We've spent a great deal of time in the last year trying to figure out just what the heck happened to cause the global economic crisis. It's natural to want to find someone or something to blame, and in this case there's plenty of blame to go around.
Financial regulators, such as the SEC, dropped the ball on their oversight duties, while banks and mortgage companies collectively reduced their lending standards to nearly nothing, all under the guise that rising home prices could cure all ills.

Higher up the food chain, investment banks spun "innovative" products that packaged up thousands of subprime loans, sliced them into pieces and sold them to an investing public that was made to believe that the product was "top-rated."

You Call That AAA?!
But one group that has avoided major finger-wagging is finally getting its due dose of criticism - the major credit ratings agencies that slapped top ratings on assets that are now considered "toxic" and threatened to derail the economy.

The credit ratings business is dominated by just three companies - Standard & Poor's, Moody's and Fitch. These companies are supposed to conduct rigid due diligence on assets like government, municipal and corporate bonds, and publicly-traded stocks. The ratings assigned to companies will largely determine how easily the company can borrow money, and how much interest will be paid in order to do so.

The ratings assigned by the major agencies are depended on by retail and institutional investors worldwide; in many cases, ratings are considered the de facto measure of safety by pension funds, mutual funds and folks like you and me. (To learn more, check out A Brief History of Credit Rating Agencies.)

Conflict of Interest
As soon as one understands how the credit ratings agencies get paid, the huge conflict of interest is as clear as day. When a bond issuer or an investment bank has a new bond security to sell to the public, they first seek out a credit ratings agency to evaluate the security and place a rating on it. That rating will largely determine how easily the security can be sold. A top rating of AAA or A+ insures a smooth selling process and handy profits to the issuer.

But the issuer then pays the ratings agency to rate the security. Think of it this way - if you went to a classy restaurant and were offered a free meal, would you me more or less likely to complain about the food?

As the surging real estate market reached its peak in 2006-2007, more and more subprime debt was making its way to the ratings agencies. The potential to earn great fees had the three major agencies competing with each other to give the highest ratings possible. The higher the rating, the more likely they would be to get future business from the issuer.

When the housing market began to turn south in 2007-2008, ratings firms were disastrously late in downgrading those top-notch ratings to reflect the reality of the present day. The results were staggering; hundreds of billions in write-downs had to be taken from banks, pensions, and local governments. Respected Wall Street firms and mortgage lenders went from being rated "stable" to imploding in the blink of an eye.

Will the Business Model Change?
So far there hasn't been any meaningful change to the business model of the ratings agencies. Need a rating? Just pay us, and we'll give you one. Winking and nodding ensues as the ratings agency knows that if they provide favorable ratings, they will get more future business (and dollars) from that particular bond issuer.

A more ideal business model is one where the investors that depend on those ratings pay the ratings agencies. Then the agency would be beholden to the investors, and their reputation would be on the line with each new security reviewed. Because, in that type of competitive environment, if an agency gave a top rating to a bond or a company that proved to be dead wrong, investors would take their trust and money elsewhere.

Ratings agencies would then be competing to be the most honest - the most prudent - rather than just being the one willing to give the top rating in trade for future business.

New Rules, Lawsuits on Horizon
Last week, the SEC proposed new rules that are designed to make the credit rating firms more transparent in how they conduct their business. Under the proposed rules, the ratings agencies will have to disclose the full history of their ratings actions (and the reasons for them), going back to 2007. They would also have to publicly disclose every firm that paid them to rate securities.

The SEC also wants to see some more players in the field to challenge the status quo where just three firms dominate the landscape. These proposed changes come as big lawsuits are being filed against the rating agencies for misleading prominent investors around the world. (For further reading, check out Policing the Securities Market: An Overview of the SEC.)

Parting Thoughts
The credibility of the ratings agencies is shot, and for good reason. Whether they are forced to, or choose to of their own volition, major changes are needed to the business model, and even then it will take time to regain investor trust.

For better or worse, one of the side effects of a financial crisis is that we can learn about where the cracks lie in the system. Step one is to find them, step two is to fix them and the final step is a gradual one where investors slowly find their way back to a point of trust. All three need to be completed before our economy can truly recover and be sturdy enough to handle future challenges.

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