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May 17, 2010
Credit Rating Agencies Face New Legislative Strictures
    by Robert Kropp

Widely criticized for assigning inflated ratings to mortgage-backed securities, rating agencies will be assigned ratings by an independent agency.

In a briefing paper authored by James Lardner of Demos, a public policy research and advocacy organization, the contribution of credit rating agencies to the financial crisis was stated bluntly:

“In the runup to the financial crisis, no institution more thoroughly betrayed its mission; and no single failure had a more devastating impact,” the report stated.

The ten credit rating agencies registered with the Securities and Exchange Commission (SEC) as Nationally Recognized Statistical Rating Organizations (NRSRO) determine the creditworthiness of financial products. Critics have charged that the rating agencies, which are paid for their services by the financial institutions whose products they evaluate, contributed to the severity of the financial crisis by providing inflated ratings for securities consisting of subprime mortgage loans.

The briefing paper serves as a valuable primer on the history of rating agencies, which began in 1909 with a guide to railroad securities written by John Moody. Rating agencies gained a more official standing in the aftermath of the Great Depression, when banks were ordered to limit their investments to investment-grade securities as determined by the agencies.

By the 1970s, the three major credit rating agencies—Moody’s Investors Service, Standard & Poors, and Fitch—had shifted their business models to one in which the issuers of securities, and not investors, paid for their services. Before the financial crisis struck in 2008, the inflated ratings provided by the agencies misled investors into believing that securities consisting of subprime mortgage loans were credit-worthy. Since then, almost all the securities have been downgraded to junk status.

The briefing paper quotes Raymond McDaniel, the CEO of Moody’s, as saying, “Unchecked competition on this basis (of market pressure for higher ratings) can place the entire financial system at risk.”

The briefing paper seconded a recommendation by the economist David Raboy, who called for “the creation of an independent clearinghouse that would receive rating applications from securities issuers, and assign each job to a rating agency in a random or unpredictable way. Payment would be based on the complexity of the securities involved.”

On Friday, the US Senate also voiced approval for Raboy’s suggestion. By a bipartisan vote of 64 to 35, the Senate approved an amendment to the financial reform bill, by Senator Al Franken of Minnesota, that a regulatory agency be established to administer the assignment of credit ratings to rating agencies. The new agency will be part of the SEC.


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