When the Internet bubble burst, regulators went after the analysts who urged investors to buy stocks that were dogs.
After Enron and WorldCom went bankrupt, regulators zeroed in on auditors who ignored the accounting tricks used by their clients to fool investors.
Now that some of the world’s biggest banks are admitting that assets backed by subprime mortgages are worth a fraction of what they claimed, regulators are training their sights on credit-rating agencies that gave a “triple-A” grade to risky financial products.
In all three cases, the problem is the same: Investors thought they could rely on a guarantee or recommendation from a neutral “gatekeeper” who vouched for the product they were buying. But in each case, the gatekeeper got paid by the company selling the product.
AGs On The Prowl
The subprime mortgage market has been melting down amid surging default and delinquency rates, a development that has caused panic among investors who put money into funds contaminated by those assets. That has prompted attorneys general from three states and the House Financial Services Committee to look into the role of the credit-rating agencies — the two biggest of which are Moody’s and Standard & Poor’s — in the mess.
Credit-rating agencies are under scrutiny now in part because regulators will only allow pension funds to buy bonds that are considered investment grade, with a rating of “A” or above.
As a result, the investment banks that repackage mortgages into more complex securities have an incentive to make sure that these products receive A-level ratings.
In practice, an investment bank approaches the ratings agencies with a hypothetical mix of financial products to see if the blend will rate a grade of A or above. If Moody’s or S&P says no, the bank reconfigures the package so that it fits the A-level classification. In this way, the ratings agency participates in the creation of the security, says Josh Rosner, managing director of Graham Fisher.
Once the bank achieves the desired quality grade on a product, it pays the agency for the rating. The process, says Rosner, is rife with conflict. “The agencies act as market regulators, investment bankers and as a sales force, all while claiming to be providing independent opinions,” Rosner says.
It wasn’t always this way, says Edward Grebeck, CEO of Tempus Advisors. In the 1980s, credit-rating agencies worked primarily with big corporations that wanted to raise money on the bond markets.
“They used to earn money from investors who bought the debt,” he says. But with the proliferation of structured finance, particularly in the mortgage business, the dynamic has changed, he says. “Now, they earn the bulk of their fees from asset-backed transactions.”
