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Credit Crunch Places Focus On Rating Agencies

The names are familiar to every investor: Standard & Poor’s, Moody’s Investors Service, Fitch Ratings. They’re the nation’s premier credit rating companies, and they’re supposed to provide investors with credible, independent information to help evaluate investment risk. All three are now under fire, accused of conflicts of interest that may have contributed to the agencies’ failure to warn of the credit crisis sparked by the subprime mortgage fiasco.

A group of federal regulators led by Treasury Secretary Henry Paulson has demanded the credit agencies change the way they do business, warning that if they don’t act quickly they will face stringent new rules. The Treasury Department and other financial regulatory agencies want the credit rating agencies to rate complex structured products differently than they do conventional bonds. The agencies routinely assigned top ratings to securities that bundled mortgages issued to borrowers with questionable creditworthiness. When those homeowners began to miss payments, the defaults had a domino effect on the whole credit system. Regulators now also want the credit agencies to toughen standards for companies that originate complex loans wrapped in securities, to disclose conflicts of interest, and to release more details of their work.

Those were among the recommendations of the President’s Working Group on Financial Markets, which includes the heads of the Federal Reserve Board, the Federal Reserve Bank of New York, the Securities and Exchange Commission (SEC), and the Commodity Futures Trading Commission. The reforms are intended to ensure that credit ratings are more accurate, timely, and understandable, and that rating agencies are objective and not beholden to the companies they rate.

The current scrutiny of these agencies was triggered by their late reaction to the nation’s burgeoning credit crisis. Moody’s, S&P, and Fitch all failed to downgrade the investment ratings of securities backed by subprime mortgage loans until July 2007, despite warnings raised months earlier by major banks. The rating agencies had also been widely criticized in 2001 and 2002, when they failed to downgrade bonds issued by Enron and WorldCom until after those companies imploded.

At the heart of the problem are potential conflicts of interest. The credit agencies rate securities while providing advice, for a fee, to Wall Street firms on how to package those securities to obtain the highest possible credit rating. In addition, the top three firms have a virtual monopoly on providing investment banks and brokerages with the risk evaluations the SEC requires. “Lack of competition has lowered the quality of ratings, inflated prices, stifled innovation, and allowed abusive industry practices and conflicts of interest to go unchecked,” says Rep. Michael Fitzpatrick, Republican of Pennsylvania.

In 2006, Congress passed the Credit Rating Reform Act, which Fitzpatrick co-sponsored. It requires rating agencies to disclose their procedures and largest clients, and it was supposed to make it easier for competitors to get into the ratings business. But critics say the law doesn’t go far enough, and now the President’s Working Group on Financial Markets is pushing the agencies to clean up their methods, with the threat of tighter regulation looming. “Regulation needs to catch up with innovation and help restore investor confidence but not go so far as to create new problems, make our markets less efficient, or cut off credit to those who need it,” Paulson said in a recent speech at the National Press Club.

The Working Group issued recommendations for other members of the financial community as well. For instance, the panel called on issuers of mortgage-backed securities to disclose whether they “shopped” for ratings, meaning they approached more than one credit rating agency before being rated. The group stopped short of calling for Wall Street firms to be held liable for creating mortgage-backed securities that they should have known carried excessive risks, but Paulson did fire a warning shot in that direction, suggesting that simply receiving a high rating for a particular product didn’t absolve investment banks and brokerages. “The idea that [the packagers of risky investments] can abdicate their responsibility and be overly reliant on ratings is something that really didn’t wash in the past and won’t wash in the future,” Paulson said. “They need to do independent analysis, and they need a better understanding of risk. There is not a free lunch.”

Questions about the integrity leading credit rating agencies reinforces the importance of investors to do their own research before making investment decisions or to enlist a trusted financial advisor to act in their best interest. Managing investment risk on your own isn’t easy. Call our office and we’ll help you review and rebalance your investment portfolio.

This article was written by a professional financial journalist for Legend Financial Advisors, Inc.® and is not intended as legal or investment advice.   

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