-- The hunt for scapegoats in the financial crisis focused firmly on credit ratings agencies Wednesday as U.S. lawmakers probed how the firms gave top ratings to debt that later turned out to be toxic.
The three leading agencies — Moody's, Standard & Poor's and Fitch Ratings — are considered key financial gatekeepers because they issue ratings that determine if a company is worth lending to, and at what cost. However, in recent years the agencies gave triple-A ratings to complex financial instruments backed by subprime mortgages. When the real estate market collapsed, the securities did too, triggering a domino effect that led to the worst financial crisis since the Great Depression.
"One reason why we had financial panic is because investors lost faith in the system. If you can't trust the gatekeeper, who can you trust?" says Douglas Diamond, professor of finance at the University of Chicago's Graduate School of Business.
The industry's three top executives — Moody's CEO Raymond McDaniel, S&P President Deven Sharma and Fitch Ratings CEO Stephen Joynt — testified before the House Committee on Oversight and Government Reform on Wednesday. All three admitted some responsibility for the crisis when District of Columbia Delegate Eleanor Holmes Norton asked, "Do you think your companies are responsible?" Fitch's Joynt said: "We weren't able to project forward … and in that sense contributed to the crisis."
Committee Chairman Henry Waxman, D-Calif., said his investigators had obtained documents showing executives knew the subprime mortgage market was weak before it collapsed. One e-mail from an unnamed Moody's employee said that some of the firm's mortgage-based securities ratings made it appear that either they were "incompetent at credit analysis," or that "we sold our soul to the devil for revenue." Another from an S&P employee said: "Let's hope we are all wealthy and retired by the time this house of cards falters."
Sharma said there was no evidence of misconduct by S&P's analysts or that the integrity of its ratings process was compromised. "All of us looked at house price declines and we didn't assume they would be as severe as has occurred," he said.
Critics say one big problem was that the agencies were paid by the very firms whose debt they were rating, and high ratings made the debt easier to sell. "When the referee is being paid by the players, no one should be surprised when the game spins out of control," said Christopher Shays, R-Conn. Moody's McDaniel defended the system. "The biggest mistake we could make is believing that an investor-paid model doesn't invite conflicts of interest," he said. "The question is, can we manage the conflicts properly?"