In July 2007, a recently hired analyst in Standard & Poor’s structured finance group exchanged a series of emails with an investment banking client who wanted to know how the new job was going. Things were just great, the analyst said sardonically, “aside from the fact that the MBS world is crashing, investors and media hate us and we’re all running around to save face … no complaints.” Part of the problem, the analyst said in a subsequent email, was that some people at S&P had been pushing to downgrade structured finance deals, “but the leadership was concerned of p*ssing off too many clients and jumping the gun ahead of Fitch and Moody’s.
I suspect that only an investment banker could find it in his or her heart to sympathize with a credit analyst in the summer of 2007, but this one suggested that some good might come from S&P’s internal conflict. “This might shake out a completely different way of doing biz in the industry,” the banker wrote. “I mean come on, we pay you to rate our deals and the better the rating the more money we make?!?! Whats up with that? How are you possibly supposed to be impartial????”
The email exchange, recounted deep in the Justice Department’s new civil complaint against S&P and its parent, McGraw-Hill, pretty well sums up the entire theory of the government’s case against the rating agency. S&P, according to the Justice Department, had a choice as the housing market began to collapse and subprime mortgages began to default. Rating agency analysts who monitored mortgage-backed securities knew the crash was coming and warned repeatedly that previous ratings of mortgage-backed instruments were no longer a reliable gauge. But rather than heed those warnings and toughen standards on mortgage-tied instruments, S&P continued to accept fees from banks in exchange for conferring its blessing on tens of billions of dollars of collateralized debt obligations. When truth collided with the client relationships that generated S&P’s revenue, in other words, money won out.
So what do we do? Frankel suggests:
There are alternatives to the issuer-pays model. ... Investors could directly share with issuers the cost of rating securities, or could fund their own independent credit rating agency. Or perhaps the government or an independent board could administer credit ratings, either by allocating assignments on the basis of market share or by overseeing auctions in which rating agencies compete for business. The point of all the alternative models is to recalibrate the incentives of rating agencies so their revenue doesn’t depend on delivering the results issuers want.
For a more detailed treatment of the various alternatuives, see Frank Partnoy's essay How and Why Credit Rating Agencies are Not Like Other Gatekeepers, in which he argues that "the best proposals would help resolve the paradox of credit ratings by creating incentives for credit rating agencies to generate greater informational value while reducing the impact of ratings on markets."