Rating Agencies Face Glare of Meltdown Probe

Frank Raiter, Former Managing Director, Mortgage-Backed Securities, Standard and Poor's; Richard Michalek, Former VP Sr. Credit Officer for Moody's; Eric Kolchinsky, Former Team MD of Structured Derivative Products Group, Moody's and Arturo Cifuentes former Moody's Sr. Vice President as they testify before the Senate Subcommittee on Investigations on Capitol Hill in Washington, Friday, April 23, 2010.(AP Photo/Harry Hamburg) AP Photo/Harry Hamburg

Credit rating agencies responsible for grading the quality of investments whose failure played a part in the financial crisis drew congressional scrutiny Friday, as lawmakers probed the decision-making that led to inflated ratings.

Sen. Carl Levin, D-Mich., opened the hearing saying the agencies were too heavily influenced by banks and ultimately failed in their duty to provide honest assessments of securities to investors.

"That trust has been broken," said Levin, the chairman of the Permanent Subcommittee on Investigations.

A Senate released a report Thursday saying the agencies deserve some of the blame for the financial meltdown. According to that report, those agencies - Moody's Investor Service, Standard & Poor's and Fitch, Inc. - helped banks disguise the risks of the investments they marketed, selling high-risk securities with low-risk labels.

Levin said there was an "inherent conflict of interest" because the rating agencies received fees from the very firms whose products they were grading.

"They did it for the money," said Levin, who cited a threefold increase of revenues for the firms between 2002 and 2007.

Frank Raiter, a former managing director for Standard & Poor's, said there was a "disconnect" between senior managers and the analytical managers responsible for assigning bond ratings. He said that, along with weak government regulation, led to agencies to award high ratings to risky investments.

Raiter said management placed increasing pressure on analysts to earn fees by attracting business from banks. He said many former colleagues had quit after clashing with management.

When analysts "show the benefits of higher-quality rating criteria, and they come back and say, 'Revenues will go down,' you either (drop the issue and) continue to work there, or you quit," Raiter said.

Raiter also said weak government regulation led agencies to award high ratings to risky investments.

The Securities and Exchange Commission is prohibited by law from overseeing credit rating agencies. The agencies have escaped legal liability by claiming their ratings are protected by the First Amendment right to free speech.

Ray McDaniel, the chairman and CEO of Moody's, said his agency failed to foresee the collapse of the housing market.

"We, like many others, did not anticipate the unprecedented confluence of forces that drove the unusually poor performance of subprime mortgages in the past several years," said McDaniel.

Eric Kolchinksy, formerly in charge of the Moody's unit that rated subprime collateralized debt obligations, said that the agencies were motivated by market share rather than providing honest assessments.

"Across the financial food chain, from the mortgage broker to the CDO banker, were compensated based on quantity rather than quality," he said.

Levin said the Obama administration's financial overhaul should more closely address credit rating agencies are paid.

"It's like one of the parties in court paying the judge's salary," Levin said, adding that other parts of the overhaul will improve oversight of the agencies, but not enough.

There is legislation in both the House and Senate that would increase regulation of the credit rating agencies. Under both, the agencies would have to register with the Securities and Exchange Commission. The Senate bill would create a new Office of Credit Rating Agencies within the SEC.

Agencies would have to disclose their methodologies, how they used third parties to conduct due diligence on their assessments, as well as their own ratings track record.

The House bill would require the SEC to issue rules that would either prohibit or require a ratings agency to disclose any conflicts of interest related to its assessments of investments. Conflicts would include how the agency is paid and whether it has business relationships with the issuer of an investment. The Senate bill would require a study of the independence of ratings agencies, including an examination of conflicts of interest. But the Senate also would require that at least half the members of agency boards be independent, with no financial stake in credit ratings.

Investors could sue ratings agencies on the grounds of reckless failure to analyze an investment.

Under the Senate bill a ratings agency could lose its SEC registration if it shows a record of providing bad ratings over a period of time.

More on financial reform:

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Schieffer: Dems Focus on Financial Reform, Elections
Financial Reform Likely to Pass
Financial Reform Fight
What Bipartisanship? Financial Reform Gamesmanship Back on
Obama Financial Regulatory Reform Cheat Sheet
Obama Tells Wall Street to Stop Fighting Reform

Credit raters have come under fire not only for their role in the broader financial crisis but also in the specific case of Goldman Sach's alleged fraud.

"The credit rating agencies failed completely," said Sen. Bernie Sanders, I-Vt, said Thursday. "You had a totally intentionally created toxic asset."

On paper it was known as "abacus 2007-AC1," a billion-dollar bet that the people living in certain homes and others were headed for foreclosure or default.

The SEC alleges Goldman Sachs helped hedge fund manager John Paulson win that bet by loading abacus up with hundreds of thousands of low-quality loans, including "a high percentage of adjustable rate mortgages" and buyers with "relatively low ... FICO (or credit) scores"

Yet when those toxic loans were presented to investors, they smelled more like French perfume, reports CBS News chief investigative correspondent Armen Keteyian. One big reason is that the deal received the highest possible credit rating - AAA - by the top two agencies, Moody's and Standard & Poor's, meaning it should have been a safe investment.

"The truth is they are working for Wall Street, and they're going to give Wall Street what Wall Street wants," Sanders said.
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