It wasn't quite as absurd as the lineup of tobacco industry executives declaring under oath to Congress back in 1994 that nicotine isn't addictive, but it was close. Top executives from the leading credit rating agencies testified before a congressional committee recently that the inherent conflict of interest in the way they operate — where the issuer of a security pays for its rating — is not a problem.
The testimony was an attempt to deflect blame for the nation's financial meltdown and hang on to a golden goose that last year brought the three largest credit rating firms more than $6-billion in annual revenues. Standard and Poor's, Moody's and Fitch reaped those riches by providing top investment-grade ratings to securities backed by risky subprime mortgages. But their profits came at the cost of the truth.
Credit rating agencies are the financial gatekeepers of the investment world. It is their job to objectively and accurately assess the riskiness of investment instruments, including structured securities where mortgages of various kinds are sliced up and packaged. The ratings are a way for investors to understand the likelihood that the underlying debt obligations will be repaid. A triple-A rating says to investors that the security is as safe as buying U.S. Treasury bonds.
But as we now know, thousands of triple-A rated mortgage-backed securities and collateralized debt obligations were only secure if home values continued to rise. With the housing downturn and the resulting foreclosure crisis, the value of the securities collapsed.
The firms got it terribly, tragically wrong. But it wasn't just an honest error in judgment. Corporate e-mails suggest, and insiders told the House Committee on Oversight and Government Reform, that the agencies traded the validity of their ratings for bulging profits.
By being paid by the issuer of the structured security, the agencies embarked on a race to loosen standards. As Jerome Fons, former managing director for credit policy at Moody's until 2007, told the committee, "A large part of the blame can be placed on the inherent conflicts of interest in the issuer-pays business model. …(Securities issuers) typically chose the agency with the lowest standards."
When Congress turns its attention to a comprehensive response to the financial crisis, limiting the issuer-pays model should be on the agenda. Historically, the big credit rating agencies generated revenue by selling their publications to investors — affording an independent analysis of risk. They didn't begin to charge issuers of debt for ratings until the 1970s.
For the ratings to be objective and dependable again, the Securities and Exchange Commission should be directed to police this conflict of interest. And investors, particularly large institutional investors such as pension funds, should be skeptical of any rating paid for by the issuer.
S&P, Moody's and Fitch were supposed to be looking out for investors by issuing objective ratings that accurately gauged risk. It turned out they were more interested in looking out for themselves.