Reference no: EM131904362

Problem: LEGAL/ETHICAL CHALLENGE

When an "A" Is Not an "A"-Who's Responsible?

It is well known that the Wall St. Meltdown and Great Recession were intimately tied to the mortgage market. At the heart of this was the pursuit of greater and greater returns. Financial institutions of all sorts (e.g., mortgage lenders, banks, investment banks, and insurance companies) got increasingly "creative" with their mortgage related products and qualifications. This creativity enabled financial institutions to sell more homes, more mortgages, more mortgage-backed securities, and more insurance than they could otherwise. This also enabled millions of Americans to purchase homes that they otherwise could not qualify for or afford. Then the bubble popped! Home values dropped, credit dried up, returns fell, and so on. Millions of homeowners were forced to foreclose or were underwater (i.e., obligated to pay more than market value). Countless, mostly smaller, financial institutions went out of business while many of the largest were acquired or bailed out. One important character in this story is missing, however: ratings agencies! S&P, Moody's, and Fitch are the three biggest in the United States. They assign grades much like school-As, Bs, and Cs-to the securities created by pooling many mortgages into packages (e.g., bonds and other mortgage-backed securities).

These grades were (and still are) fundamentally important to the entire market, as they determined to whom and at what terms these securities were sold. For example, many institutions (e.g., pension funds) can only purchase A-graded securities. It also is important to note that the agencies were and are paid for their "grading services" by the firms whose products they grade. Citigroup, for instance, pooled many mortgages it bought into packages (e.g., bonds). They then took these bonds to S&P to be graded, grades for which they paid. (A-rated bonds have more buyers than Bs, which have more than Cs.) It is no surprise then that those financial institutions shopped around for higher grades. As it is now well known, the agencies' grades were often inaccurate. Like a professor assigning grades to papers without looking at them, they assigned As to many securities that weren't worthy. If this wasn't problem enough, under current law, the agencies are not legally responsible for their ratings or grades. (It's like randomly assigning As to everybody in the class with no consequences to the professor.) The agencies have long contended that their conclusions are simply "opinions" and are protected by the First Amendment.98 While pending legislation intends to hold agencies accountable and liable, as it stands today they are not responsible for the grades they assign.

What Should Be Done about the Ratings Agencies?

1. Ratings agencies should be liable for their ratings. If financial institutions that create and sell fraudulent securities (e.g., those they expect to fail) can be prosecuted, then so too should the agencies that rated them as secure and sellable (e.g., an A rating).

2. Ratings agencies cannot be expected to fully understand the increasingly complex financial products presented to them. It is unreasonable for them to be held accountable.

3. Neither #1 nor #2 matters. The entire situation would take care of itself if the financial institutions were not the ones paying agencies for their ratings. An alternative payment arrangement would remedy the situation.

4. Invent another alternative and explain.