It was that kind of oversight that led the agencies to confidently put AAA ratings on CDOs consisting of BBB-rated mortgage bonds. (More than 90% of AAA-rated subprime residential mortgage-backed securities issued in 2006 and 2007 have since been downgraded to junk status; see the chart above.)
It’s difficult to figure out if the rating agencies were merely kowtowing to pressure from Wall Street banks, didn’t know what they were doing, or didn’t care as long as the money was rolling in. And, in defense of the agencies, news broke at press time that New York attorney general Andrew Cuomo was investigating whether eight large banks provided misleading information to them in an effort to win inflated ratings.
Whatever the case, “the real problem is the inaccuracy of the ratings,” says Phillips. “If they were accurate, nobody would care about the peripheral issues. And we have done nothing to encourage the rating agencies to be accurate.”
If Congress and federal regulators prove incapable of meaningful reform, it may be left to the marketplace to cast the final vote.
Already, there’s evidence that investors are looking elsewhere for information. “It’s clear the public debt markets are better indicators of trouble than ratings,” says Michael Muldowney, CFO of Houghton Mifflin Harcourt Publishing Co., which has debt rated by both Moody’s and S&P. “There have been empirical studies showing credit spreads on debt widening ahead of a ratings downgrade.”
It’s unlikely, of course, that the rating agencies will disappear completely. As Egan points out, it would be horribly inefficient if, say, 500 buyers of a bond offering had to assemble 500 teams of credit analysts to do the same due diligence.
But Cifuentes doesn’t think it would be bad if “Moody’s and S&P [were] prevented from giving ratings, at least in structured finance. They have been proven ineffective. How much worse could you be?” He suggests that “we all would be better off if a new group of five or six rating agencies came along.”
Eventually, investors may simply tire of waiting, especially if they are freed from rules requiring them to consider credit ratings when making investment decisions. In short, if Congress doesn’t get credit-rating-agency reform right — and soon — it may not have to bother at all.
Randy Myers is a contributing editor of CFO.