The Role of the Rating Agencies in the Credit Market Problems

The excerpts below from a WSJ article describing the part the rating agencies played in the recent developments in the credit markets is excellent. The entire article is a must read to better understand the role of rating agencies in the process. The proper question in my mind that requires an answer is how can a rating agency be included in the process of rating bond issues, be paid by the bond issuer, and still remain independent. I was in risk much of my professional career and every time there was a breakdown in the underwriting/profit process, it was because risk was somehow compromised.

Stay tuned, this issue is not over, especially if the stock and bond markets get worse.

In 2000, Standard & Poor's made a decision about an arcane corner of the mortgage market. It said a type of mortgage that involves a "piggyback," where borrowers simultaneously take out a second loan for the down payment, was no more likely to default than a standard mortgage.

While its pronouncement went unnoticed outside the mortgage world, piggybacks soon were part of a movement that transformed America's home-loan industry: a boom in "subprime" mortgages taken out by buyers with weak credit.

In all fairness to the rating agencies, when underwriting criteria were tight seven years ago, this was probably a good decision. (my comment)

Six years later, S&P reversed its view of loans with piggybacks. It said they actually were far more likely to default. By then, however, they and other newfangled loans were key parts of a massive $1.1 trillion subprime-mortgage market.

Today that market is a mess. As defaults have increased, investors who bought bonds and other securities based on the mortgages have found their securities losing value, or in some cases difficult to value at all. Some hedge funds that feasted on the securities imploded, and investors as far away as Germany and Australia have suffered. Central banks have felt obliged to jump in to calm turmoil in the credit markets.

It was lenders that made the lenient loans, it was home buyers who sought out easy mortgages, and it was Wall Street underwriters that turned them into securities. But credit-rating firms also played a role in the subprime-mortgage boom that is now troubling financial markets. S&P, Moody's Investors Service and Fitch Ratings gave top ratings to many securities built on the questionable loans, making the securities seem as safe as a Treasury bond.

Also helping spur the boom was a less-recognized role of the rating companies: their collaboration, behind the scenes, with the underwriters that were putting those securities together. Underwriters don't just assemble a security out of home loans and ship it off to the credit raters to see what grade it gets. Instead, they work with rating companies while designing a mortgage bond or other security, making sure it gets high-enough ratings to be marketable.

The result of the rating firms' collaboration and generally benign ratings of securities based on subprime mortgages was that more got marketed. And that meant additional leeway for lenient lenders making these loans to offer more of them.

The credit-rating firms are used to being whipping boys when things go badly in the markets. They were criticized for being late to alert investors to problems at Enron Corp. and other companies where major accounting misdeeds took place. Yet they also sometimes get chastised when they downgrade a company's credit. . . . .