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Credit rating agencies: The real villain in the financial crisis?

WASHINGTON - OCTOBER 22:  Deven Sharma, presid...

Image by Getty Images via Daylife

Big Wall Street banks have been demonized as the villains of the financial crisis -- creating exotic financial instruments that no one really understood, maybe misleading investors about efficacy of those instruments and then blithely mailing the risk off into a black hole, better to be forgotten.

So this morning's news that New York Attorney General Andrew Cuomo -- picking up the disgraced Elliot Spitzer's role as the bane of Wall Street -- has issued subpoenas to several of those big banks raised few eyebrows.

However, you should also note that Cuomo has issued subpoenas to the three major credit rating agencies: Standard & Poor's, Moody's and Fitch. Some people think the rating agencies are the real villains of the financial crisis. (S&P President Deven Sharma is pictured here.)

Every one of those exotic investment vehicles that Wall Street banks created was rated by one of the agencies, which assessed its credit-worthiness and assigned a grade. Ratings are among the most important attribute of an investment -- it is a stamp of approval or a warning sign. A high credit rating from one of the big three has for years been considered equivalent to the Good Housekeeping seal of approval -- if an investor saw a high rating, they should feel comfortable putting their money in.

We discovered from the financial crisis that wasn't so. Investments full of securitized toxic assets -- sub-prime mortgages, for one -- were given high ratings, misleading investors.

The rating agencies were hauled before Congress during the crisis and flogged, and they said, yes, well, we probably should have done a better job evaluating things. But we only know what the banks tell us, pointing the finger back at the investment banks.

That's what Cuomo and others have been trying to get at: Has the relationship between the rating agencies and the big banks been too cozy? Remember this: The rating agencies don't rate products for free. They get paid for their evaluation. There is an implicit incentive for rating agencies to pass out high ratings in order to get repeat business from the banks.

Here's an excerpt from an October 2008 posting I wrote while covering a hearing of Rep. Henry Waxman's (D-Calif.) oversight committee, as he was laying into the rating agencies. Here he is quoting anonymous executives from the agencies in documents his committee obtained:

He quoted from anonymous executives at Moody's, Standard & Poor's, Fitch and other ratings agencies, telling a tale of unheeded warnings. The ratings agencies continued to rate risky securities -- such as the collateralized debt obligation, or CDOs -- because they were getting paid big bucks, the quotes suggest.

"We sold our soul to the devil," one ratings agency employee said, according to Waxman.

"It could be structured by cows and we'd rate it," said another.

"Rating agencies continue to create an ever bigger monster -- the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters,” said another.

"The story of the credit-rating agencies is a story of a colossal failure," Waxman concluded.

There no doubt is a symbiotic relationship between the banks and the rating agencies, and that's probably impossible to avoid. But investors depend on the agencies to use a clear, unflinching, unbiased eye when examining what the banks are trying to peddle. Further -- and this is probably even more important -- the rating agencies need to fully understand these exotic instruments. (Many of which serve legitimate financial purposes.) And they need to fully understand and appreciate all of the upstream and downstream consequences if they fail. That should be part of the duty of a rating agency.

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By Frank Ahrens  |  May 13, 2010; 11:55 AM ET
Categories:  Congress , Corporations , Wall Street  | Tags: Business, Collateralized debt obligation, Credit rating agency, Good Housekeeping, Moody, New York State Attorney General, Standard & Poor, Wall Street  
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I have some exotic powder and I'm keeping it dry here. It can't fail although some will not make it and all the better that they don't. I do my best.

Posted by: tossnokia | May 13, 2010 12:54 PM | Report abuse

The rating agencies' track record over the past decade:
The dotcom bubble - didn't see it coming.
Enron et al. - didn't see it coming.
The Housing bubble & financial instability - didn't see it coming.

I hate sounding so paranoid, but I have to admit I've been concerned about the rating agencies for some time. It seems there is either a) a serious flaw in their rating methods or b) a serious flaw in their management practices.

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