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07/24/2010 Financial Reform Killing Off Bonds By Both Requiring Ratings & Making It Impossible To Rate Bonds Ah, the unintended consequences of bad legislation. It's no surprise that many people have pinned a lot of the blame on the financial crisis on the ratings agencies (mainly Moody's and S&P). After all, they were the ones who went out there and said that collections of slices of dices of the worst mortgages around should be rated as top notch, sure-fire, investments. And there were clear conflicts of interest in how the ratings agencies did their ratings. But, in the end, the ratings agencies were really just giving an opinion -- and opinions are (last we checked) supposed to be protected by the First Amendment.

Real problemcame from the government writing those rating agencies 'in the law . Basically, the government, in a really short-sighted attempt to avoid financial problems, required certain institutions had to maintain a percentage of "highly rated" or "investment quality" bonds, in order to engage in certain activities. Suddenly, these "opinions" weren't just opinions, but had important legal consequences. If a ratings agency downgraded an investment, it could validity some holders of those bonds to have to sell them to maintain its investment ratios. With that, those ratings also took on the sheen of something objective and factual, rather than a random opinion put forth by a bunch of guys (mostly guys) who might not know what's really going on, and who have some serious conflicts of interest.

However, with the new financial reform bill in place, apparently one provision is that rating agencies can be liable for getting the rating wrong. Planet Money explains the unintended consequences this creates:

Under the new law, ratings agencies can be sued for making bad ratings decisions, if the ratings are included in formal documents that companies file with the SEC when they issue bonds.

That's making the agencies nervous. As a result, they're telling the issuers not to include their ratings in the formal documents filed with the SEC, according to the WSJ.

That's a particular problem for asset-backed securites -- bonds made up of bundles of consumer loans such as mortgages and auto loans. Federal law requires those bonds to include ratings in their formal documentation.

Because of that, the issuance of asset-backed securities has vanished. So, basically, the government requires these ratings be used on these types of financial instruments, but makes the ratings agencies liable if they make a bad guess in doing their ratings. You can understand the reasoning, but no ratings agency can be perfect. It's really making a guess, and eventually you're going to make a bad guess.

I really wonder if the part of the law making ratings agencies liable would stand up to a First Amendment challenge. But, in the meantime, asset-backed securities are on hold. Now, some may argue that this is a good thing, because "asset-backed securities" were part of the problem in the financial crisis. But that's definitely throwing out a very large baby with a little bit of bathwater. Yes, there were massive problems from asset-backed securities, but that doesn't mean the concept of asset-backed securities themselves are bad. In fact, they can be quite useful.

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