Rating agencies in the hot seat

Lawmakers will scrutinize the role firms played in subprime mortgage mess - what went wrong, and why?

By Grace Wong, CNNMoney.com staff writer

LONDON (CNNMoney.com) -- Since the subprime crisis erupted, plenty of blame has been pinned on the big credit rating agencies. Just what went wrong at these firms - and what can be done to stave off another disaster - will be the topic of hearings on Capitol Hill this week.

Lawmakers are expected to grill executives from Moody's and Standard & Poor's, two of the biggest agencies, before the Senate Banking Committee on Wednesday. Securities and Exchange Chairman Christopher Cox is also scheduled to testify. The House Financial Services Committee will follow with a hearing on Thursday.

Critics say the firms failed investors by blessing complex mortgage-backed bonds and other products in turn for big fees. The critics say the agencies were blinded by their close relationship with issuers and their eager pursuit of profits.

But aside from finger-pointing, many say there is little Congress can do to overhaul the rating system, and in turn, restore confidence in the complex debt products that have exploded on Wall Street in recent years.

"This is an opportunity for politicians to condemn the people who have been involved in subprime," said Sylvain Raynes, a principal at R&R Consulting, a valuation advisory firm. "But it won't amount to an improvement in the quality of the rating process."

The rating agencies have responded to the criticism by contending that they only issue opinions about creditworthiness - and investors can choose to ignore their ratings.

"Ratings are not recommendations to buy, sell or hold a particular security. They simply provide a tool for investors to assess risk and differentiate credit quality," Vickie Tillman, executive vice president of credit market services for S&P, wrote in an op-ed in The Wall Street Journal last month. Tillman is scheduled to testify on Wednesday.

In their handling of the subprime crisis, rating agencies have been blasted for being slow to react to the problem. Defaults on subprime loans began rising in the spring, but it wasn't until July that Moody's and S&P began aggressively downgrading bonds backed by these risky home loans.

Moody's, for its part, has said that the credit crisis enveloped the markets with breakneck speed. "Recent events with regard to U.S. subprime mortgages show markets can change rapidly and dramatically," a Moody's executive wrote in an op-ed in the Financial Times.

But some critics like Janet Tavakoli, president of Tavakoli Structured Finance, a research firm, argue that ratings of these complex securities were flawed from the start.

"The rating agencies underestimated default probabilities, underestimated loss given default and overly relied on historical data when assigning ratings. In a repeat of past mistakes, the basis of the analysis was flawed, and the amount of protection required to award the various ratings was insufficient at the outset," Tavakoli, a long time critic of the agencies, wrote in a commentary last week in Lipper HedgeWorld.

There is recognition that the conflicts of interest in the rating industry are problematic, but reform won't come easily, according to Sean Egan, managing director of independent ratings firm Egan-Jones. Unlike the major agencies, his firm isn't paid by the companies whose debt it rates.

The big three agencies - Moody's, S&P and Fitch - play a dominant role across the spectrum of the credit market, from helping Wall Street firms structure debt to issuing credit ratings that investment managers rely upon.

Regulators have started looking into the way these firms made their ratings. Under legislation passed last year, the SEC has the authority to inspect credit rating agencies.

But Egan is doubtful there will be a significant increase in regulatory oversight, largely due to the heavy costs that would incur. "The SEC and other regulators aren't prepared to come in and police the opinions issued by rating firms," he said. Top of page