Who's to Blame? Ratings Agencies


Each day for five days, a different writer from TheStreet.com will made the case for why one of five prime culprits -- the banks, Congress, irresponsible home buyers, the Federal Reserve or the rating agencies -- is most to blame for the credit crisis and ensuing economic meltdown.

A good measure of who is responsible for getting us into this mess is looking at who got rich off of it. Bond ratings agencies certainly got their share of the take.

Moody's Investors Service (Stock Quote: MCO) saw its profits quadruple between 2000 and 2007 and had a higher profit margin than any other company in the S&P 500 for five straight years, according to opening statements from Henry Waxman, chairman of the House Committee on Oversight and Investigations, in a congressional hearing on the ratings agencies he held in October.

Investors in Moody's, Fitch Ratings and McGraw Hill Cos. (Stock Quote: MHP) unit Standard & Poor's made out like bandits during those years because they practically had a license from the government to print money. Throughout the 1990s, they were the only nationally recognized statistical rating organizations. While the Securities and Exchange Commission began letting other entities into this club in 2003, the big three had such a huge head start that they still dominated the scene.

Their revenues exploded in recent years, however, as the debt securitization market began to catch on. As banks like Citigroup (Stock Quote: C) and Merrill Lynch (since bought by Bank of America (Stock Quote: BAC)) bought up more and more bad loans and piled them into synthetic securities, they turned to the ratings agencies to give them triple-A ratings so they could be widely sold and distributed. The triple-A rating was important, because large institutional investors like pension funds and insurance companies that are barred from riskier investments needed its deal of approval to buy the securities. They had rules established by their investment committees and regulators, which prohibited them from buying securities with ratings below a certain threshold.

But many of those triple-A rated securities have since been downgraded. In all, Standard & Poor's has downgraded $1.25 trillion out of $3.22 trillion in housing-related securities issued between the first quarter of 2005 and the third quarter of 2007. About 66% of those securities originally rated investment-grade have been downgraded to junk-bond status.

"The ratings agencies have caused us problems at both ends of this -- by not spending enough time in their due diligence, and also by overreacting once the credit problems have happened," says Tom Brown, head of financial services hedge fund Second Curve Capital.

Though the ratings agencies held themselves up as independent arbiters of credit quality, it appears they actually just pimped themselves out to the issuers, who paid them for their ratings. As The New York Times reported in December, when Countrywide Financial complained to Moody's that it didn't like a rating on a security it issued, Moody's changed it a day later without any new information coming to light. A Moody's spokesman denies the agency has ever done this, the Times reported.

When they weren't being pushovers, they were being incompetent. As the Financial Times reported last year, a computer glitch caused Moody's to incorrectly give a triple-A rating to billions of dollars of securities called constant proportion debt obligations. And then, when Moody's found out about the glitch, their methodology had conveniently changed, to allow these ratings to stay in place.

"They put their own interest in front of the public's interest, and anyone that relied on them was let down," says Jack Ablin, CIO of Harris Private Bank.

Some believe a way to address the conflict of interest the agencies face is to scrap the model in which they are paid by issuers. That is the model followed by Egan-Jones, a ratings agency started 12 years ago.

Egan-Jones founder Sean Egan has been an outspoken critic of his competitors for years, and his business is starting to grow, as investors frustrated with the big three ratings agencies have turned to his firm for research. Egan says Moody's, S&P, and Fitch are the chief reason for the current economic mess.

"You have to understand what has caused us to be in this crisis: at its heart it's a credit crisis," Egan says. "It's not as though we have a meltdown because of some smallpox disease, or people returning from the war and the economy declining by 20% because you don't need the war materials anymore."

Congressmen Gary Ackerman (D-N.Y.) and Michael Castle (R-Del.) introduced legislation last month that would place restrictions on the types of securities ratings agencies can rate. Their legislation will not attempt to address the compensation model, however.

Second Curve's Brown has a simpler solution.

"I think we should just blow 'em up," he says, noting that there is no nationally recognized ratings agency for equities, and for good reason. "Ratings are based on people, and people make mistakes."


Brown has a point. The ratings agencies missed Enron, they missed the subprime debacle, and they likely will miss the next financial disaster as well. Taking away their official status, on which insurance companies, pension funds and other large investors based their decisions, may help limit the damage.

It is hard to believe they'll be missed.

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