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Credit rating industry dodges reforms, despite role in financial meltdown
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Credit rating industry dodges reforms, despite role in financial meltdown

The California Public Employee Retirement System requires that bonds it holds be rated by one of the top three credit raters even after it sued those companies for issuing "untrue, inaccurate and unjustifiably high credit ratings."

"These credit ratings were false at the time they were initially assigned, and continued to be false during the existence of the" investments, Calpers, the nation's biggest pension fund, claims in its 2009 lawsuit against Moody's Corp., Fitch Inc. and the parent company of Standard and Poor's. The state pension fund says the bad ratings cost it as much as $1 billion.

That Calpers still depends on S&P, Moody's and Fitch to rate its investments shows how much power these companies continue to wield in the global financial industry even after several investigations concluded their AAA ratings on mortgage bonds and other complex investments helped lead directly to the 2008 financial collapse. Calpers settled with Fitch without receiving payment, and the suit against S&P and Moody's is pending.

Calpers, which manages $288 billion in assets, isn't alone. Most major pension funds, insurance companies and mutual funds require investments in corporate bonds, mortgage bonds or collateralized debt obligations be rated by one of the three major ratings agencies.

Pimco, the world's largest bond investor, also requires many of its investments to be rated by S&P and Moody's even after its chairman, Bill Gross, in 2007 vividly thrashed the two companies for giving high ratings to trash investments.

"What was chaste and AAA years ago may no longer be the case today," Gross wrote in his weekly investment outlook. "You were wooed, Mr. Moody's and Mr. Poor's, by the makeup, those six-inch hooker heels and a 'tramp stamp.' "

The ratings industry has mostly escaped reform despite its central role in the financial crisis because the Securities and Exchange Commission has failed to implement many proposed changes and the companies themselves have fought off others.

The Dodd-Frank financial reform law, which passed in 2010 in response to the crisis, devoted an entire section to fixing the broken credit rating industry.

The changes were supposed to boost oversight, increase competition, reduce investor reliance on credit ratings, and make the companies liable for negligent practices. The law also required the SEC to consider changing the entire business model to eliminate the conflicts of interest that arise when credit ratings are paid for by the companies issuing the securities.

Four years after President Barack Obama signed Dodd-Frank into law, many of the reforms to the credit rating industry have not been implemented, and the private sector continues to rely on the same companies for investment opinions.

While lawmakers who worked on Dodd-Frank agreed the system needed a fix, they disagreed on how to do it, according to congressional staffers involved in writing the law. The result is a mishmash of vague mandates with contradictory goals that try at once to diminish the importance of credit ratings while increasing competition in the industry, to diminish conflicts of interest while failing to eliminate the central problem, and to create an oversight office with little authority.

"The change has been minuscule," said former Pennsylvania congressman Paul Kanjorski, D-Pa., who was an author of the credit rating section of the Dodd-Frank law. "I have to be honest. It was the most disappointing section the bill."

Reprinted by permission of The Center for Public Integrity.

Key findings

  • Despite contributing to the 2008 financial crisis by rating bonds made up of toxic mortgages as ‘AAA,’ the big credit rating companies are as powerful as ever.
  • State pension funds are suing credit raters, yet they still depend on ratings from the firms to guide investment decisions.
  • Most industry reforms haven’t been fully implemented or have failed outright, setting up the markets for another possible fall.
  • The Securities and Exchange Commission has promised not to enforce part of the Dodd-Frank law that would make credit raters liable for bad ratings.
  • The credit rating system is rife with the same conflicts of interest that caused distorted ratings before the financial crisis.

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