Even last week, when a proverbial run on the bank put Bear in desperate straits, the agencies’ downgrades left the firm’s rating still at “investment grade.” This, when JP Morgan Chase was about to acquire Bear (including its Manhattan office tower) for only $2 a share—a smidgen of Bear’s closing stock price Friday, $30 a share. If Bear was that hollow, what was the investment-grade seal of approval supposed to mean to investors?

This too-little-too-late adjustment by the agencies last week echoes their reluctance in 2007 to come to terms with the spread of the subprime mortgage debacle. While top officials at the agencies blame inadequate information and faulty mathematical models, it is also clear that market incentives led to foot-dragging by the ratings agencies.

The raters are paid by the issuers of securities (the borrowers), not by investors (the lenders). Moreover, the bond rating agencies not only assigned risk to the bundled (or “securitized”) issues of sub-prime mortgages—the ones that turned sour once house prices began to fall. They were also active (and well-paid) early-stage participants in the packaging of such issues into more complex Collateralized Debt Obligations (CDOs).

The ratings agencies added to their portfolio of services, stepping in to show CDO originators how to attain the highest bond rating for a given level of risk. As the ratings agencies became more like investment banks, charging additional fees for what amounts to consulting services, the ratings they assigned became marketing tools.

Not surprisingly, along with this new marketing role came a debasement of the ratings. As Moody’s has admitted, the 2001-2006 default rates for its lowest investment-grade CDOs were at least 8 times as high as for comparably rated corporate bonds. And that was before financial markets seized up in the latter half of 2007.

No wonder there is now talk of more regulation of the raters. Yet on two counts regulation can be seen as part of the problem. First, the creation of the toxic CDOs fell within the bounds of current, generally accepted accounting principles—and banking regulations. Their potential risks appear to have been poorly understood by everyone, including the regulators. Is there any reason to think the regulators will be ahead of the curve next time?

Second, the government’s Securities and Exchange Commission (or SEC) has been the guarantor of the cozy, monopolistic arrangements the ratings agencies have enjoyed. In 1975 the SEC installed a certification process to anoint quasi-official ratings agencies. These were dubbed Nationally Recognized Statistical Rating Organizations or NRSROs (also known by critics as “No Room—Standing Room Only”). In recent years today’s big three agencies were the only such accredited raters. Their ratings became legally required for many bond issuers. And all three were paid by the issuers of the securities.

Now, in the backwash of the sub-prime crisis, the SEC has finally certified a ratings firm that is paid by investors—not bond issuers. On December 21, 2007, the SEC declared Egan-Jones Ratings of Haverford, Pennsylvania, an NRSRO. This, following petitions by Egan-Jones for the better part of a decade.

The big three are also making gestures toward self-reform. In particular, Moody’s has decided to separate its ratings services from the rest of its business operations, so as to dispel any hint of a conflict of interest.

Ironically, the Credit Rating Agency Reform Act of 2006 is already on the books as an attempt to introduce more competition into the ratings game. It requires the raters to begin to show the default rates over time for its various asset groups and ratings levels, so investors can look at the record and decide for themselves whom to believe. Too little, too late? Possibly. But also, perhaps, a step in the right direction.

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