Raters Make a Live-and-Learn Defense

In congressional hearing, the three largest credit rating agencies say they've learned from their mistakes, and shove off suggestions that they need more regulation.

Leaders of the top three credit rating agencies acknowledged during a congressional hearing that they could have been more accurate in their evaluations of mortgage-backed securities before the housing market exploded. But they refrained from taking the blame for the credit crisis, saying that they couldn’t have predicted the subprime-mortgage meltdown and the subsequent problems in the credit market.

The raters have been criticized for not acting quickly enough to lower their investment-grade ratings of complex financial products that — because they were laden with shaky mortgages — in retrospect clearly had a higher risk of default than the firms reported. They have since downgraded thousands of their ratings. As a result, “trust has been lost” in the agencies, according to U.S. Rep. Elijah Cummings (D-Md.) at today’s House Oversight and Government Reform hearing on the raters’ role in the financial turmoil.

Oversight chairman Henry Waxman, a California Democrat, said that the lax practices of the agencies broke the “bond of trust” between them and investors. “The result is that our entire financial system is now at risk,” he said.

The chief executives of Standard & Poor’s, Moody’s Corp., and Fitch Ratings are well aware of the lack of confidence in their firms. S&P’s “legacy, our most valuable asset, has been challenged by recent events,” said Deven Sharma, president of the agency. During an internal meeting last year, Moody’s CEO Raymond McDaniel said an institutional investor has asked what the point of his agency’s ratings were if the firm couldn’t see breakdowns in the securities it had rated ahead of time.

During the past year, the Big Three have made changes to their policies and procedures. They have also been subject to increased scrutiny from their regulator, the Securities and Exchange Commission, which released a revealing report about them in July.

Internal documents the SEC reviewed and that were widely quoted during Wednesday’s hearing showed the high pressure analysts were under to give investment-grade ratings to mortgage-backed securities and collateralized debt obligations because of their managers’ competition and revenue concerns. At the same time, the growth of these types of financial products fed the agencies’ coffers: total revenue for the three firms double from $3 billion to more than $6 billion between 2002 and 2007, according to Waxman, who chairs the Oversight committee.

Much of the criticism has focused on the agencies’ inability to properly manage conflicts of interest from their issuer-pay models. Moreover, they have been accused of structuring the same products they rate.

Former employees told the committee that the agencies’ greed and profit-driven culture led to inflated ratings. Frank Raiter, a former managing director at S&P, said his former employer did not keep its models for reviewing the performance of underlying loans of mortgage-backed securities up to date. He also claimed to be discouraged by his manager for requesting more specific information about home loans that supported a CDO and felt he was instead encouraged to “guess what a rating might be.”

The head of a rating agency on the fringe of the industry dominated by the Big Three faulted the system itself for causing a breakdown in investors’ lack of confidence in the sector. Sean Egan, managing director of Egan-Jones Ratings, touted his business model of having investors pay for his ratings as the main reason his agency has proven to have more accurate ratings. The “crux of the problem” is the other agencies’ lack of independence, he said.

Over the summer, the SEC proposed rules that attempt to solve the industry’s conflict-of-interest issues, along with investors’ apparent ignorance over the different risks involved among various types of asset-backed securities. If approved, the changes would require all rating agencies to publicly release all their ratings, and share the information on which they are based.

In response, the agencies have said such reform would hurt their market. Prompted by a congressman’s suggestion that a blue ribbon commission look over the agencies’ activities, the executives said they were open to the idea but felt the SEC provided enough regulation on their industry already.

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