Forbes: Political Will Falters On Fixing Credit Ratings Agencies

This is the 10th in an 11-part series on the failed promises of the Dodd-Frank financial reform package and the continued, dangerous imbalances in our financial system.
The 10 members of the Financial Crisis Inquiry Commission didn’t agree on everything when they analyzed the causes of the financial meltdown. But there was very little disagreement about the role of the credit agencies when the Commission released its findings in January 2011.
From the majority report: “We conclude the failures of credit rating agencies were essential cogs in the wheel of financial destruction. The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms.”
From the minority report: “Failures in credit rating and securitization transformed bad mortgages into toxic financial assets. Securitizers lowered the credit quality of the mortgages they securitized. Credit rating agencies erroneously rated mortgage-backed securities and their derivatives as safe investments. Buyers failed to look behind the credit ratings and do their own due diligence. These factors fueled the creation of more bad mortgages.”
Those reports came as no surprise. In April of 2010, I sat as a member of the Senate Permanent Investigation Subcommittee during a hearing on “Wall Street and the Financial Crisis and the Role of Credit Rating Agencies.” Our final report said: “The most immediate cause of the financial crisis was the July 2007 mass ratings downgrades by Moody’s MCO +0.75% and Standard & Poor’s that exposed the risky nature of mortgage-related investments that, just months before, the same firms had deemed to be as safe as Treasury bills. The result was a collapse in the value of mortgage related securities that devastated investors. Internal emails show that credit rating agency personnel knew their ratings would not ‘hold’ and delayed imposing tougher ratings criteria to ‘massage the … numbers to preserve market share… The mass rating downgrades they finally initiated were not an effort to come clean, but were necessitated by skyrocketing mortgage delinquencies and securities plummeting in value. In the end, over 90 percent of the AAA ratings given to mortgage-backed securities in 2006 and 2007 were downgraded to junk status… When sound credit ratings conflicted with collecting profitable fees, credit rating agencies chose the fees.”
When everybody in Washington agrees there is a problem—oh, you know what’s coming. Actually, in February of this year the Department of Justice did bring a civil suit against Standard & Poor’s Rating Services. The suit alleges that S&P engaged in a scheme to defraud investors in structured financial products known as Residential Mortgage-Backed Securities (RMBS) and Collateralized Debt Obligations (CDOs). It also alleges that investors, many of them federally insured financial institutions, lost billions of dollars on CDOs for which S&P issued inflated ratings that misrepresented the securities’ true credit risks. Finally, it alleges that S&P falsely represented that its ratings were objective, independent, and uninfluenced by S&P’s relationships with investment banks when, in actuality, S&P’s desire for increased revenue and market share led it to favor the interests of these banks over investors.
Of course, S&P asked for a dismissal of the lawsuit, the Justice Department asked a federal judge to allow the suit to move forward, and eventually there will be a resolution, followed by appeals. If the government wins, maybe the credit agencies will eventually be forced to change the way they do business. Eventually, as in years from now.
In the meanwhile, what else has been done to alter the behavior of the credit agencies?
Nothing. Back when Dodd-Frank was being debated, Senators Al Franken (D-MN) and Roger Wicker (R-MS) offered a “Restore Integrity to Credit Rating Agencies” amendment the was passed by the Senate with a 64-35 vote. Their amendment would have prevented the securities industry from shopping around among credit rating agencies to get a product’s initial rating. Lost somewhere in the sausage machine that makes laws in Washington, the amendment did not make it into the final Act. Instead, as it did with so many other problems, Dodd-Frank kicked this one down to the regulators. The Act instructed the SEC to come up with a proposal that would eliminate the conflict of interest inherent in the credit rating agencies being paid by the issuers of the securities they rate.
Glaciers move faster than a regulatory agency dragging its feet. Last December–imagine, only two and a half years later!–the SEC finally issued a report saying that conflicts of interest exist and contributed to the meltdown. A leisurely five months after that, in May, the SEC sponsored a roundtable discussion of possible solutions.
Some have favored eliminating the conflict of interest problem by having the CRAs paid by transaction fees. Others would have those who use the ratings pay for them. Some like the idea of a panel to keep check on the CRAs. Others talk about setting up investor-owned agencies.
There you have it. Lots of talk. No action. A lot of dithering about possibilities, but not the political will to confront Wall Street and make the changes that are necessary.
The Washington Post got it right when it reported in May: “Three years after Congress told federal regulators to consider changing the way credit-rating agencies are paid, the industry appears poised to dodge a major overhaul.”