The Great Escape: How Credit Raters Ducked Reform

There’s a revealing scene in the film version of Michael Lewis’s The Big Short. It’s 2007; the subprime mortgage crisis has yet to unfold. Two hedge fund managers visit a Standard & Poor’s executive in her office on Water Street in Manhattan. One asks the exec to name a time in the past year when the company didn’t give a bank the AAA rating it was seeking. She demurs. “If we don’t work with them,” she says, “they will go to our competitors. It’s not our fault. It’s simply the way the world works.”

That was the way the world worked then—and, 10 years later, it’s not entirely clear how much has changed. Before the crisis, Standard & Poor’s Global Ratings (now S&P), Moody’s Investors Service, and Fitch Ratings—the Big Three—showered investment banks with a bounty of AAA blessings, giving them the regulatory license to gobble up mortgage-backed securities. When the subprime market crashed, these complex debt instruments infected the balance sheets of banks worldwide, wiping out an estimated $11 trillion of household wealth in the U.S. alone. Of all the securities classed as investment-grade by Moody’s (Baa3 or higher) in 2007, for example, 89 percent were subsequently downgraded to junk. “This crisis could not have happened without the rating agencies,” the Financial Crisis Inquiry Commission concluded in 2011.