Rating Agencies Stuck On The Hot Seat

A probe of credit rating agencies was announced by the California Attorney General's Office right before his targets were called on the carpet during the National Association of Insurance Commissioners conference last week.

California Attorney General Edmund G. Brown Jr. issued a statement saying he had issued subpoenas to Standard & Poor's, Moody's Investors Service and Fitch Ratings to determine whether the firms violated California law when they "recklessly" gave "stellar ratings to shaky assets."

As this edition went to press, the NAIC had put rating agencies in the hot seat, convening a day-long hearing on Sept. 24 at the conclusion of their fall national meeting just outside of Washington, in National Harbor, Md.

Indeed, some testified at the gathering that the reliance of the NAIC Securities Valuation Office on rating agencies to determine risk-based capital requirements for insurers should be reevaluated in light of events connected to the recent credit crisis.

But before that, Mr. Brown announced his own investigation, charging that "Standard & Poor's, Moody's and Fitch put their seal of approval on high-risk mortgage-backed securities, recklessly giving stellar ratings to shaky assets that proved toxic to the entire financial system."

He said his probe is meant to determine "how these agencies could get it so wrong, and whether they violated California law in the process."

Moody's, S&P and Fitch grade the creditworthiness of corporations and municipalities and the financial instruments (such as bonds and securities) they issue.

Investors depend on these ratings to gauge risk and make investment decisions, while insurance regulators use them when examining the state of insurers' equity investments.

"At the peak of the housing boom, these agencies gave their highest ratings to complicated financial instruments–including securities backed by subprime mortgages–making them appear as safe as government-issued Treasury bonds," said Mr. Brown.

The attorney general said the agencies, in rating these securities, had "worked behind the scenes with the same Wall Street firms that created them. For their work, the firms earned billions of dollars in revenue, at a rate nearly double what they earned for rating other financial products."

He said banks, pension funds and other investors "relied on these ratings when they purchased trillions of dollars of securities backed by subprime mortgages because of the high returns and apparent low risk."

Those purchases, he noted, "helped fuel the housing bubble by providing funding for lenders to issue ever-riskier subprime and other toxic mortgages. When the bubble burst, however, those risky mortgages defaulted in record numbers and investors were left holding worthless securities, unable to sell them."

According to Mr. Brown, the agencies downgraded the credit ratings of $1.9 trillion in residential mortgage-backed securities, "a tacit acknowledgement of their failure to adequately assess the risks of the debt they rated. The rating agencies either ignored or did not understand the risks of the debt they rated."

In addition to a variety of governmental scrutiny, the rating firms have been sued by investors in various locations who allege they sustained huge losses based on inaccurate ratings.