Can We Really Trust the Credit Ratings Agencies?

As I was researching an article on the recent bank credit rating downgrade, I began to wonder about how agencies such as Moody's (NYS: MCO) , Standard & Poor's, and Fitch treated banks right before the financial meltdown. Banks that were punished last month - JP Morgan Chase (NYS: JPM) , Goldman Sachs (NYS: GS) , Citigroup (NYS: C) , Morgan Stanley (NYS: MS) , and Bank of America (NYS: BAC) were considered top-drawer back in the day, yet everyone now knows that each of those banks received billions i n bailout funds - with B of A, Citigroup, and JP Morgan getting the biggest boosts.

Another example of the glamour effect
A recent news item helps to explain just how close the relationship between banker and credit rater was in those heady, pre-crash days of yesteryear. An investor lawsuit against Morgan Stanley alleges that the bank somehow convinced S&P to give the best possible ratings to a bucket full of securities backed by subprime mortgages. A former S&P analyst says that the rating agency did this as a matter of course to endear itself to Morgan Stanley. Moody's was culpable as well, according to investors, agreeing to rate products consisting of subprime mortgages in the same manner as those that used stellar mortgages as backing.

Of course, the agencies deny the charges, but the fact is that those securities blew up in investors' faces. In fact, fully 83% of securities rated AAA in 2006 had been downgraded by 2010. How do they explain that little problem? They claim that their ratings are merely "opinions," and thus protected by the First Amendment.

Things haven't really changed
A post-meltdown investigation of 10 agencies by the Securities and Exchange Commission turned up many problems, such as conflict of interest with the companies they were rating, lack of consistency in the use of rating formulas, and lack of communication with investors when changes in the rating models occurred.

The results of that report were released less than a year ago, and a more recent article in American Banker reminds us that many in the industry still consider these agencies as problematic, specifically, their reliance on esoteric and possibly outdated statistical models. As the author notes, Congress has barred the agencies' participation in deciding banks' capital requirements, apparently reflecting legislative concern with the industry's reliability.

Fool's Take
Of course, the credit ratings agencies weren't entirely to blame for the financial crisis; investigations by bodies, such as the Financial Crisis Inquiry Commission, have certainly proved that there were plenty of players that contributed to the meltdown.

What is troubling is that there isn't any evidence that the industry has really changed. The old problems are still around, namely, that the banks pay the agencies who rate them. However, the fact that the recent downgrades went through, despite lobbying by the subject banks against them, may be a sign that rating agencies have begun to shape up. Fellow Fool John Grgurich notes that the entire financial industry is still in a state of post-crisis flux, which may be true - but, as he says, five years is a long time to wait for rating agencies to finally get it right.

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At the time thisarticle was published Fool contributorAmanda Alixowns no shares in the companies mentioned above. The Motley Fool owns shares of JP Morgan Chase, Bank of America Corporation, and Citigroup.Motley Fool newsletter serviceshave recommended buying shares of Moody's and Goldman Sachs Group. The Motley Fool has adisclosure policy.We Fools may not all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.

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