Many institutions and individuals share responsibility for the mortgage crisis and the meltdown that followed: Congress, several successive presidential administrations, top executives at
Fannie Mae of Washington and
Freddie Mac of McLean, Va., Wall Street's investment banks, mortgage bankers and brokers, and, last, but not least, credit rating agencies.
Other than investors' own skepticism and due diligence, the credit rating agencies were the last officially sanctioned line of defense.
They were supposed to act as the combination lock that prevented robbers from entering the bank vault.
Unfortunately, they failed. It is time to ask why they failed, and to examine if the structure of the credit ratings business needs rethinking.
This re-examination, however, shouldn't be undertaken by Congress because it will seek only to find scapegoats for its own failures.
Rather, the examination of the perceived failures of the rating agencies should be part of a wider examination of the financial meltdown that should be undertaken by an independent, non-partisan commission made up largely of leading academics.
In theory, rating agencies provide independent verification of the creditworthiness of fixed-income investments. Investors rely on credit ratings to decide whether they should invest in particular securities — that is, whether the return being offered is worth the risk being taken.
Even issuers often relied on the rating agencies for an independent assessment of their own creditworthiness. In addition, government regulators use the credit ratings to determine whether banks have the required capital reserves.
Unfortunately, in the wake of the mortgage crisis, the credibility of the rating agencies has been seriously damaged. Their independence and impartiality has been called into question, in part because of the way they are compensated.
The credit rating agencies are paid for their ratings, not by the prospective buyers of the securities, but by the issuers, a situation that seems to be inherently conflicted.
There are suspicions that some rating agencies tailored their ratings to the desires of the issuers, particularly in the case of the mortgage-backed securities issued by Wall Street's investment banks.
The agencies may have been concerned they wouldn't get future business from an investment bank to whose mortgage backed securities they assigned a low rating.
Other observers suspect that, at the very least, some investment banks learned to game the systems that the rating agencies used to calculate their ratings.
One former rating agency executive testified before Congress two weeks ago that his firm had, in the early part of the decade, cut the budget used to update its credit rating models to save money and enhance profitability. As a result, he told a congressional committee, the models weren't updated to account for changes in the markets and totally missed the increase in the number of subprime mortgages and the likelihood of defaults.
An independent commission could examine all these issues to determine which of them contributed to the failure of the rating agencies, and to suggest changes that could improve their performance. Perhaps the buyers of securities should be required to pay for the ratings.
The rating agencies deny that they are conflicted, and deny that they tailored ratings to satisfy the Wall Street issuers. They argue that their ratings are only "point in time" ratings.
If conditions change, the previous ratings are no longer valid and the ratings of the securities will be changed.
The question is: Why were the ratings on mortgage-backed securities not adjusted as the real estate outlook darkened? That is a question for an independent commission.
