The Credit Ratings Blame Game

Congressional hearings raise questions about how credit ratings agencies evaluated mortgage securities and managed potential conflicts

The mortgage market crumbled. Now, assessing blame has become one of the hottest games around. And in Washington, they're looking for someone to pay. That's put the ratings agencies under fresh scrutiny because they gave high grades to some mortgage securities that faltered as the housing market has weakened. "Everyone is looking for someone to blame," Securities & Exchange Commission Chairman Christopher Cox told reporters following a Sept. 26 Senate hearing.

The SEC is focusing on whether the fees that big Wall Street bond issuers pay Moody's Investors Service (MCO), Standard & Poor's (which, like BusinessWeek, is a unit of the The McGraw-Hill Companies (MHP)), and others to grade their securities "unduly influenced" those ratings, Cox told lawmakers. "There's a mismatch between the ratings and the results," he said.

Former Senate Banking Chairman Richard Shelby (R-Ala.) was more blunt in his view of the agencies: "They're central to this whole debacle. They're conflicted. It's driven by money, not responsibility and ethics."

Executives from both Moody's and S&P defended the role they have played in the market for the structured finance products that were developed out of subprime and other mortgages. "Our reputation is our business; when it comes into question, we listen, learn, and improve…. S&P has spoken out—and taken action—early and often on subprime issues," said Vickie Tillman, executive vice-president of Standard & Poor's credit market services, in testimony before the Senate on Sept. 26. She added that "we are taking steps to ensure that our ratings—and the assumptions that underlie them—are analytically sound in light of shifting circumstances."

Michael Kanef, group managing director at Moody's, addressed the issue of financial conflicts head-on in his opening statement to the Senate the same day. "The issuer-pays business model used by Moody's…gives rise to potential conflicts of interest," he said. "Issuer fees were introduced over three decades ago, and since that time we believe we have successfully managed related conflicts of interest and provided the market with objective, independent, and unbiased credit opinions." He cited a number of principles used to avoid conflicts, including using committees rather than individuals to make ratings decisions and assigning a surveillance team separate from the initial monitoring team to track credit ratings after their initial issuance.

Oversight Law Challenged

This isn't the first time the ratings agencies' performance has come under scrutiny. Following the collapse of Enron and WorldCom in 2001 and 2002, critics argued the ratings agencies had been too late to suss out troubles and issue downgrades; fraud was eventually discovered at both the energy and the telecom giants. In response, Congress passed a new law last year that gave the SEC more access to inspect the rating agencies' policies and procedures.

Despite that law, some argue that the SEC's authority to supervise or sanction the industry remains too limited. In part, that's because the law explicitly prevents the SEC from imposing its own judgments on how credits are assessed. "If you look at the legislation that passed last year, it is so weak," says former SEC Chief Accountant Lynn Turner. "The SEC doesn't even have the power to go in and inspect these agencies. There's very, very little oversight."

In response to questions at the hearing, however, Chairman Cox told lawmakers he feels the SEC has sufficient power to monitor the agencies: "We have a great deal of authority that we are on the front end of exercising."

The power Congress gave the SEC last year to regulate national ratings agencies was also designed to increase competition against the three big agencies that held the SEC's coveted approval as Nationally Recognized Statistical Rating Organizations. The designation is needed to rate most securities, and only Fitch, Moody's, and S&P had it until recently, when four other firms were named. The idea is that more competition will lower costs and improve the quality of the ratings. The new law streamlines the registration and approval process for smaller ratings agencies such as Egan-Jones. "Our application is actively being worked on right now," says the firm's co-founder Sean Egan. "It wasn't before, now it is."

States Weigh In

Cox plans to maximize authority Congress gave his agency. "We're focused on how this all came about," he said, noting the SEC can inspect the agencies for any possible conflicts of interest, abusive and unfair practices, or insufficient resources to do the job.

Nonetheless, some on Capitol Hill are now debating whether the SEC needs more power to oversee the industry. In addition, Ohio and several other states with aggressive new attorneys general are banding together to look into the industry's practices as part of several broader mortgage probes.

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