Credit-Rating Agencies Must be More Accountable to Restore Confidence in Financial Markets

 

WASHINGTON, D.C., August 5, 2009 – Credit-rating agencies should be subject to some lawsuits and held more accountable for their actions, to help avoid a repeat of last year’s financial crisis, Columbia Law School Professor John C. Coffee told the Senate Banking Committee.

 

“The credit-rating agencies today do not face any meaningful risk of liability,” said Coffee, the Adolf A. Berle Professor of Law.

 

Companies like Moody’s, Standard & Poor’s and Fitch Ratings came under harsh criticism for assigning their highest ratings – AAA -- to bundles of mortgage-backed securities filled with subprime loans that went into default.

 

Part of the problem, noted Coffee, is that most of the revenue for the rating agencies comes from the issuers of these securities. Coffee conceded that business model is likely to remain intact. In turn, he argued changes are needed or there will be a “persistence of the status quo, dysfunctional and perverse as it is.”

 

Coffee said greater due diligence by an independent third party should be required – an Obama administration proposal would make it optional -- before a rating is assigned.

 

Coffee supplied to the committee data that reveal a precipitous decline in due diligence by securities firms this decade at the same time the number of risky mortgages jumped. That became even more problematic when credit-rating agencies did not require due diligence as a condition for their ratings.

 

“To the extent that you choose to rely on third-party due diligence, that verifies the essential facts,” Coffee said.

 

Credit-rating agencies, Coffee said, are unlike other gatekeepers in the financial world, like accountants and investment banks, because they have never been held liable for their actions even though they have a “built-in bias” as a “watchdog paid by the entities they are expected to watch.”

 

While Coffee does not want to open the floodgates to litigation, he favors exposing the agencies to some liability in structured finance offerings, such as collateralized debt obligations, when they are “willfully ignorant” of inherent risks in these investments.

 

“Over the last decade, they have essentially been issuing hypothetical ratings in structured finance transactions based on hypothetical assumed facts provided them by issuers and underwriters,” Coffee wrote in his prepared remarks.

 

In the end, Coffee said, greater due diligence is needed not because it is a good idea, but because it is good for business.

 

“Ultimately, unless the users of credit ratings believe that ratings are based on real facts … the credibility of ratings, particularly in the field of structured finance, will remain tarnished, and private housing finance in the U.S. will remain starved and underfunded because it will be denied access to the broader capital markets.”

 

To view the webcast of the hearing, click here.

 

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