Another Problem in the Credit Markets: Now Its the Rating Agencies

That’s funny, I just mentioned this to a friend of mine yesterday at a 4th of July picnic. This is another problem that the credit markets are going to have that will make this summer and fall interesting. I strongly suspect the rating agencies are going to come under increasing pressure. If this causes more downgrades of various credit instruments it will result in more illiquidity in the market. From CNNMoney.com:

While Bear Stearns is the most recent financial institution to find itself caught up in the subprime-mortgage quagmire, the three credit-rating agencies - Standard & Poor's, Moody's (Charts), and Fitch - may be the next ones to see their good names dragged through the mud.

The reason? Ohio attorney general Marc Dann is building a case against them based on the role he believes their ratings played in the marketing of risky mortgage-related securities.

"The ratings agencies cashed a check every time one of these subprime pools was created and an offering was made," Dann told Fortune, referring to the way the bond issuers paid to get their asset-backed securities (ABSs) and collateralized debt obligations (CDOs) rated by the agencies.

These ratings run from AAA for debt with the lowest risk of default all the way down to noninvestment- grade bonds, which many pension funds are prohibited from purchasing in their charters. "[The agencies] continued to rate these things AAA . [So they are] among the people who aided and abetted this continuing fraud," adds Dann.

Ohio has the third-largest group of public pensions in the United States, and they've got exposure: The Ohio Police & Fire Pension Fund has nearly 7 percent of its portfolio in mortgage- and asset-backed obligations.

Moody's and its cohorts might have some wiggle room. "The agencies are on fairly strong ground that their ratings are just opinions, but that doesn't absolve them from liability risk," says Steve Thel, a securities law professor at Fordham University.

Dann contends also that the ratings are used as benchmarks by institutional investors. He is not alone in this assessment. According to experts in structured finance valuations, the ratings agencies are the central drivers, particularly in the riskier areas of asset-backed securities markets. The pool of buyers would be much smaller without a rating because pension and mutual funds hold only investment-grade bonds . . . .

Others point out that CDOs are too complex for even sophisticated investors to parse, so the ratings take on great importance. "It is unreasonable to think that people could do the quantum math to figure out the ultimate aggregate default rate on a CDO. So, yes, there is a greater expectation that the gatekeepers will scrutinize the underlying credit," says Doug Cifu, a partner who specializes in private equity and finance at Paul Weiss Rifkind Wharton & Garrison.

Regardless of whether a lawsuit materializes, the ratings agencies already seem to be policing themselves. Of the pool of securities created from 2006 subprime mortgages, Moody's has downgraded 19 percent of the issues they've rated and put 30 percent on a watch list. Sadly for Wall Street, if the ratings agencies feel the need to downgrade even more, it will certainly constrict the cheap debt that has fueled the bull market.