Rating Agencies Remain a Weak Link in the Financial System

Last week's downgrade of major banks by Moody's is a reminder that the credit rating industry continues to pose significant risk to the financial system well after the crisis, owing to a fundamentally flawed business model. 

While the spectacular meltdown of many marquee banking names during the financial crisis continues to haunt the industry for good reason, the rating agencies today operate with far less oversight than the banks that they rate. And yet these companies have the potential to significantly amplify market turmoil due to inherent pro-cyclicality of the rating process. 

Title IX, Subchapter C of the Dodd-Frank Act addresses rating agency regulation. However, these firms continue to operate with a number of concerning weaknesses in their underlying processes and governance that were highlighted in the Securities and Exchange Commission's summary examination report of the rating agencies last year.

As noted by the Financial Crisis Inquiry Commission, the rating agencies were a contributing factor in the escalation of private-label mortgage securitizations and associated derivatives that ultimately crashed, precipitating the financial crisis. In part the agencies suffer from an inability to provide accurate ratings due to their reliance on statistical models that are no better at providing forward-looking views of risk than what we have seen recently with JPMorgan's value-at-risk models. 

And yet, while so much focus has been given to the role that changes in JPMorgan's VaR model had in the bank's trading loss incident, it is surprising how the processes and models used by the rating agencies to come to their determinations remain largely a mystery to many observers. 

Perhaps it is unfair to expect these companies to provide an accurate view of risk when they are so dependent on statistical models (hence the phrase "Nationally Recognized Statistical Rating Organization") that rely on historical information, which may not reflect future market conditions. This was clearly evident during the housing boom, where the years before the crisis painted an overly optimistic view of long-term mortgage security performance, as reflected by the abnormal level of highly-rated mortgage securities – which was followed abruptly by an avalanche of downgrades after the bubble popped on subprime mortgages.

This tendency of the rating agencies to take corrective action on understated risks only after the horse is out of the barn and galloping down the road calls into question the reliability of ratings in general. As further corroboration of the poor timing of ratings, one of the rating agencies was chastised at a Congressional hearing investigating the MF Global debacle. Why was Jon Corzine's brokerage rated investment-grade right up until its failure? 

Congress effectively gave ratings agencies a vote of no confidence when prohibiting their use by banks in determining their capital requirements. And the Federal Reserve Board's latest proposal surrounding their implementation of Basel III capital requirements is a nod to the Dodd-Frank prohibition on the use of credit ratings in making critical risk assessments. So if there are such grave concerns regarding the use of ratings in estimating bank capital, why are they allowed to persist in rating the banks, other companies or even sovereigns for that matter? 

Moreover, I find it confusing after the release of the Fed's severe stress-test results how divergent the views of the Fed and Moody's are concerning the perceived strength of the U.S. firms. The stress tests were held up as a clear indication of these banks' general abilities to withstand a catastrophic shock, and yet the latest downgrades suggest something else. 

More troublesome is the mischief that the rating agencies can pose to two potentially global destabilizing events upon the world stage right now: namely the European debt crisis and the looming fiscal crisis in the U.S.  We have observed the destabilizing influences of what a downgrade by a rating agency of U.S. debt means for markets during last year's debt-ceiling crisis, when Standard & Poor's downgraded the country for the first time, subjecting stock markets to severe volatility.

Adding insult to injury, S&P made what amounted to a $2 trillion math error in its downgrade assessment. That such an error was allowed to make it through the S&P review process, given the impact the downgrade would undoubtedly have, underscores the SEC's findings regarding fundamental weaknesses in rating agency controls. 

Looking back on this event provides a little perspective. What matters most: a $2 billion nick to profits by JPMorgan, or a massive error leading to the unprecedented downgrade of the world's most powerful economic force? 

Somewhere, a wake-up call is in order to reinvigorate attention on rating agencies. To permit a continuation of the current process simply invites greater turmoil into financial markets that are already far too turbulent.

Clifford Rossi is an executive-in-residence and Tyser Teaching Fellow at the University of Maryland's Robert H. Smith School of Business. He has held senior risk management and credit positions at Citigroup, Washington Mutual, Countrywide, Freddie Mac and Fannie Mae.