Subprime: Let the finger-pointing begin!

While the wizards of Wall Street could use financial alchemy to turn shoddy mortgages into respectable bonds, they still needed the blessing of rating agencies like Standard & Poor's and Moody's. And the agencies were often all too willing to comply.

In the Wall Street pecking order, rating agencies are seen as worthy but plodding accessories. Analysts at the agencies earn far less than their brokerage counterparts, and decisions are nearly always made by a tedious committee process. As a result, they typically fail to react quickly enough to questionable trends and innovations.

But they are not simply bystanders. They have long played a big role in helping investment banks structure mortgage-backed securities by conferring with the banks on what rating a certain structure might get. It sounds innocuous, but critics say it allows Wall Street to gain too much influence over the rating.

S&P spokesman Chris Atkins replies: "Dialogue helps issuers understand our ratings criteria and helps us understand the securities they are structuring so that we can make informed opinions about creditworthiness."

The shortcomings of the system became blindingly apparent in July, when Standard & Poor's and Moody's abruptly downgraded nearly $6 billion of subprime-mortgage-backed bonds. Many of the subprime mortgages backing the bonds were less than a year old. That means the rating agencies had little idea about the quality of those loans when the bonds were issued.

In a now famous exchange, Steven Eisman, a managing director at hedge fund Frontpoint Partners, spoke out on an S&P conference call. "I'd like to understand why you're making this move today, and why you didn't do this many, many months ago," he said. "It's a good question," responded an S&P analyst. "You need to have a better answer," said Eisman.

Yes, you could argue that bond buyers are sophisticated institutions that can make their own judgments. You could also argue that rating agencies are like stock analysts whose recommendations investors could choose to ignore. But they're not. If a bond carries less than an investment-grade rating, many insurance companies, pension funds and mutual funds are barred from buying it. Once the rating agencies had blessed the mortgage-backed paper, everyone was free to grab some.

They should have been quicker off the mark, and they need to work on some potential conflicts, but they hardly made out big from this boom.