions by Congress and the various regulators to leave those securities virtually unregulated while the credit boom was going on.

Nor were there harsh words for the institutional investors who snapped up these securities without doing much, if any, homework.

As the IOSCO report put it, "There are serious questions whether institutional investors, either through ignorance or lax internal governance and risk management, relied excessively on credit ratings, with little regard for the underlying risks of the financial instruments they bought, sold and in some cases even designed."

Instead, it was the agencies that took the rap. "Because rating agencies underestimated the risks of subprime-based securities, these securities were allowed to spread throughout our financial system without their real risk being detected before it was too late," said Sen. Richard Shelby of Alabama, the ranking Republican on the committee.

Sen. Christopher Dodd, D-Conn., who is the committee chairman, practically begged Christopher Cox, the SEC chairman, to ask for new legislative authority. He suggested that perhaps it would be a good idea to leave credit rating to some kind of nonprofit agency that would not have conflicts of interest. Both he and Shelby suggested that the SEC should revoke the operating license of a credit rating agency that was wrong too often.

It looks as if the rating agencies are well on their way to becoming the scapegoat for this disaster, much as securities analysts took much of the blame for the technology stock bubble whose bursting led to the last recession.

That the rating process was badly flawed is now clear. But so was much else.

Mortgage brokers made loans to people who could not hope to repay them unless house prices continued to rise, sometimes using inflated appraisals to get the loans approved. Wall Street packaged the loans into securities, and the credit rating agencies blessed many of them with high ratings based on foolish assumptions.

Regulators and congressmen cheered on the whole process because it was enabling more people to buy homes and allowing the commercial banks to use the securities to transfer risks to others.

Little is being done about most of those sinners. There are new rules to prevent foolish mortgage loans, but those rules came after the debacle had already assured that such loans would no longer be made. The Treasury Department thinks the Federal Reserve, which refused pleas to intervene in the subprime lending boom when it might have done some good, should get more power over the financial system.

Under the rules that the SEC is expected to propose this summer, rating agencies will be able to try a different business model, one that relies on payments from investors rather than issuers.

It will be interesting to see if institutional investors are willing to support such agencies. Had they been willing to pay for research before -- and to buy securities only from issuers who released enough information to allow informed investment decisions -- this disaster might never have happened.

Floyd Norris comments on finance and economics in his blog at norris.blogs.nytimes.com.