Quit Whining, Ratings Agencies!

Editor's note: We've updated this article with corrections to several errors (which the Fool regrets) and new updates that occurred after its original publication. Please scroll to the bottom of the page for the latest information.

Absurd conflicts of interest and incompetence among the rating agencies tasked to accurately rate structured products played an important role in the financial crisis. If the agencies hadn't slapped triple-A ratings (as good as cash) on deals destined to become junk, we'd likely have avoided much of the mortgage mess. And unlike Goldman Sachs (NYSE: GS  ) , which could hire an armada of lobbyists to defend it against its embarrassing implications in the housing debacle, the raters were politically vulnerable.

In short, everyone knew reform would be coming for them. Hard. Heck, I'm surprised they got off this easy.

"Unintended consequences"!?
Fast-forward to the day financial reform is signed into law. Moody's (NYSE: MCO  ) , Fitch, and Standard & Poor's (a division of McGraw Hill (NYSE: MHP  ) ), the big three debt ratings agencies, are refusing to rate debt.

They complain that new laws subject them to unknown legal liabilities, and their lawyers need time to sort things out.

This is a big deal, because it has the potential to freeze up corporate debt markets. Raters' intransigence has already torpedoed Ford's (NYSE: F  ) new debt sale. This has led some ill-informed commentators to scream "Unintended consequences!"

Foolish with a small-"f"
But how badly are the ratings agencies whining? Let's count the ways:

1. No-brainer provision: With the repeal of Rule 436(g), which exempted the agencies from what's known inside the industry as an "expert liability," ratings agencies can now be sued for a "knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source." Since these three companies enjoy a market oligopoly on how buyers measure risk and price debt, a "knowing or reckless failure" to actually do your job seems like reasonable grounds for a lawsuit.
2. This isn't news: Those of us who have been closely following financial reform -- which presumably includes the raters' ineffectual lobbyists -- knew this provision would be part of the final legislation, since it was approved by the conference committee around, oh, June 16. Dropping this bombshell the day after reform is passed appears to be an attempt to hold debt markets hostage, so that legislators will undo a much-needed provision.
3. "Please put us down": As Michael Corkery at The Wall Street Journal put it so well: "Raters could come dangerously close to arguing their way out of business. After all, they're admitting that they will only stand by their ratings up to a point." He's exactly right, and I'll take it one step further. What the agencies are basically saying is, "Not only are we unwilling to stand by the quality of our services, we can't even guarantee that 'knowing or reckless failure' isn't so widespread that you should bother to use our services."

What next?
The big three ratings agencies need to stop hiding behind their lawyers and step up their game. Yes, their entrenched market position, augmented by government mandates, has been noted by Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) Chairman Warren Buffett (a large investor in Moody's) for a long time. But with many of those mandates now removed by Sen. George LeMieux's amendment to the financial reform bill, you have PIMCO's Bill Gross saying that raters "no longer serve a valid purpose." In other words, debt investors don't have an excuse for relying on agencies to do the research for them.

But even if lazy investors don't manage to put away the pipe, and continue deferring to raters' expert judgment, the reform bill includes a study based on an idea by Sen. Al Franken that, if implemented, would assign the first rater to structured finance deals randomly, based on past accuracy. This has the potential to provide a toehold for new entrants with untarnished reputations like Morningstar (NYSE: MORN  ) .

Threats are emerging. It's time for the raters to stop whining and start doing their jobs.

Am I being unfair? Sound off in the comments box below.

UPDATE:
I regret there are some errors in this piece. Also, the issues are slightly more complicated than I made them out to be, and more news came out just after publication.

1. Agencies aren't refusing to rate debt – they're refusing to allow their ratings to be used in prospectuses.
2. There are two separate liabilities in question. Under Section 933 of the financial reform bill, ratings agencies could be held liable if they "knowingly or recklessly failed to conduct a reasonable investigation" of the facts or obtain analysis from an independent source. A separate measure, repeals the SEC's Rule 436(g), which exempted nationally recognized ratings agencies from "expert liabilities" that could have arisen from their ratings being used in prospectuses. It's only the latter issue that pushed them to disallow ratings from being used in prospectuses.
3. Proponents for repealing 436(g) argue that the exemption, which only applied to a class of nationally recognized ratings agencies, protected them from new entrants. Removing the exemption, they add, could make agencies more careful and accurate with their ratings. Raters are concerned that being subjected to "expert liabilities" could put them in a class with fact-based experts like auditors. In 1994, one commenter argued that ratings "are expression of opinion about risk, not statements," so the "expert liability" would be inappropriate for debt ratings.
4. The debate has been going on for some time. Only with this new announcement, in which agencies refuse to allow their ratings to be used in prospectuses, has the media begun to really focus on the issue.
5. Update: To prevent a possible freeze-up in new debt issues, the SEC ruled yesterday that for the next six months, certain prospectuses are no longer required to include ratings. This will give everyone a little more time to think everything through.
6. My take: The big three ratings agencies operate in an oligopoly market structure that requires their services to function. Moreover, despite raters' efforts to manage conflicts of interest, there remain concerns that the issuer-fee structure incentivizes loose ratings. Unless financial reform makes the market less captive and/or ends cooky incentives strongly favoring issuers, buyers of debt should have a way to hold agencies legally accountable. Fair accountability should be based, as much as possible, on process -- did agencies try do their best with the information available -- rather than results.