How credit watchdogs fueled the financial crisis

NEW YORK (CNNMoney.com) -- A slew of internal e-mails from the leading credit rating agencies show employees at those firms knew of the dangers in subprime mortgages, but gave them the seal of approval anyway.

"Let's hope we are all wealthy and retired by the time this house of cards falters. :o)," wrote an employee from Standard & Poor's Rating Agency in an internal e-mail in December of 2006.

"This is frightening. It wreaks of greed, unregulated brokers, and 'not so prudent' lenders," said one S&P internal e-mail dated September 2006. And another from that same month: "...this is like another banking crisis potentially looming!!"

The e-mails and other documents were presented as evidence at a hearing on Capitol Hill Friday, part of an 18-month investigation by the Senate Permanent Subcommittee on Investigations, led by Senator Carl Levin, examining the causes of the financial crisis.

Wall Street relies heavily on the rating agencies tasked with analyzing risk and giving debt a "grade" that reflects the borrower's ability to pay the underlying loans. The safest are given an AAA rating.

The Subcommittee asserts that the rating agencies were well aware of the risks in the housing market and used rating models they knew inflated the grades given to securities.

As a result, AAA-ratings were issued far too often.

As the real estate market worsened, the flawed risk models were exposed as the underlying home loans began defaulting.

The agencies were forced to revamp their models in 2006, but they chose to continue using the old models on existing securities, the Subcommittee says, out of fear that the ratings would be downgraded, resulting in very unhappy customers.

Because investment banks hire credit rating agencies to assess the risk of their portfolios, the agencies have an incentive to give the banks the ratings they want, or else risk losing business to competitors.

"Credit rating agencies allowed Wall Street to impact their analysis, their independence and their reputation for reliability," said Levin during Friday's hearing. "And they did it for the money."

In an e-mail the Subcommittee obtained from April 2006, a Moody's employee complained of feeling pressure from Goldman Sachs, which was eager to start selling a high-rated product.

"I am getting serious pushback from Goldman on a deal that they want to go to market with today.*** Goldman needs more of an explanation (I do not know how to get around this without telling them we were wrong in the past)."

Executives from S&P and Moody's (MCO) acknowledged during the hearing that investment banks shop around for the best rating. Some agreed that ultimately, it's the investment banks that are their clients, not the investors who end up with the securities.

So it often comes down to a choice between issuing a correct, but unfavorable rating and losing business, or inflating a rating to keep a customer.

In his testimony, Richard Michalek, a former vice president at Moody's, admitted that he felt constant pressure to accept deals, even if they looked risky.

"The independence of the group changed dramatically during my tenure," said Michalek. "The unwillingness to say 'no' grew."

"The message from management was not, 'just say no,' but instead, 'just say yes,'" he said.

It wasn't until the brink of the mortgage meltdown in 2007 that the rating agencies finally began applying their new models to existing securities, realizing that the inflated ratings on the mortgage-backed securities weren't going to hold.

This realization resulted in a mass downgrade, shocking the market and leaving investors with securities worth less than the paper they were printed on, said Levin.

In 2007, a whopping 91% of AAA-rated mortgage securities were downgraded to junk status, meaning they were now the riskiest kind of security.

"Looking back, if any single event can be identified as the immediate trigger of the 2007 financial crisis, it would be the mass downgrades," said Levin. "Those downgrades hit the market like a hammer, making it clear that [they] had been a colossal mistake."

And what makes it worse, said Levin, is that credit raters and the banks knew that what they were giving to investors was junk all along.

In one e-mail, a UBS employee even refers to the securities he was selling investors as "crap."