Issue of the week: The spotlight turns to the bond raters

With Washington focusing its fury on investment banks and hedge funds, said Blake Ellis in CNNmoney.com, it has been easy to overlook the role bond-rating agencies played in the financial crisis of 2007–08. But last week, Raymond McDaniel, the CEO of bond-rating agency Moody’s, and Kathleen Corbet, the former president of Standard & Poor’s, testified before a Senate committee investigating the meltdown. They had a lot of explaining to do. Wall Street firms paid millions of dollars to Moody’s and S&P to assess the creditworthiness of complex mortgage bonds, called collateralized debt obligations, that firms were rushing to market during the housing boom. Many of the CDOs won the coveted AAA rating, which supposedly meant that they were as safe as U.S. Treasury bonds. Of course, they weren’t. Beginning in 2007, Moody’s and S&P downgraded more than 90 percent of the CDOs to “junk” status—a mass downgrade that Sen. Carl Levin of Michigan called “the immediate trigger of the 2007 financial crisis.”

So what went wrong? asked Kevin Hall and Chris Adams in The Sacramento Bee. E-mails released at the Senate hearing suggest that the rating agencies were more interested in securing their high fees than in the integrity of their standards. In one typical missive, a Moody’s employee apparently pressured Merrill Lynch to cough up a big fee in exchange for a positive rating. “We have spent significant amount of resource on this deal,” wrote Moody’s Yvonne Fu, “and it will be difficult for us to continue with this process if we do not have an agreement on the fee issue.”

What has now been exposed, said Paul Krugman in The New York Times, is “a deeply corrupt system.” Moody’s and S&P knew their ratings played “a central role in our financial system,” especially for pension funds and other institutional investors that by law can buy only AAA-rated debt. The ratings agencies also knew that Wall Street firms could choose among several rival ratings firms, steering their business “to whichever agency was most likely to give a favorable verdict.” So the raters skewed their assessments to please their clients. One investor aptly likens the situation to a big, boozy party—“with ratings agencies handing out fake IDs.”

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The party may soon be over, said Brian Dickerson in the Detroit Free Press. The regulatory reform bill pending in the Senate would for the first time subject the rating agencies to Securities and Exchange Commission oversight and make them liable for damages “when their analysts abet securities fraud.” Until that happens, though, “investors should keep in mind that a triple-A bond rating is only as trustworthy as the bank that paid for it.”