Current Commentary: Breaking Dishes in the Credit Market BY Larry M. Elkin

 Parents have a sixth sense that warns us when a small child has been too quiet for too long. We call out “What are you doing?” and the little munchkin chirps back, “I’m helping you! I’m washing all the nice china!”

The next thing we hear is a loud crash.

So it goes with President Obama and the current Congress. They want to help, but they just can’t keep from breaking the dishes.

Take, for example, their latest effort to ensure that investors get adequate information from credit rating agencies. The legislative fix was included in the recently passed financial regulatory reform act.

Thanks to this particular reform, would-be buyers of the affected securities now receive no ratings at all. Oops.

The Securities and Exchange Commission has for a long time required asset-backed securities to have ratings from established agencies like Standard & Poor’s, Moody’s or Fitch. Asset-backed securities are instruments such as auto loans that are packaged into bonds before being sold to investors.

When the credit markets crashed, it became evident that many of these securities were riskier than the agencies had thought. The bonds lost their AAA ratings, and their values plummeted. Investors lost a lot of money.

The financial legislation that Obama signed on July 21 attempts to make the credit ratings agencies more accountable for their perceived failures. These firms now are exposed to claims of “expert liability,” the same legal risks facing accountants and other parties involved in bond sales.

The agencies’ response was quick and definitive. They stopped letting bond-sellers use their ratings. Rating agencies do not have crystal balls. Sooner or later a security they’d rated highly would be bound to default, leaving the raters on the hook under the new standard. The only way the agencies could ensure that they would never be wrong was to get out of the guessing game.

This was a potentially shattering development for the president and his fellow Democrats on Capitol Hill. One of the keys to getting the economy rolling again is to restore a healthy flow of credit, as voters are likely to remind Washington in November. Asset-backed securities are essential to the credit market because they allow lenders to quickly recoup most of their funds so they can lend again.

But SEC rules require the investment bankers who create such securities to have them rated, and the new law made this impossible by prompting the rating agencies to quit a game that now seemed rigged against them. The market for these asset-backed securities was immediately dead in the water.

As a result, the SEC temporarily suspended the rule requiring securities to be rated. This six-month suspension, in theory, is to allow credit rating agencies to implement policy changes to comply with the new law. In the meantime, securities will be sold without ratings.

What will be different in six months? Nothing, other than the upcoming elections will be history – though the SEC would never acknowledge that political considerations enter into its rulemaking.

Actually, one more thing will be different six months from now: we will have a new Congress. Maybe the incoming group of legislators will be mature enough to fix the new law so the ratings agencies will conclude it is safe to re-enter this line of business.

Or the SEC might just let the marketplace decide whether it needs ratings at all. If the asset-backed securities market can function during the next six months without ratings, then the original SEC requirement will be exposed as having been pointless, and the new liability standard will stand as nothing more than an attempt to give unhappy investors one more deep pocket to sue.

It’s pretty upsetting when valuable things get broken, and it’s easy to get mad if you have repeatedly warned your little tyke to stay out of the china closet. But we must be patient with little children, inexperienced presidents and congressional Democrats. They are only trying to help.

Larry M. Elkin, CPA, CFP®, is president of Palisades Hudson Financial Group a fee-only financial planning firm headquartered in Scarsdale, NY. It offers estate planning, insurance consulting, trust planning, cross-border planning, business valuation, family office and business management, executive financial planning, and tax services. Its sister firm, Palisades Hudson Asset Management, is an independent investment advisor with about $950 million under management. Branch offices are in Atlanta and Ft. Lauderdale. Website: www.palisadeshudson.com.