WASHINGTON — Although credit-rating agencies played a crucial role in creating the nation's severe financial crisis, the legislation to revamp financial regulation that Congress is considering would give them a dangerous pass.
Neither the Senate Banking Committee bill that's being debated now nor the version that the House of Representatives passed last year would require credit-rating agencies to do any due diligence when they rate complex financial instruments.
It was the failure to verify the soundness of underlying loans that led to the global financial meltdown; complex mortgage-backed bonds with investment-grade ratings were sold worldwide, but later proved to be junk.
A McClatchy investigation last October exposed how Moody's sacrificed the quality of its ratings in order to preserve a lucrative market share even as it knew of brewing problems in the housing market and what that might mean to the broader financial system.
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Ratings agencies grade bonds on their risks of default. Until the September 2008 near-collapse of financial markets, their word was gold. However, the three leading agencies — Moody's Investors Service, Standard & Poor's and Fitch Ratings — downgraded to junk status billions of dollars' worth of mortgage-backed bonds that they'd given top ratings to earlier.
Beginning in 2007, those downgrades set a chain of events in motion that resulted in a freezing of global credit markets, the rescue and sale of investment giant Bear Stearns, the failure of investment bank Lehman Brothers and the $180 billion-plus taxpayer bailout of insurance titan American International Group. The financial crisis snowballed into an economic recession, and more than 8 million Americans have lost their jobs.
At the leading edge of this devastating chain of events was a collapse in underwriting standards. People who'd previously been deemed not creditworthy received mortgages; for slightly higher interest rates, lenders didn't even verify borrowers' incomes or employment.
Since there was no requirement for due diligence, the credit-rating agencies simply worked off mathematical models, treating as gospel whatever information was provided by the Wall Street firms that packaged the rotten mortgages into complex mortgage-backed securities.
The Wall Street firms didn't do sufficient research on underlying loan quality, either. At every link in the chain, the risks grew and were passed on to new investors. A joke during the boom said that a rolling loan gathered no loss.
None, that is, until the investor who'd believed the bond's investment-grade rating from the ratings agency was left holding worthless junk.
"The current (ratings) firms, for various reasons, claim to do no due diligence. They do not engage in what most people call due diligence. They take the facts, and then they run with it. They don't go any further than that," said Jerome Fons, a former managing director of credit policy for Moody's. "If investors owned or controlled the rating agency, they would certainly want more work done."
The Senate Banking Committee's legislation discourages the government's use of credit ratings for its own purchases and would create a special regulatory office within the Securities and Exchange Commission to focus solely on credit-rating agencies. The legislation, similar to the House version that passed in December, also would create an annual SEC inspection process for these agencies.
However, neither bill would require the ratings agencies to conduct due diligence on the underwriting of bonds they rate. Both bills would require a measure of certification that due diligence had been done by someone, but neither would dictate who'd pay for it.
In a hearing last month before the Senate Permanent Subcommittee on Investigations, Moody's CEO Raymond McDaniel claimed that his company had warned about deteriorating underwriting standards beginning as early as 2003.
Moody's and its competitors didn't stop rating the complex securities backed by shaky loans, however, and the panel's chairman, Sen. Carl Levin, D-Mich., made public documents that showed how the companies went out of their way to avoid examining the quality of the underlying loans.
Levin presented e-mails that showed that a Moody's analyst who was rating one deal alerted superiors that the troubled lender — Fremont General, in Anaheim Hills, Calif., which later filed for bankruptcy_ had the highest delinquency rates on mortgages in the country. Yet the deal in late 2006 got a top rating anyway.
The documents were even more damning for S&P.
One of its analysts on a subprime deal with Fremont loans being packaged by Goldman Sachs asked whether more collateral should be demanded of Fremont. The analyst hinted at Fremont's growing problems, including trouble with regulators and the fact that it had severed ties with 8,000 mortgage brokers who'd originated bad loans that Fremont had underwritten.
The answer separately from two supervisors was no, it's not S&P's job to make that call.
Levin's documents proved that ratings agencies overlooked obvious problems because they weren't required to conduct due diligence.
Since then, the collapse of investment grade ratings on mortgage-backed bonds has damaged the ratings agencies' reputations severely, lowered their share prices — by almost two-thirds for Moody's — and made investors wary of all ratings.
The issuers of bonds pay ratings agencies for the ratings they get, a conflict of interest that's had disastrous consequences. During the housing boom, as the McClatchy investigation and Levin's subsequent hearing revealed, Wall Street banks such as Goldman Sachs exploited this conflict to shop for ratings.
"Our view is that the model is fundamentally broken," said Sean Egan, a co-founder of Egan-Jones Ratings Co., a small firm that conducts due diligence on the underlying loans of products it rates for sophisticated investors.
Ratings agencies have replaced credit examiners in banks, but those examiners did look at the quality of loans, he said.
"There should be responsibility to the ultimate investors, and that's not the case" with ratings agencies, "and there's nothing in the proposals that is addressing that, unfortunately," Egan said, speaking of the bills before Congress.
Enter Kroll Bond Ratings, which is to open in late summer. Its founder Jules Kroll, well-known in the esoteric field of forensic accounting, bets that from now on, investors will demand due diligence before they purchase another complex security packaged by Wall Street and given an investment-grade rating by a ratings agency.
"It's a fundamental difference; we're going to accept responsibility for doing a certain level of due diligence," he said.
Fons, the former Moody's executive, is now an executive vice president at Kroll. "We'd like to compete on the quality of ratings, and we don't think that's happening today," he said.
Moody's and S&P enjoy huge profit margins, however, in part because they didn't invest time and manpower in verifying underlying assets. Kroll's business will be more expensive.
"That's going to be a big challenge. It's going to cost more money because we're putting in more time and doing things," Kroll acknowledged.
Investors, not the issuers of bonds, will hold the key to his success or failure.
"It's the only way we can have a material impact as a company, with the support of the investment community. We need them to say, even if it is for a second look or second opinion, get me a Kroll or someone" else who's willing to research the quality of underlying loans, Kroll said.
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