Paulson's Plan: All Prevention, No Cure

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In February, both Moody's and S&P announced a series of steps intended to increase confidence in the integrity and independence of their ratings. The moves included hiring outsiders to review possible conflicts of interest and reviewing the work of analysts who leave to take a job at a credit issuer. In response to the Paulson proposals, McGraw-Hill spokesman Steven Weiss said on Mar. 13: "Standard & Poor's fully supports the working group's efforts to bring greater transparency, stability, and confidence to the capital markets. We recently introduced a range of policy and process initiatives that are consistent with the working group's recommendations and that we believe will further strengthen our ratings operations."

The responsibility to improve the performance of ratings on mortgage-backed securities and other securitized products won't lie with the credit ratings agencies alone. Paulson said the PWG also wants the issuers of mortgage-backed securities themselves to do a better job disclosing "the level and scope of due diligence" they perform on the assets in their pools. Just as important, they will also have to disclose whether they have "shopped" among agencies for a better rating—and if so, why.

Managing Risk for Investor and Regulators

Paulson also made clear that investors must do a better job of assessing what they're buying and the risks they are running. Many investors, he said, "bought products they didn't fully understand, or bought products based solely on credit ratings." That kind of complacency about risk has clearly been costly, and he urged investors in the future to conduct more independent analysis and to be less reliant on ratings. "Investors must demand and use better information about investment risk characteristics, when they buy and as they hold," Paulson added.

As for regulators, Paulson called on them to be more aware of risk and asked for improved risk management. The PWG wants bank regulators to pay closer attention to how banks manage risk and to coordinate better with the Financial Accounting Standards Board to improve accounting standards. The group also urged stronger state and federal oversight of mortgage originators and made clear that regulators need to look closely at whether banks have adequate capital and are properly managing liquidity.

Some revisions to the way regulators supervise the ratings agencies may also be in the works. Paulson said that regulators will revisit the need for "stronger oversight if the industry-led reforms do not lead to the integrity and transparency we seek."

Political Positioning

So how much difference will it all make? Analyst Jaret Seiberg of the Stanford Group says the recommendations are a positive—and necessary—first step to prevent a repeat of the mortgage crisis. But he said the plan isn't likely to resolve today's problems or lead to big shifts in the way companies do business. "There is nothing here that will radically change any of the industries involved in the crisis," Seiberg says. Even Treasury officials concede that the recommendations remain just that—recommendations. Much will depend on the specifics of implementation—none of which has been worked out yet.

Still, Clifton points out, the announcement should help the Administration buy some time as it works to fend off broader proposals being debated in Congress to aid struggling homeowners, such as having the government step in to help refinance troubled mortgages or allowing bankruptcy judges to renegotiate their values when home prices have fallen.

In recent weeks, as the number of such proposals floating around Washington (BusinessWeek, 3/13/07) has multiplied, momentum in the debate over housing policy has shifted toward the Democrats. Administration officials from Paulson on down have dismissed such moves as bailouts that risk doing more harm than good, and analysts say that rolling out the guidelines now should help blunt that momentum.

But ultimately, figuring out what to do about the current mess in the housing and financial markets is still where the big fight lies. "At the end of day, the Administration was losing the political spotlight," says one close observer of the battle. "They needed to reassert their leadership in the process before they could go on to tackle the other proposals."

Sasseen is Washington bureau chief for BusinessWeek.