Within the financial sector and around the Beltway, credit ratings agencies took a pounding for their role in the financial crisis of 2008. While it was the mortgage lenders, banks and regulators who drew the most public scorn, many insiders spoke up to point out that, while the commercial interests of the lenders and bankers was understandable given that they were (irresponsibly) chasing profits and the regulators’ failings were understandable because they were … well … regulators, it was the theoretically independent and thought-to-be wise ratings agencies that really let down the market.

They continued to rate junk as investment grade, helping to maintain a status quo of insanity.

As this Wall Street Journal piece notes, at least one person saw this coming — 70 years ago.

Decades before anybody had ever heard of a mortgage derivative, an economist named Melchior Palyi predicted key causes of the 2008-2009 financial crisis with precision that makes a modern reader’s hair stand on end.

His warnings help explain why investors insist on trusting market gatekeepers they know to be fallible—such as policy makers, regulators and credit-ratings firms.

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The root of the problem, in Palyi’s eyes was that the 1936 reforms of the Banking Act mandated federal banks to only hold securities rated as investment-grad by at least two ratings firms.

Many people have asked “how did these ratings agencies get all this power over the market?”

If you want to pinpoint one date, it was this one.

Mr. Palyi, then teaching at the University of Chicago, was a vocal skeptic from the outset. Looking back into the 1920s, he found that investment-grade bonds went bust with alarming frequency, often in the same year they were rated. On average, he showed, a bank that followed the new rules would end up with a third of its bond portfolio going into default

The record was so unreliable that it would be “still more responsible,” Mr. Palyi growled, to “stop the publication of ratings altogether.” He was especially troubled that the new banking rules switched the responsibility for credit safety from bankers—and even bank regulators—to ratings firms.

“From there,” he warned, it “will have to be shifted again—to someone else,” presumably taxpayers. Liquidity, Mr. Palyi argued, was being replaced by what he scornfully called “shiftability,” a new kind of risk that could someday “be magnified into catastrophic dimensions.”

The whole WSJ piece on Palyi is interesting, so I encourage you to click through and finish the rest.

Meanwhile, now that we know ratings agencies are flawed, what can we do about it? Sheila Keefe offers an unfortunate yet poignant perspective: if not the ratings agencies, who else?

This knee-jerk reaction by Congress to limit the power of an industry that contributed to the meltdown ignores the need for independent credit-rating agencies. In the vacuum in credit rating information created by the Congressional, there are no other effective and efficient sources for evaluating investments.

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Since the passage of Dodd-Frank other credit-rating mechanisms have been discussed, and all of them seem to be either: (a) onerous to small investors and banks who lack the resources larger institutions possess or (b) eerily similar to the process and function previously filled by the credit-rating agencies.

As noted in the Wall Street Journal on November 16, 2010 in “Rating Firms Maintain Their Hold’: Among the possibilities being floated: having regulators gauge the risk level of individual assets, requiring banks to perform in-house assessments subject to oversight, or allowing firms to use a third-party ‘financial assessor’ to gauge the risk level of assets.

The reforms implemented by the credit rating agencies could be are a good start, and with additional regulatory efforts to ensure that credit rating agencies have processes in place to ensure that they are providing independent, sound advice, continued use of credit-rating agencies could be just what America needs to restore confidence in its capital markets.

Under this lens, it seems to be a damned-if-you-do, damned-if-you-don’t scenario.

But of course, there is a third way. Maintain the importance and the authority of the ratings agencies but also have a reformed, better regulatory system that can ensure things are not veering too far off the reservation. Some of the things Sheila mentions sound like a way to get there.

Now, as always comes the hard part — making it reality.