How and Why Credit Rating Agencies Are Not Like Other Gatekeepers

This article revisits some issues I raised in a 1999 article on credit rating agencies, which increasingly are the focus of scholars and regulators. I discuss how and why credit rating agencies differ from other financial market gatekeepers, such as underwriters and accountants, and assess several recent policy proposals by considering the extent to which they take into account these differences. The credit rating industry has changed radically since 1999. Credit rating agencies are now more profitable than other gatekeepers, face different and potentially more serious conflicts of interest, and are uniquely active in structured finance, particularly collateralized debt obligations, now a multi-trillion dollar market. I argue that these changes are related: Moody's Corp. has a $20 billion market capitalization in part because it earns high operating margins from conflicted transactions and credit derivatives. I describe a new approach to understanding the rationale for creating synthetic CDOs, whose assets consist of credit default swaps instead of bonds or loans. These transactions pose interesting theoretical challenges to some concepts of market efficiency and arbitrage based on mathematical modeling. I also assess the agencies' argument that ratings are merely opinions protected by the First Amendment. In several recent cases, including the Enron litigation, judges have dismissed rating agency defendants on free speech grounds, and the agencies increasingly cite journalist privileges in opposing government subpoenas and proposed legislation that would subject them to securities law-type registration requirements. I critique the agencies' free speech claims, but find they are consistent with the agencies' past success in obtaining exemptions from securities law requirements such as Section 11 and Regulation FD.