California takes aim at rating agencies
The Golden State is the latest to take the heavily criticized rating agencies to task for ignoring subprime risks. But the industry shortcomings aren't easy to fix.
NEW YORK (Fortune) -- The most ridiculed players in the financial markets have found a new tormentor.
California Attorney General Jerry Brown said Thursday he will launch an investigation of the major credit rating agencies for the role they played in the financial crisis.
The three top agencies -- McGraw-Hill's (MHP, Fortune 500) Standard & Poor's, Moody's (MCO) Investors Service and the Fitch unit of France's Fimalac -- raked in huge fees in exchange for assigning high ratings to "complicated financial instruments, including securities backed by subprime mortgages, making them appear as safe as government-issued Treasury bonds," Brown's office said in a statement Thursday morning.
Fitch said Thursday afternoon that it "regularly provides information to regulatory and state authorities as requested and we expect to provide similar information in this situation once the request is received." S&P didn't comment and Moody's didn't respond to a request for comment.
By now, it's well established that these so-called structured finance offerings were nothing like Treasury bonds. Massive losses on residential mortgage backed securities, collateralized debt obligations and other structured debt helped pave the way for the failures of Bear Stearns and Lehman Brothers and last fall's economic collapse.
What's more, it seems that the rating agencies -- which were castigated for their failure to note the massive frauds at Enron and WorldCom earlier this decade -- were aware of the problems in structured finance. Yet they did nothing to warn investors who had come, rightly or wrongly, to depend on credit ratings in making investment decisions.
In the most famous instance of rating agency self-reproach, documented in a Securities and Exchange Commission report issued in July 2008, a worker in S&P's structured products division bemoaned the firm's standards in an instant message exchange with another employee.
"We rate every deal. It could be structured by cows and we would rate it," the employee wrote.
The market for structured finance products has collapsed since the housing bubble burst, sharply reducing the opportunities for cloven-hoofed animals to sell bonds. But policymakers are still puzzling over how to prevent yet another replay of the rating agencies' failures.
In July, the Obama administration issued a lengthy white paper that promised to strengthen SEC oversight of the rating agencies. The Obama plan would focus on better managing of conflicts at the major rating agencies, which -- unlike some smaller ratings firms -- are paid by bond issuers rather than investors.
Critics say this conflict goes a long way toward explaining the major rating agencies' willingness to put triple-A ratings on paper backed by mortgages issued to borrowers with limited ability to pay.
But the administration's paper was "shockingly weak," said Barbara Roper, director of investor protection at the Consumer Federation of America, an alliance of pro-consumer groups.
The administration's plan isn't the only possible approach. Sen. Jack Reed, D-R.I., has proposed letting investors sue rating agencies for reckless conduct. A court ruling this month limited the rating agencies' reliance on a free speech defense in some suits brought by investors burned by the subprime meltdown.
But the administration hasn't embraced Reed's plan to make rating agencies liable.
Others say the administration should end the agencies' favored status as so-called nationally recognized statistical rating organizations, or NRSROs, for structured finance products. Doing so, they say, would eliminate the illusion that the rating agencies are providing an objective-minded service to investors.
But Roper said simply downgrading the ratings agencies, as it were, is no solution either. The agencies, if managed properly, could serve an important function in limiting how public pension funds, for instance, invest their money.
"It's tempting to say third strike and you're out, or, in this case, 25th strike and you're out," she said. "But you still have to fulfill this important function of constraining investment choices."
Roper said she's hopeful that legislation will pass Congress this fall reducing investors' reliance on ratings while supplementing oversight and reforming the industry's funding practices.
In the meantime, Brown -- like attorneys general Andrew Cuomo of New York and Richard Blumenthal of Connecticut before him -- will continue to poke and prod at the ratings agencies to see what they cough up.
"The states tend to be better at exposing problems than they are at crafting the solutions," said Roper. "But anything that keeps the heat on is potentially helpful." 
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