Probably the least discussed aspect of the recent market crash is the role played by the credit rating agencies (CRA’s). While some on Wall Street were hard at work creating exotic bonds and investment products that included bundles of toxic, subprime mortgage loans, the CRA’s were providing the necessary cover for these instruments to be bought in large volumes by providing them with stellar, ‘objective’ ratings.
Traditionally, credit rating agencies–such as S&P, Moody’s and Fitch–served as a sort of signal or barometer for investors as to the level of risk attached to specific corporate bonds. Over time, they began rating additional types of investment products, including new financial instruments such as collateralized debt obligations (CDOs) that consisted of massive bundles of subprime mortgages. Amazingly, these agencies rated these products AAA–the highest possible rating, indicating “the highest level of capacity of the obligor to honor its financial commitment on the obligation.” The importance of this cannot be understated. What makes this particularly troublesome is that the firms that issued the debt were the ones paying the CRA’s for the ratings, creating a significant conflict of interest. Common practice, sure. But given what transpired in this particular case such a conflict cannot help but be scrutinized.
What was once a reliable indicator for measuring the level of risk attached to an investment has now come into question as possibly nothing more than a rigged instrument. Now, US Congressional leaders are focusing aspects of their financial reform bill on the CRA’s. Senator Dodd’s version of the bill included a number of provisions aimed at restoring trust and confidence in these vital agencies. Just yesterday, the Senate passed an amendment offered by Sen. Franken (MN) that would require a newly-formed government body to assign the task of rating a specific asset-backed security to a specific CRA. The hope is that such a move would end the practice of ratings shopping that many believe led to creation of perverse incentives by CRA’s and the misleading rating of unstable securities.
I am not by any means an expert on the CRA industry (I know just enough to be dangerous, I guess), but here is my take. Continue reading