Q. So this is a nationally recognized statistical rating organization — so that’s the technical term, but we normal folks call them credit agencies, right? And they’re back in the news because of the new DOJ suit.
A. Yes, and of course the big ones are S&P, Moody’s, and Fitch. And as we also know,
they’re paid to rate securities by the issuers, not the buyers. It’s pretty obvious that creates a horrendous conflict of interest; many folks think that the competition to get business drives them to issue inflated ratings. Meantime, nobody would buy an unrated security. So it was a vicious cycle.

Q. But you say that government regulations themselves helped make the rating agencies so powerful?
A. Right… we were all kind of feeding the beast, because everything from ERISA to bank and insurance regulations were judging the prudence of investment by rating agencies, often by name: S&P and Moody’s especially. Dodd Frank stripped a lot of that out, but you still see it in things like the Basel III regulations.

Q. Why haven’t they been sued before?
A. They have– there are all sorts of lawsuits out there from investors, like pension plans, that lost hundreds of billions in the meltdown, and who claim the agencies should have known better. Up till now, the agencies have defended themselves with an argument many people find, well, humorous: that what they said was just an opinion, one protected by the First Amendment.

Q. And how is that going down?
A. At first it got a little traction, but since then a number of courts have rejected the argument. But the agencies so far have won on other grounds, saying plaintiffs have failed to show negligence. But the DOJ is bringing a fraud charge, and I’m betting they have some nasty internal documents to back that up.

Q. So what’s next? How do we get out of this whole mess?
A. The SEC is supposed to recommend alternatives… with luck– in my humble opinion, we’ll wind up with broad competition and a bunch of buy-side firms doing the ratings… in my opinion, there’s no way to fix a system in which there are a small number of firms and they’re all getting paid by the issuers!