In some idealistic, simplified world, the three major credit rating agencies – Standard & Poor's (S&P), Moody's and Fitch – would operate in a nonbiased, infinitely informed and flawlessly trustworthy way.
By acting as a sort of (equally idealized) Food and Drug Administration for finance, they would ensure debt obligations are always sound, that securities are always marked with appropriate risk labels and that no one is unknowingly ingesting materials with potential to cause massive damage somewhere down the road.
Of course, if these agencies truly did function as distinguished, disinterested judges, they would probably not have been called to testify before the U.S. House of Representatives' Committee on Oversight and Government Reform this week. The official purpose of the hearing, led by Chairman Henry A. Waxman, D-Calif., was to examine the three rating agencies' roles in the current financial crisis.
Retroactive blame – targeted at everyone from Wall Street executives to supporters of the Community Reinvestment Act – is the name of the game right now, and it seemed to be only a matter of time before the rating agencies would be formally spotlighted. After all, weren't they supposed to beâ�¦ rating these mortgage-backed securities (MBS) and related instruments?
The Congressional hearing's opening statement from Waxman, coupled with the array of internal e-mails and other evidence scooped from the agencies' files and posted on the House committee's Web site, crystallizes the long-time murmurs from many in the mortgage industry.
It appears that while basking in MBS' warm and profitable glow for years, the Big Three handed out their coveted top grades in an increasingly competitive and indiscriminate feeding of the great subprime machine.
Meanwhile, they knew of the risks lurking in collateralized debt obligations (CDOs) and other packages but kept their suspicions contained to private conversations and e-mails. Or, like almost everyone else, they did not understand the most complex of the instruments, yet gave them their investment-grade blessing nonetheless.
The agencies' official versions of the story range from claiming full innocence (‘We had no idea subprime mortgages might be dangerous!’) to admitting that while a few mistakes were made, the core rating system remains sound.
But in his testimony, Jerome Fons, a former executive at Moody's, told a different story. ‘My view is that a large part of the blame can be placed on the inherent conflicts of interest found in the issuer-pays business model and rating shopping by issuers of structured securities,’ he said. ‘A drive to maintain or expand market share made the rating agencies willing participants in this shopping spree.
‘It was also relatively easy for the major banks to play the agencies off one another because of the opacity of the structured transactions and the high potential fees earned by the winning agency,’ he added.
Ray McDaniel, Moody's CEO, echoed these conflict-of-interest concerns – but only in a (previously) confidential presentation delivered to his board of directors in fall 2007 and subsequently obtained by the House Committee as evidence of the rating agencies' prior knowledge that they were working with broken securities in a broken system.
On the individual employee level, an April 2007 instant-message conversation between S&P's Shannon Mooney and Rahul Dilip Shah strikingly reveals the pair's uneasiness with one recent affirmation handed out by the agency.
‘â�¦That deal is ridiculous,’ Shah tells Mooney, according to a conversation transcript posted on the House Committee's site.
‘I know, right – [the] model def does not capture half the risk,’ Mooney agrees.
‘We should not be rating it,’ Shah ventures.
‘We rate every deal,’ says Mooney. ‘It could be structured by cows and we would rate it.’
Now, those ratings have been withdrawn en masse: According to Waxman's statement, S&P has downgraded more than two-thirds of its investment-grade ratings, while Moody's has downgraded over 5,000 mortgage-backed securities.
Waxman, however, believes that a critical sense of security has already been broken.
‘The story of the credit rating agencies is a story of colossal failure,’ he said. ‘The credit rating agencies occupy a special place in our financial markets. Millions of investors rely on them for independent, objective assessments.
‘The rating agencies broke this bond of trust, and federal regulators ignored the warning signs and did nothing to protect the public,’ he continued.
What now? Whether or not the rating agencies ultimately accept blame for allowing the old market to spiral out of control, they also must look ahead and prepare their models for the new market.
A few years ago, many colleges and universities incessantly fretted over a grade-inflation crisis. Graduate schools, employers, professors and even students were complaining that because of enormous pressures on professors to hand out excessive A's, so many students were receiving the top grades that an A had become worthless – and the colleges feared their own reputations were being eroded.
So they all threw out the existing system. They then debated, re-evaluated and recalibrated until a new grading system had been developed and thoroughly defined for all participants.
Two semesters of number-crunching later, top marks had become – statistically and anecdotally – much more difficult to land, but transcripts regained actual value.
While CDOs are not English literature classes, a similar principle applies. No matter what any eventual rating-agency reform measures might include, a substantial re-evaluation and overhaul of the ratings scale itself is in order. Then, these grades might have meaning once again.
– Jessica Lillian, Commercial Mortgage Insight
