As banks and investors continue to assess damage from the country's credit crisis, the private companies that rate the quality of stocks and bonds and other instruments are weathering a storm of their own. Moody's, Standard & Poor's and Fitch Ratings — the country's three major credit rating agencies — are facing intense scrutiny for their leading roles in the housing-boom-turned-meltdown.
The agencies assigned ratings to the securities backed by thousands of subprime mortgages. Those expensive mortgages, which often came with high interest rates that "reset" to even higher levels after a few years, were largely sold to borrowers with shaky credit histories, often with very little documentation of the buyer's ability to repay. For much of the boom, the rating agencies assigned these bundles of mortgages high credit ratings indicating they were safe investments. But the agencies relied largely on the issuers' information when assessing risk and had few historical data for how these securities would perform.
Many of the mortgage-backed securities and "structured finance" vehicles like collateralized debt obligations, or CDOs, were given highly prized triple-A ratings. Securities with those ratings are deemed least likely to default, making them more marketable and valuable. And high credit ratings win firms lower interest rates, making it easier to raise capital.
Since 2005, however, Moody's and S&P have together downgraded more than 9,500 mortgage-backed securities, according to Sen. Christopher J. Dodd, D-Conn., chairman of the Senate Banking Committee. The rating agencies often maintained the coveted ratings even while the securities sold for much less on the market. As markets for the securities dried up and banks were forced to write down the securities' values on their balance sheets, investors lost tens of billions of dollars.
The agencies now are facing criticism for taking too long to downgrade those ratings once the risks became apparent. Much of the criticism may sound familiar, too: In 2001, the firms were criticized because they kept Enron's bonds at investment grade right up until the giant Texas energy company's collapse.
"This is not the first time these guys have screwed up," says Lawrence White, a professor of economics at the Stern School of Business at New York University.
Much talk of reform has focused on the credit agencies' prevailing business model, in which the issuers of securities pay for the ratings. Before the 1970s, the agencies relied on investors to pay for ratings. The new model leads to inevitable conflicts of interest, critics contend, because much of agencies' profits depend on payments from clients who could — and do — easily shop elsewhere for more favorable ratings.
John Coffee, an expert on credit agencies who teaches law at Columbia University, says this is particularly a problem now that CDOs and other structured finance vehicles are controlled by basically five or six large investment banks.
"Loan originators and investment banks have learned how to game the model, how to play with it," Coffee told Dodd's committee in April. "This is partly because, for a large advisory fee, the rating agencies show them how their model works."
"There is a lot of competition to get this business," says Randall Wray, a professor at the University of Missouri-Kansas City. "If you don't give the ratings that allow these pools of securities to be sold, you're not going to get the business."
And structured finance has been a boon for the rating agencies. Moody's, for example, saw its profits nearly triple from 2002 to 2006 largely because of revenues from rating structured finance vehicles.
The federal Securities and Exchange Commission is expected to propose new rules for credit rating agencies in coming months. (Getty Images)
The credit agencies, for their part, argue they can effectively manage conflicts of interest. They have announced new safeguards, too. Moody's and S&P say they will perform "look-back" reviews when analysts take jobs with firms whose investments they had been rating. S&P has also announced it will hire an ombudsman to look into possible conflicts as well as their analytical and governance processes. Both also say they may include modifiers warning of volatility.
"We have to make clear that people understand the ratings are comments," not verification of liquidity or pricing, says Vickie Tillman, executive vice president of S&P's credit market services. Her company has embarked on numerous reforms and reviews of its procedures, as well as efforts to educate investors, she notes. Over the last nine months, she adds, "we didn't rest on our laurels."
Until Dodd's committee hearings in April, the last congressional action on credit agencies came with the Credit Rating Agency Reform Act of 2006. The bill increases the Securities and Exchange Commission's oversight, requires rating agencies to disclose rating methods and seeks to limit conflicts of interest. The SEC is expected to propose new rules in coming months.
White argues against new legislation but calls for regulations that put the burden of proving securities' "safety and soundness" on bank officials, "where it ought to be," he says. In his view, the rating agencies would take on less significance as bankers prove to regulators why they deserve the agencies' ratings. Coffee argues that the SEC should require rating agencies to have securities' collateral independently examined before they assign investment-grade ratings.
"I think it will be a long and difficult road back to win back confidence," Stephen Joynt, president and CEO of Fitch Ratings, told Dodd's committee. "We have, however, aggressively started down that road, and we believe we are making progress, although slowly."
— Andrew Tangel, a freelance reporter in New York City