Yesterday, I noted that the economy-strangling credit crisis was largely due to the purchase of "risky" financial assets by large financial and other institutions. But when these firms purchased the assets, they believed (or could plausibly claim they believed) they were making risk-free investments, because credit rating agencies (CRAs) -- the private entities that grade the riskiness of debt instruments -- judged the mortgage-backed securities (MBSs) the financial firms were buying to be so. Of course, it turned out that the CRAs failed spectacularly in their assessments.

Any financial reform package, then, should address the role that CRAs play in nation's financial systems. And as I read the proposal offered by the Obama Administration, I see that Treasury Secretary Geithner intends to do exactly that. The Obama financial regulation plan proposes:

Enhanced regulation of securitization markets, including new requirements for market transparency, stronger regulation of credit rating agencies, and a requirement that issuers and originators retain a financial interest in securitized loans.

Specifically, the proposed legislation addresses two widely-cited problems with CRAs: The opacity of their rating methodolgies and the conflicts of interest that arise from CRAs' dependency on the fees they collect from the firms whose offerings they rate.

All for the good, but the New Yorker's James Surowiecki sees a more fundamental problem with CRAs. Because they are deemed by the federal government as "nationally recognized statistical rating organizations," CRAs set the investment menu for large, institutional investors like pension funds and money market funds. And, when CRAs downgrade MBSs from prime investment grade to junk, these large investors are required to quickly dump their holdings while other investors are prohibited from acquiring them at steeply-discounted rates, creating a rapid downward spiral in recently-downgraded investments. Surowiecki concludes:

But we need a divorce: the rating agencies shouldn’t be government-sanctioned and government-protected institutions and their judgments shouldn’t be part of the rules that govern how investors can act.

Indeed, the Obama proposal not only considers institutional reliance on ratings problematic, but also recognizes regulatory reliance on ratings as cause for concern. In press materials for the financial re-regulation plan, the Treasury Department indicates serves up some pretty weak tea in this regard.

Treasury will work with the SEC and the President’s Working Group on Financial Markets to determine where references to ratings can be removed from regulations.

And

...the SEC requested public comment on whether to eliminate references to ratings in the regulation governing money market mutual funds, as a way to reduce reliance on ratings. Treasury will work with the SEC to examine opportunities to reduce reliance and increase the resilience of the money market mutual fund industry.

Investors, of course, should have been doing their due dilligence, but it's impossible to ignore the central role that CRAs played in the financial system breakdown. I remain mystified as to why regulatory reform efforts give just a sideways glance to these government-sanctioned institutions.

Image by Flickr user kyz used under a Creative Commons license.