Bad Credit Ratings: What Critics Say Obama's Financial Reforms Won't Fix

June 19, 2009— -- Imagine a restaurant owner paying a food critic to give reviews. Or a meat producer paying a meat inspector for checking his beef. Or parents paying a teacher to give their child grades.

In each situation, there's a monetary incentive for the person doing the assessment (the food critic, the meat inspector, the teacher) to give good reviews or marks, no matter how lousy the product (the meal, the beef, the student's performance) may be.

These all are analogies that critics use to describe the credit rating industry and the "issuer pay" model, in which a bank must pay credit rating giants Moody's, Standard & Poor's and Fitch Ratings to grade the bank's own investments, including now-infamous, risky mortgage-backed securities. Now, some are steamed that the Obama administration, for all its new proposals on financial regulation, isn't doing much to end it.

"It's a missed opportunity," said Sean Egan, managing director of Egan Jones, a smaller credit rating company. "At the heart of the credit crisis have been unsound, inflated ratings and it's very unfortunate that the administration did not attempt to address that continuing problem."

Egan, whose company gets paid by investors instead of securities issuers, has a vested interest in opposing the "issuer pay" model. But he's not the only one speaking out against it: Industry watchers from NYU economics professor Lawrence J. White to Jeff Glenzer, the managing director of the Association for Financial Professionals, have advocated for changes to the model.

The large credit rating agencies, meanwhile, contend that their ratings were not influenced by fee-paying banks but rather arose from their own, admittedly flawed, assumptions about the housing market and other economic conditions.

"Like others, we did not fully anticipate the extent of the extraordinary declines we have seen recently in the U.S. housing and mortgage markets, and the consequences this has had for certain structured securities," S&P president Deven Sharma said earlier this year at a conference of European regulators.