Q: What role did rating agencies play in the credit collapse?
A: Credit rating agencies, or CRAs, have enjoyed quasi-regulatory status since the Great Depression. Inherent flaws in the system have survived repeated efforts at reform. By 2007, the entire infrastructure of securitized debt depended upon a handful of rating agencies whose conflicts of interest were manifest.
Their dismal performance in evaluating complex securities, compounded by a systemic dependence upon their ratings, is central to understanding the credit collapse.
Three players dominate: Standard & Poor's, Moody's and Fitch. These agencies were granted the imprimatur of "Nationally Recognized Statistical Rating
Organizations" by the Securities and Exchange Commission in 1975.
Since then regulatory actions by federal, state and municipal governments often mandated ratings from one of the companies while many funds and pension plans relied on them in constructing portfolios.
The Federal Deposit Insurance Act defined "investment grade" securities as bonds receiving one of the four highest ratings from at least one agency, and state insurance commissioners often included ratings as criteria for suitability of investments.
This definition effectively gave CRAs control of the toll booth, since any new issue needed a rating for which the issuer paid the agency.
By 2007 there were 10 NRSROs, but the big three maintained a 95 percent market share. With an effective oligopoly and a massive conflict of interest, the stage was set for disaster.
The explosion in bundled debt securities required high ratings to come to market, and agencies were willing enablers. They constructed complicated models to justify investment-grade ratings on piles of subprime loans, collecting fat fees along the way, and provided justification for money managers to boost returns by holding ugly debt inside pristine wrappers.
The rest is history.
The models did not anticipate declining house prices, leading to a vicious cycle of defaults. During the meltdown, credit agencies downgraded $1.9 trillion of mortgage securities, some all the way from AAA (solid gold) to CCC (bottom rung). By then, the horse was out of the barn.
Partial reform was included in the Dodd-Frank bill, but has yet to be implemented. CRAs have taken the preposterous position that they should not be held to a fiduciary standard since their ratings are "opinion," to be treated as editorial commentary.
The new law mandates statutory changes that eventually eliminate the requirement of agency ratings and force investors to conduct more of their own due diligence. It won't ensure against another credit bubble, but it's a start.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Chris Hopkins is vice president, investments, at Barnett & Co. Inc. Submit questions to his attention by writing to Business Editor Dave Flessner, Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at email@example.com.