WALL STREET GRADE CREEP

Some high school teachers and college professors try to please students and parents by marking “A” on work that doesn’t deserve it. The same thing has been done by the big national agencies that rate the quality of bonds. They have been giving their top ratings of AAA and AA to new types of risky bonds.

This questionable behavior is being widely blamed in part for a current drying up of credit, the collapse of some major investment pools and last week’s 500-point drop in the Dow Jones Industrial Average.

Bear Stearns, the major investment banking and securities trading firm, explained the recent collapse of its two multi-billion-dollar hedge funds partly on “unprecedented declines in the valuations of highly rated (AAA and AA) securities.” It was referring to complex bonds called “collatoralized debt obligations” backed by low-quality U.S. home mortgages known as “subprime” mortgages.

The American public is mostly unaware of this spreading disruption of financial markets. Details can be found mainly in the arcane jargon of the financial pages. But individual home owners and investors are already affected. Investments that looked safe are proving risky. Even homeowners with good credit are finding it hard to refinance their mortgages.

A July 25 article in The New York Times by the managing director of an investment research firm brought the issue to general public attention. Joshua Rosner, of Graham Fisher & Co. in New York, wrote that “only slightly more than a handful of American non-financial corporations get the highest AAA rating, but almost 90 percent of collatoralized debt obligations that receive a rating are bestowed such a title.”

He wrote that the three big ratings providers, Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, had made structured securities ratings their “fastest-growing line of business.” The Wall Street Journal reported on March 22 that the ratings companies had for years “reaped profits by charging issuers for rating bonds backed by loans to borrowers with weak credit.” So these firms were profiting by giving high ratings in what looks like a classic conflict of interest.

Despite the worsening housing market and the increase in mortgage defaults in the past year, most of the high ratings have stayed in place until recently. Only in the past few days have the firms been reconsidering their ratings and lowering some of them.

Mr. Rosner’s column notes that Fitch and Moody’s claim they can rely without verification on information given them by issuance of the bonds, although Standard & Poor’s recently questioned the accuracy of data it had been accepting.

Mr. Rosner suggests that the federal government should require regular review and revision of ratings and better training of ratings analysts. He also proposed a “cooling off period” that would prevent analysts from “taking a lucrative job at a bank whose deal he has just rated.”

It is high time for putting a leash on these watchdogs.