When the major credit ratings agencies found themselves on the hot seat some years ago after the accounting scandals at Enron and Worldcom, their defenses were reasonable.
If those fraud-ridden companies were essentially handing out inaccurate financials, it meant the ratings agencies were being duped like everyone else. After all, you couldn’t expect Standard & Poor’s and Moody’s Corp. to act as auditors. So, their ratings of the companies were too high when the companies’ real and troubling situations tumbled into public view.
Around the same time, the business models of the major ratings agencies were called into question – they are paid by the issuers whose securities they rate. The ratings agencies said they knew how to handle the apparent conflicts and because they were employed by so many issuers, the potential conflict was diminished as no one company represented a large percentage of the raters’ revenues.
Now the major ratings agencies are feeling heat again. This time it’s about the way they rated mortgage-backed securities, often AAA, before the housing collapse.
Those earlier defenses no longer hold up.
The Senate Permanent Subcommittee on Investigations found a host of problems with the big ratings agencies’ work as the housing bubble inflated and more and more sub-prime loans were stuffed into securities sold far and wide.
Inaccurate rating models and competitive pressures were two of the issues cited by the subcommittee.
“Investors trusted credit rating agencies to issue accurate and impartial credit ratings, but that trust was broken in the recent financial crisis,” said Sen. Carl Levin, D-Mich., subcommittee chairman.
Meanwhile, revenues of the three major ratings agencies – Standard & Poor’s, Moody’s and Fitch – went from under $3 billion in 2002 to more than $6 billion in 2007, thanks in significant part to the growth in securities based on subprime mortgages, The Wall Street Jornal reported.
That presumably represented a greater concentration of revenue in a reasonably small number of issuers of mortgage-backed securities, a change from when the major raters almost solely were evaluating corporate bonds.
The Senate subcommittee cited, among other emails, one written by a Moody’s executive in October 2007. “It turns out that ratings quality has surprisingly few friends: issuers want high ratings; investors don’t want rating downgrades; short-sighted bankers labor … to game the rating agencies.”
A sad summary.
In response to the subcommittee’s claims, S&P said this: “S&P has a long tradition of analytical excellence amd integrity. We have also learned some important lessons from the recent crisis and have made a number of significant enhancements to increase the transparency, governance and quality of our ratings.”
A Moody’s spokesman was quoted in an April 23 Wall Street Journal article on the subcommittee’s views saying the firm “is committed to delivering the highest quality opinions about the securities we rate.”
The answer, everyone says, is that investors, especially large institutions, shouldn’t be so dependent on ratings agencies. They should do their own research.
Hard to argue with ‘do your own research,’ but the fact is the world isn’t made up only of big invetsors who can afford the people to research each and every securities purchase. There’s a time element as well as buy-sell decisions often have to be made with some alacrity.
The major ratings’ agencies have thrived for a long time because clearly there is a need in financial markets for independent and dependable analysis of the default likelihood of bonds, notes and asset-linked securities.
The Senate subcommittee’s view is that the ratings of mortgage-linked securities as the housing bubble inflated fit neither of those criteria.