I read this news story first on the front page of NYTimes.com.
A couple of hours later, I checked the Drudge Report and it was the top story. The killer headline? “Payback”!
The rating agencies have gotten much of the blame for the housing crash. They badly judged the soundness of numerous mortgage-backed securities.
How did they get it so wrong? Because there was no track record for these exotic financial instruments. We only had a track record on conventionally performing mortgages aka prime mortgages. We had no historical record on subprime mortgages. So the ratings agencies just made their best guess.
This would not have been so damaging if the U.S. government did not require that one of three of these agencies must rate all the major bond issues. The government would not just leave things up to the free market.
A successful case or settlement against a giant like S.& P. could accelerate the shift away from the traditional ratings system. The financial reform overhaul known as Dodd-Frank sought to decrease the emphasis on ratings in the way banks and mutual funds invest their assets. But bank regulators have been slow to spell out how that would work. A government case that showed problems beyond ineptitude might spur greater reforms, financial historians said.
In particular, Professor Sylla said that the ratings agencies could be forced to stop making their money off the entities they rate and instead charge investors who use the ratings. The current business model, critics say, is riddled with conflicts of interest, since ratings agencies might make their grades more positive to please their customers.
Before the financial crisis, banks shopped around to make sure rating agencies would award favorable ratings before agreeing to work with them. These banks paid upward of $100,000 for ratings on mortgage bond deals, according to the Financial Crisis Inquiry Commission, and several hundreds of thousands of dollars for the more complex structures known as collateralized debt obligations.