Rating Agencies, Discredited

With the global economy frozen in a protracted credit crunch, consumer loans have unquestionably been in short supply. Banks are jacking up interest rates on credit cards or cancelling accounts altogether; auto financing is nearly impossible to obtain. This week, the Federal Reserve began implementing a program designed to combat the problem and make more loans available to citizens. However, the central bank could be courting disaster by relying on the same rating agencies that helped cause the crunch in the first place.

The Fed hopes that its new Term Asset-Backed Securities Lending Facility (TALF) will get consumer credit flowing again by giving the securities market a boost. Under the plan, the central bank will give money to financial companies that agree to buy up newly issued securities composed of car and credit-card loans. This fresh demand from investors will ideally enable banks to extend more loans to consumers. But by relying on the major credit-rating agencies to ensure the quality of the loans financed, the Fed risks putting taxpayers on the hook for hundreds of billions of dollars in freshly issued toxic assets, all while creating a massive windfall for the very ratings firms that played a central role in the financial collapse.

Among those who follow the intricacies of structured finance, rating agencies are almost universally reviled, forging a rare alliance between consumer-protection advocates, pension-fund managers, and Wall Street executives. Their business is the evaluation of creditworthiness: When a corporation issues debt to investors, a rating from agencies like Fitch, Moody's, or Standard & Poor's is supposed to reflect the likelihood that the corporation will pay that debt off. Some of the investors who buy these securities oversee Wall Street hedge funds, but thousands of others handle retirement accounts and mutual funds, managing the life savings of millions of ordinary citizens.

These credit raters were also essential to the process of packaging sub-prime mortgages into extraordinarily complex securities that would later become the "toxic assets" trapped on the balance sheets of banks around the globe. The process began with investment banks buying hundreds of mortgages and packaging them together into a byzantine security to sell to investors. Since the sheer complexity of this new security rendered it effectively impossible to analyze, investors relied on credit ratings to determine just how risky it was. Fueled by a false confidence in rating-agency credibility, the market for sub-prime mortgage securities exploded between 2001 and 2006 from about $100 billion to over $1 trillion.

The ratings were bunk. Many mortgage-backed securities that earned AAA ratings -- the highest grade a rating agency can bestow -- turned out to be nearly worthless, and the value of the securities market plummeted 70 percent between January 2007 and December 2008. This was not just a problem for investors on Wall Street. By creating the illusion that these securities based on predatory loans were high-quality investments, rating agencies were fueling Wall Street demand for abusive mortgages, encouraging banks to make absolutely dreadful loans, and entrapping millions of borrowers in loans they could never hope to afford in the process.

There were two basic problems with the credit-rating agency business model. First, they were not paid by investors who used their ratings, but by the investment banks that created the securities. This gave the agencies overpowering incentives to inflate ratings.

Second, the agencies were not legally required to ask for the information needed to accurately rate securities. When that information was available, they often chose to ignore it, knowing that awarding high ratings meant generating big profits and that too much information could cut into revenues. In an October 2008 House Oversight Committee hearing, lawmakers presented a damning e-mail exchange between an S&P credit analyst and his supervisor: When the analyst asks to review the loan files for the security he is supposed to rate, his supervisor emphasizes that the request is "TOTALLY UNREASONABLE!"

"It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so," the e-mail reads. "Please provide the credit estimates requested!"

This methodological gaming alone could be grounds for bringing a fraud complaint against S&P, according to William Black, a former banking regulator who now teaches law and economics at the University of Missouri. "He's ordering him to make up a methodology that is going to justify the ratings," Black says.

The deception made large losses inevitable, and when highly rated securities plunged in value, so did millions of retirement accounts. "Certainly the credibility and reputation of the credit-rating agencies has been damaged beyond repair," says Gerard Cassidy, a banking analyst with RBC Capital Markets.

So damaged, in fact, that the market for complex securitized loans nearly disappeared altogether in the second half of 2008. Rating agencies found themselves with a huge hole where their primary business once was.

Yet today the agencies are positioned to profit enormously through the Fed's consumer loan financing program. The central bank has made an inexplicable decision to outsource its analysis of the quality of these consumer loans to the very rating agencies that helped create the financial meltdown. Instead of staffing up to evaluate borrowers' ability to repay new credit-card and auto loans, the Fed is simply agreeing to finance any investment in a consumer loan security that receives a AAA rating from at least two major rating agencies. Just as the rating agencies are starting to lose revenues as a result of their malfeasance, Treasury Secretary Timothy Geithner and Federal Reserve Chair Ben Bernanke are rushing in to flood them with business.

"What an irony to turn around and say, 'Oh, let's give an enormous amount of work and money to them,'" Black says. "It doesn't make any sense."

TALF is not only funneling money to the culpable, it is reigniting the securitization process that created the current economic firestorm. Credit-rating agencies have proven that they are more than willing to assign top ratings to economically destructive sub-prime securities. Under TALF, thousands of loans will be packaged into securities that are nearly impossible to analyze, with no quality assurance from anyone except discredited rating agencies. These securities will create artificial demand for consumer loans, encouraging banks to issue loans to consumers who cannot afford them, knowing full well that they can pass the loan off to investors financed by the government. This has already caused a disaster once. It's hard to see how it will turn out better when the consumer loans are made amid near-depression economic conditions.

The best solution to this mess-in-the-making would be to cancel the TALF and have the government directly finance any essential consumer loans that the private sector will not make. Short of cancellation, the Fed could demand that credit-rating agencies that do not operate under immense conflicts of interest serve as the gatekeepers for the program. Instead of relying on S&P, Moody's, and Fitch to rate new securities, the Fed could enlist smaller Securities and Exchange Commission-licensed rating agencies that are paid by investors rather than investment banks.

Credit-rating reform is absolutely necessary for rehabilitating the financial system, but regulators have been reluctant to take action. In 2008, the SEC proposed new rules banning a few questionable activities, such as allowing investment bankers to take credit analysts to expensive meals or offer them gifts. But it failed to address the most important issue: where the money comes from. Into the 1970s, all rating agencies were paid by investors, not securities issuers. If the SEC would simply revoke the license of any rating agency that is not paid by investors, it would take a critical step toward restoring confidence in the financial system.