Ratings Agencies caused trouble

Here is some Info about a regulatory change that should be instituted by the SEC. The real questions that we should be asking now are how to set up an effective regulatory structure for the financial system so we can move on and stop the panic.

The Securities Exchange Commission began working directly with ratings agencies when its Net Capital Rule took effect in 1975. The primary purpose of the net capital rule was to create capital requirements for regulated broker dealers in the United States. The rationale behind this rule was to limit the leveraging ratios that these dealers could take onto their balance sheets. In order to limit risk even further the act required that debt be rated by newly designated nationally recognized statistical ratings agencies (NRSRO’s). Prior to the net capital rule the government was not involved in ratings. Ratings agencies sold their information to its clients and that accounted for the ratings agencies profits.
Net Capital Requirements were added to the Securities & Exchange Act of 1934 through new legislation in 1975. The purpose of the legislation was to create a maximum rate at which financial institutions could leverage their assets and create a system for determining reserve requirements. This act mandated that financial institutions could not leverage more than 1500 percent of its net capital assets at any point. This section of the Securities Exchange act of 1934 also specifies reserve ratios that are based on the risk inherent in the debt kept on their books. Firms that held safer assets, like treasury bills, could use more of their cash and hold fewer reserves than firms that held common stock. To determine this risk, NRSRO’s were used. Investments that got a sufficiently high rating (lower risk) from the ratings agencies required a lower reserve ratio. This legislation truly incorporated the NRSRO’s into the regulatory framework.
Another critical change that was brought about by the net capital requirement standard was the idea that all debt would now need to be rated by NRSRO’s for reserve calculating purposes. This change is critical because it shifted the way that ratings agencies made money. In the original framework investors bought the reports that were generated by ratings agencies. In this framework the interests of the ratings agency and the investors were in line. The ratings agency tried to rate the bonds and other debt in a way that was beneficial to the investors who were paying them. Under the new framework, the companies issuing debt would have to pay the ratings agencies to have their debt rated. Now, NRSRO’s best way to maximize profit was to get companies to come back to have more of their debt rated. The best way to get companies to continue using a certain NRSRO was for the NRSRO to issue high ratings.