Thursday, October 23, 2008

Credit Agencies grilled on the Hill (Tian Weng)

Members of Congress held the third in a series of hearings on the financial crisis titled “Credit Rating Agencies and the Financial Crisis.” The hearing, held on Wednesday in 2154 Rayburn House Office Building, examined the roles and responsibilities of credit rating agencies in the current financial turmoil. Top credit rating agency executives also testified before the House Committee on Oversight and Government Reform.

In his opening statement, Committee Chairman Henry Waxman briefly outlined the sequence of events which lead to today’s crises. “The story of the credit rating agencies is a story of colossal failure,” Mr. Waxman said. He pointed out that leading credit rating agencies are essential financial gatekeepers. However, the agencies assigned triple-A ratings to securities and CDOs backed by risky subprime mortgage loans. As a result, the entire financial system is now at risk.

The three largest credit rating agencies - Standard & Poor’s, Moody’s, and Fitch Ratings control over 90% of rating market. They contributed substantially to the financial crisis by failing to warn investors of risk. They cannot evade their responsibility. The three current executives of the leading rating agencies were subject to major criticism:

Unsound rating and model failure. Undoubtedly, ratings are key. The methodologies used for rating CDOs are complex, arbitrary, and opaque. Credit rating agencies rely primarily on quantitative models to develop these ratings. However, these quantitative models cannot accurately reflect the specific credit characteristics of a particular security or issuer. A number of the assumptions they used were not realistic. A representative questioned agencies’ rating methodologies and assumptions because the CDO model seemed far from capable of capturing true risk. The witnesses responded that the business model they were using failed and definitely needed adjustments, but they explained the models were very complex, and hence had to go through several empirical tests. A Democrat read a message from an unnamed S&P's employee: “We rate every deal. It could be structured by cows and we would rate it.” Mr. Egan, Managing Director of another rating agency, admitted that’s ridiculous. “If you don’t understand it, then don’t rate it.” He said.

Fraud. There is an inherent conflict of interest in the industry. Agencies were paid by bond issuers whose debt they were rating instead of by investors who use and trust their ratings. This inhibits agencies from providing accurate and honest ratings. Someone posted questions to executives, “Investment banks got high ratings. Credit Agencies got investment banks’ fees. What did investors/taxpayers get?” Another Democrat cited profit charts of big agencies to strengthen her argument. It showed that S&P’s revenue from US RMBS and CDOs ratings drastically increased, by 25% to 35% as a percentage of total rating revenue, since 2002. Moody’s revenue from structured financial transactions skyrocketed over the same time period. Hence, it is clear that profits play a huge role in rating. But the three executives of credit agencies denied that conflicts of interest had impaired their judgment on mortgage securities. Mr. Fons, former executive of Moody’s, claimed that the analysts took their responsibilities seriously and demonstrated high moral character.

Another concern addressed was next steps going forward to ensure a crisis like this would not happen again. Efforts are needed to restore faith in the system. Rating Agency executives acknowledged that their companies' reputations had been harmed. Nevertheless, they expressed their fervent belief that substantive reforms can restore the integrity and stature of the bond rating industry.

(Tian Weng,
Master of Economics' 09
George Washington University)