Will Credit Rating Agencies Be Monitored?

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The G-20 last weekend committed to exercising strong oversight of credit rating agencies. Many of the financial instruments that are at the heart of the financial crisis had been given AAA ratings, meaning they were supposed to be of the highest quality. That turned out to be wrong. Will the G-20 declaration change anything?

STEVE INSKEEP, host:

Next, we are going to examine one small proposal to fix part of the world financial system - gets a little complicated, but it touches everything - and it's one of the subjects that world leaders discussed at the White House last week as they were talking over the financial crisis while eating rack of lamb and sipping glasses of wine. NPR's David Kestenbaum has been looking into that item on their list, improving credit-rating agencies. He's in our studios. David, good morning.

DAVID KESTENBAUM: Good morning.

INSKEEP: Explain if you can, why it is that credit-rating agencies would touch everything?

KESTENBAUM: The rating agencies have a huge amount of power. The big ones are places like S&P and Moody's and Fitch. And they basically look at, you know, a bond or a mortgage-backed security and they give letter grades. They say, you, you're really safe; I give you a triple-A. You, you're a double-A. And they a have lower grades, too. The problem was that some of the things they gave triple-A to and double-A to were not actually so safe as...

INSKEEP: There was a little bit of grade inflation or (unintelligible)...

KESTENBAUM: There was a little bit of grade inflation. And they're powerful in part because pension funds and school boards in cities and states, they are, in some cases, required to only invest in things that get triple-A or double-A.

INSKEEP: So, when they said, mortgage-back securities are totally safe, this is something that contributed to the world financial crisis in a big way.

KESTENBAUM: Right. And you know, you could argue this whose job was it? It was the credit-rating agencies to look at these things and figure out how safe they were.

INSKEEP: So, when leaders from around the world, the so-called G-20, met, what did they decide to do about this?

KESTENBAUM: Well, let me play you this tape. This is Nicolas Sarkozy, the president of France, and he was very animated, and it turns out he speaks French.

(Soundbite of laughter)

(Soundbite of speech)

President NICOLAS SARKOZY (France): (French spoken).

INSKEEP: Translation, please.

KESTENBAUM: Right, OK. So, then I found one of those magic little boxes with headphones that gives you translation. What he was saying is that the rating agencies will be regulated. He said, never, ever had this point been agreed to or accepted in what I would describe loosely as the Anglo-Saxon world. He said rating agencies will be registered and they will be monitored.

INSKEEP: What does that mean?

KESTENBAUM: Well, some people would tell you it actually means very little. Registered would mean that you - that rating agencies have to sign up and maybe disclose some of their inner workings. Monitored would mean that you might get an official body to look at the rating agencies and put out a report saying how well they do.

INSKEEP: Isn't it the same way that Securities and Exchange Commission looks at stock brokers or looks at different companies and stock offerings?

KESTENBAUM: Right. It would be sort of rating the rating agencies. I mean, they would say, look this guys rated this things triple-A, but a lot of them had to get downgraded. It would give you a way as a consumer to look and say which rating agencies are doing a good job and which are not.

INSKEEP: Well, who's smart enough to know if a rating agency is giving the right rating as they decide on the risk of an investment?

KESTENBAUM: Well, you can only tell after the fact, right? So, I talk to Joseph Mason. He's a professor of banking at Louisiana State University. He did not think very much of what Sarkozy and the G-20 folks had agreed to, because he felt like that it didn't really have any teeth. And his solution was just - look, these rating agencies, we will not use them as official guides when it comes to complex things like collateralized-debt obligations and mortgage-backed securities, the stuff that got us into trouble. Dr. JOSEPH MASON (Finance, Louisiana State University): Not every financial instrument can be reliably rated. When you have brand new subprime mortgages, not enough is known about the historical performance of those mortgages for any rating agency, no matter how talented, to go out and predict.

KESTENBAUM: You know, I talk to one securities lawyer, and he said if you look overall the rating agencies have not done so bad, historically. They just flunked one course, and they flunked this one really badly.

INSKEEP: But let me ask about whether the rules aren't sensible. Because if I've got this investment vehicle that I am trying to sell the people, I go to the rating agency and say I'll pay, you to give me a grade. Doesn't that give this huge potential for a conflict of interest? The rating agency is going to want to give them a good grade, because they're getting paid by that guy.

KESTENBAUM: It can, and in particular, if you're going to try and issue a bond, right, you might go to a bunch of rating agencies and see who gives you the best rating and go with that, right? But you know, there is a potential problems anyway you want to do this. Imagine, I, the person, buying it pay the rating agency. Well, then there is an incentive for them to rate it artificially low, the other way around, so that I can buy it for cheap from you. I mean, this is why the world leaders can say, look, we've made real progress. They can stand on a stage and get a photo taken, but it could be very hard to work out exactly how to implement these things in way that's going to make a real difference.

INSKEEP: NPR's David Kestenbaum, looking a little further behind the financial news. David, thanks very much.

KESTENBAUM: You're welcome.

INSKEEP: And you can look even more deeply by going to our Planet Money blog and podcast, which are at npr.org/money.

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