Senate report criticizes Wall Street credit rating agencies for betraying investors
Moody’s and Standard & Poor’s, Wall Street’s two largest credit rating agencies, were roundly criticized in the Levin-Coburn Senate report for betraying investors’ trust and triggering the massive mortgage-backed securities sell-offs that caused the 2008 financial crisis.
Credit rating agencies are supposed to provide independent, third-party credit assessments to help investors understand the risks in buying particular securities, debts and other investment offerings. For example, securities that have earned the highest ‘AAA’ rating from Standard & Poor’s (S&P) should have an “extremely strong capacity to meet financial commitments” or have “a less than 1% probability of incurring defaults.” Investors would use the ratings to help evaluate the securities they’re seeking to buy.
However, the standard practice on Wall Street is fraught with conflicts of interest. In reality, the credit rating agencies have long relied on fees paid by the Wall Street firms seeking ratings for their mortgage-backed securities, collateralized debt obligations (CDOs), or other investment offerings. The Levin-Coburn report found the credit agencies “were vulnerable to threats that the firms would take their business elsewhere if they did not get the ratings they wanted. The ratings agencies weakened their standards as each competed to provide the most favorable rating to win business and greater market share. The result was a race to the bottom.” Between 2004 and 2007, the “issuer pay” business model fostered conflicts of interest that have proven disastrous for investors.
Following a two-year inquiry conducted by the Senate Permanent Subcommittee on Investigations, the Levin-Coburn report exposed the role credit rating agencies played in triggering the 2008 financial crash. Here is an overview of what happened based on the subcommittee’s findings:
- Between 2004 and 2007, Moody’s and S&P issued top credit ratings to tens of thousands of mortgage-backed securities and CDOs. In late 2006, the economy was slowing down and a growing number of homeowners (particularly in the subprime market) were having trouble paying their mortgages. Despite the clear signs of the declining housing market, Moody’s and S&P continued to issue top ‘AAA’ ratings for many mortgage-backed securities and CDOs and pocketed lucrative ratings fees. The Senate report explained: “It was not in the short term economic interest of either Moody’s or S&P, however, to provide accurate credit ratings for high risk [mortgage-backed] and CDO securities, because doing so would have hurt their own revenues.”
- But the housing market worsened, and more and more people were defaulting on their mortgages around the country. By July 2007, Moody’s and S&P were forced to abruptly downgrade credit ratings for the mortgage-backed securities and CDOs that were deemed to be sound investments only few months earlier. “Over 90% of the AAA ratings given to subprime RMBS (mortgage-backed) securities originated in 2006 and 2007 were later downgraded by the credit rating agencies to junk status,” according to the Senate report. Consequently, the investors who trusted the credit ratings provided by Moody’s and S&P saw their investments suddenly plummet in value and lost a lot of money.
- To make matters worse, the sudden rating downgrades forced a massive sell-off because state and federal laws prohibit certain investors like banks, insurance companies, and pension funds from holding non-investment grade securities. Thus, the market was flooded with downgraded mortgage-backed securities, and very few investors were willing to buy them. The result was the collapse of the mortgage-backed securities market, bringing about the financial crisis of 2008 and the worst economic recession since the Great Depression.
Given how Moody’s and S&P apparently betrayed investors’ trust in their pursuit of higher revenues and market shares, shouldn’t credit rating agencies be held accountable when they inflate ratings or fail to conduct reasonable due diligence?
- U.S. Senate Permanent Subcommittee on Investigations: Levin-Coburn report on Wall Street and the Financial Crisis: Anatomy of a Financial Collapse (PDF) released April 13, 2011
- U.S. Senate Permanent Subcommittee on Investigations: Levin-Coburn report pages 243 – 317 on the Moody’s and Standard & Poor’s case study (PDF)
- U.S. Senate Permanent Subcommittee on Investigations: Levin-Coburn report pages 5 – 7 executive summary on credit rating agencies (PDF)
- Moody’s credit ratings
- Standard & Poor’s credit ratings
- Sen. Carl Levin’s statement on the Levin-Coburn report
- Official website of Sen. Carl Levin (D-MI)
- Official website of Sen. Tom Coburn (R-OK)
Category: Banking & Finance, Current Events, Economy, Housing, News, Politics, Waste, Fraud & Abuse · Tags: AAA rating, CDO, collateralized debt obligation, conflicts of interest, credit rating agencies, defaults, downgrade credit ratings, financial crisis, Great Depression, homeowners, housing market, investors, issuer pay model, junk status, Levin-Coburn report, Moody's, mortgage, mortgage-backed securities, S&P, Senator Carl Levin, Senator Tom Coburn, Standard & Poor's, subprime mortgage, US Senate, Wall Street