In the early 2000's, I covered bonds sold by major US airlines, underwritten by bulge bracket investment banks and "wrapped" by monoline insurance providers such as MBIA and Ambac (which has recently developed quite a few problems of its own!). The result was that many of these deals were given fairly high credit ratings by the agencies despite the junk-bond ratings of these airlines' unsecured debt and the difficult market the companies were facing as the dot-com boom went bust and companies started making their execs fly coach instead of business class. After 9/11, the US airline industry all but collapsed and had to be bailed out by taxpayers in the form of federal loan guarantees. And the structured bonds issued by the airlines saw their high ratings based on structural enhancements rather than the underlying asset downgraded to sub-investment grade overnight.
What happened to the airline industry was repeated with mortgage-backed securitizations several years later. As Lowenstein makes abundantly clear in this article, one of the major problems is the god-like power the rating agencies play in the world of high finance, combined with the existence of clear conflicts of interest with their clients (whose securities they simultaneously were evaluating and passing judgement on)and the fact that there was no SEC-led overview of these firms' activities. In effect, the government outsourced its regulatory function to three for-profit companies.
As Lowenstein points out:
Who was passing judgment on the quality of the mortgages, on the equity behind them and on myriad other investment considerations? Certainly not the investors. They relied on a credit rating.
Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody’s and Standard & Poor’s that set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. Effectively, they did the job that was expected of banks and government regulators. And today, they are a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more.
In the wake of the housing collapse, Congress is exploring why the industry failed and whether it should be revamped (hearings in the Senate Banking Committee were expected to begin April 22). Two key questions are whether the credit agencies — which benefit from a unique series of government charters — enjoy too much official protection and whether their judgment was tainted. Presumably to forestall criticism and possible legislation, Moody’s and S.&P. have announced reforms. But they reject the notion that they should have been more vigilant. Instead, they lay the blame on the mortgage holders who turned out to be deadbeats, many of whom lied to obtain their loans.
Arthur Levitt, the former chairman of the Securities and Exchange Commission, charges that “the credit-rating agencies suffer from a conflict of interest — perceived and apparent — that may have distorted their judgment, especially when it came to complex structured financial products.” Frank Partnoy, a professor at the University of San Diego School of Law who has written extensively about the credit-rating industry, says that the conflict is a serious problem. Thanks to the industry’s close relationship with the banks whose securities it rates, Partnoy says, the agencies have behaved less like gatekeepers than gate openers. Last year, Moody’s had to downgrade more than 5,000 mortgage securities — a tacit acknowledgment that the mortgage bubble was abetted by its overly generous ratings. Mortgage securities rated by Standard & Poor’s and Fitch have suffered a similar wave of downgrades.
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