Credit-Rating Firms Grilled Over Conflicts
Thursday, October 23, 2008
Executives at the country's leading credit-rating companies, whose optimistic assessments of risky investments helped fuel the financial meltdown, have privately acknowledged for more than a year that conflicts of interest contributed to the industry's failures, according to internal company documents released yesterday.
The disclosures emerged at a heated congressional hearing where lawmakers grilled the heads of the three major rating companies, accusing them of betraying the public by letting corporate greed trump their responsibility to provide unbiased appraisals for investors.
"The story of the credit-rating agencies is the story of a colossal failure," said Rep. Henry A. Waxman (D-Calif.), chairman of the House Oversight and Government Reform Committee. "Millions of investors rely on them for independent, objective assessments. The ratings agencies broke this bond of trust, and federal regulators ignored the warning signs."
In one of the confidential documents obtained by the committee, Raymond W. McDaniel, chief executive of ratings firm Moody's, said analysts and executives are "continually 'pitched' by bankers, issuers, investors . . . whose views can color credit judgment."
"we 'drink the kool-aid,' " he wrote in a Oct. 21, 2007, memo to the board. "Unchecked, competition on this basis can place the entire financial system at risk."
The three major credit-rating companies -- Standard & Poor's, Moody's and Fitch -- assigned some of their highest ratings to mortgage-backed securities whose risks were grossly underestimated. As homeowners began defaulting on subprime mortgages, it became clear that many of those securities were overvalued. The companies finally downgraded thousands of those securities over the past year, contributing to the collapse of major firms and heightening the economic crisis.
Lawmakers are looking at whether the business model of these companies was a key factor in their failure to accurately predict the risk of the securities. The big credit-raters are paid by the issuers of the securities they evaluate, creating what executives acknowledge is an inherent conflict of interest. Some industry critics advocated banning the practice and replacing it with a model in which companies are paid by investors.
"When the referee is being paid by the players, no one should be surprised when the game spins out of control," said Rep. Christopher Shays (R-Conn.), reflecting the committee's unanimous bipartisan criticism of the industry. "You have so screwed up the ratings as to not be believable."
All three executives acknowledged their firms had badly erred in assessing the mortgage-backed securities and said those mistakes had contributed to the financial meltdown. But they said the errors were not intentional or malicious, adding that they had made their procedures more transparent and implemented safeguards to prevent additional mistakes.
"We have to earn our credibility back," said Deven Sharma, president of Standard & Poor's.
Before the firm chiefs testified, the committee heard from two former high-ranking credit-rating executives who described their frustrations in dealing with conflicts of interest and pressure on analysts to gloss over problems.
Frank L. Raiter, who had been head of residential mortgage-backed securities ratings at Standard & Poor's for 10 years, said that he developed a new model for better assessing loan performance in 2001 but that it was not implemented because of budgetary constraints.