Merrill Lynch and other banks got into the CDO business several years ago.  The CDOs received an imprimatur from agencies such as Moody's, Standard & Poor's, and Fitch.  Some CDOs were even evaluated as investment grade securities.  The analysts at Moody's, Standard & Poor's, and Fitch apparently ignored the risks involved in the subprime mortgage market as well as the risks in real estate prices.

This segment generated lots of money for Merrill Lynch and the other banks.  The CDO business brought in millions and millions of revenues.  This line of business was at least as profitable for the bond rating agencies, too, as their ratings produced massive amounts of money.

Not surprisingly, problems developed because the financial institutions were lending funds to marginal borrowers, those with less-than-stellar credentials for loan applicants.  When some of these riskier borrowers defaulted on their mortgages, the CDOs started losing value.  The credit rating agencies did nothing; presumably, they felt that the CDOs still had investment grade status.

With the losses by Merrill Lynch out in the open, everybody knows not only that the CDOs have less fair value, but also that the credit raters aren't earning their keep.  Unfortunately, members of Congress believe that they should hold investigations on the matter.  I say unfortunate because such a move would be a waste of time, energy, and money.

Recall the downfall of Enron and the high credit ratings that Enron received from the credit rating agencies.  These agencies did not downgrade Enron's debt until after the 2001 third quarter results became public and Enron's stock price started its nosedive.  When Congress passed the Sarbanes-Oxley Act in 2002, section 702(b) required the SEC to conduct a study of credit rating agencies to determine why these credit rating agencies did not act as useful watchdogs and warn the public about Enron's true situation.  It accomplished little at the time; if Congress holds hearings now, nothing new will be learned.  Until policy makers focus on the institution of credit ratings and follow the cash, they waste their time with investigations.

Moody's and the other agencies make money by charging the business entities who are issuing debt.  It doesn't take a genius to see the conflict of interest.  The credit agencies lean on the issuer for more money or risk receiving a poor rating.  Payment not only entitles one to a good rating, but also it gives one the privilege of not receiving a downgrade unless bad news becomes public.

The SEC barely mentions this institutional feature in its "Report on the Roles and Function of Credit Rating Agencies in the Operation of the Securities Markets." 

This essay, written in January, 2003, practically ignores the problem.  On page 41, the SEC report states, "The practice of issuers paying for their own ratings creates the potential for a conflict of interest."  The SEC goes on to review comments by the large rating agencies themselves on how they manage this potential conflict of interest.

The comments are pathetic.  First, the SEC and the managers at credit rating agencies mangle the English language when they refuse to identify conflicts of interest for what they are.  My dictionary defines conflict of interest as "the circumstance of a public officeholder, corporate officer, etc., whose personal interests might benefit from his or her official actions or influence."  The term does not mean that they actually do benefit, but calls attention to the possibility.  Calling such circumstances "potential conflicts of interests" merely attempts to push ethics aside.  I can understand this behavior by the managers, but I don't comprehend the words of the SEC staff.

Second, the comments rely heavily on the assertions of the credit rating agencies themselves.  Managers of these agencies claim there is no problem, and of course the SEC should listen to them and accept every word as truth.  Yeah, right!

Third, on page 42 of the report, the SEC promises to explore whether these credit rating agencies "should implement procedures to manage potential conflicts of interest that arise when issuers [pay] for ratings."  Either the SEC did not keep its promise or such actions are inadequate.  Clearly, the credit rating agencies have not responded any differently to the CDO problem than they did with Enron's circumstances.

Policy makers can reduce the problems by reducing the very real conflict of interests that perniciously raises its ugly head from time to time.  The solution is to prohibit credit rating agencies to receive any funds from the issuers.  If the ratings have any merit, then investors will be willing to pay for them. 

This essay reflects the opinion of the author and not necessarily the opinion of The Pennsylvania State University.