2008 Congressional Hearings Sheds Light On Rating Problems

September 13, 2010 by · Leave a Comment
Filed under: SEC, The Rating Agencies 

From Congressional testimony in 2008, only 2.2% of corporate bonds rated “investment grade” by Moody’s defaulted between 1983 and 2005.  However, 24% of complex structured financial products like collateralized debt obligations (CDOs) based on sub-prime mortgages, also rated “investment grade” by Moody’s, defaulted between 1994 and 2005.

Congressional testimony records that CDO issuers had shopped around for ratings until their high-risk securities came to be rated as safe. According to a 2008 study published by the U.S. Securities and Exchange Commission (SEC), the “issuer pays” model leads to serious conflicts of interest for credit rating agencies. An issuer can have a security evaluated by multiple rating agencies and then choose to use the best rating it can get. However a rating agency is paid only when its rating is used. The incentive, therefore, is to give a security the highest rating possible in order to be paid for the work.

There were only several mortgage companies and investment banks that were issuing CDOs and other complex instruments, and they paid large fees for these ratings. Between 2002 and 2007, Standard & Poor’s, Moody’s, and Fitch saw their revenues rise twofold to $6 billion a year, mostly from work with CDOs.

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