Dodd Frank: How rating agencies contributed to the financial crisis


The Dodd-Frank Wall Street Reform and Consumer Protection Act, passed in response to the financial crisis of 2008, added new regulations and new regulators for some—but not all—of the institutions whose actions led to the crisis. Over the next several days, we’ll be taking a look at each of the major groups of contributors to the economic crisis, who the major players were, what political influence they brought to bear on Congress and regulators, how Dodd-Frank intends to regulate them, and, using our new Dodd-Frank Meeting Logs tool, what rules these groups are trying to influence as agencies implement the legislation.

Group: Credit Rating Agencies

Members: Standard and Poor, Moody’s Investor Service, Fitch’s Ratings

Regulators: Securities and Exchange Commission

Political Influence: Compared to investment banks, commercial banks, government-sponsored enterprises like Fannie Mae and the mortgage mills like Countrywide Financial, the three credit ratings agencies seem like minor players. Altogether, lobbyists for the three agencies have reported spending a total of $9 million to influence federal policy since 2001, and collectively, campaign contributions from their employees and family members amount to less than $300,000 over the past two decades. By contrast, in the first six months of the 2012 election cycle, Goldman Sachs’ PAC, employees and their family members have contributed more then $512,000, and over the same six months, securities and investment firms have reported spending $49.5 million on lobbyists, according to the Center for Responsive Politics.

But when Standard & Poor downgraded U.S. debt from the highest rating, AAA, to the second highest, AA+, they demonstrated a kind of influence that corporate CEOs, the hapless investors who plowed their money into mortgage-backed securities, leaders and citizens of Eurozone countries including Greece and Italy have already learned quite well. By offering their opinions of the soundness of debt, credit ratings agencies can make fortunes for some and break them for others.
How They Helped Cause the Crisis: Starting around 2004, credit rating agencies offered the highest ratings to financial instruments that were far riskier than advertised; investors bought the triple-A-rated bonds believing they were putting their funds in low risk investments. Specifically, the rating agencies issued investment grade ratings for tens of thousands of residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs) peddled by Wall Street firms. In return, the rating agencies saw an increased revenue stream from these firms.
Later in 2007, when the first mortgage delinquencies started to get reported, the rating agencies began downgrading the RMBS and CDOs. Some institutional investors who are barred from owning low rated securities had to dump the holdings, an investigation by the Senate Permanent Subcommittee on Investigations found earlier this year. The independent committee poured over tens of thousands of pages of internal documents and conduced several dozen interviews as part of the investigation.

One focus of investigators was the inherent conflict of interest that ratings agencies presented. While rating agencies were required to provide accurate ratings, they were dependent on the firms selling the assets they were rating for payment. Giving their products low ratings was potentially bad for business. After the financial crisis played out in 2007 and 2008, evidence that emerged showing that credit rating agencies continued to ignore several signs—including the high-risk nature of many of the loans packaged to investors, including evidence of fraudulent mortgages—and continued to assign them investment quality ratings.
How They Fared: Despite giving inflated ratings to assets that turned out to be toxic, the credit ratings agencies continue to rate corporate and public debt, and have preserved their position of influence in the economy.
How Dodd-Frank Regulates Them: The new law created the Office of Credit Ratings at the SEC to examine the agencies—which are designated Nationally Recognized Statistical Rating Organizations (NRSRO)—and release a report at least once a year. It also called for the NRSROs to disclose their methodologies—disclosures that are due next month—and reduces the dependence on ratings goading investors to take on more independent reviews.
To eliminate conflicts of interest, under Dodd-Frank compliance officers were barred from working on ratings, methodologies or sales and added a liability clause for “reckless failure to conduct a reasonable investigation.” It also gives the SEC the authority to deregister a rating agency.
But despite these changes, one of the main conflict of interest features continues to plague the credit ratings agencies, where there has been no change to the business model where the raters are still paid by the investors whose products they rate.

How They’re Reacting to Dodd-Frank: According to our Dodd-Frank meeting log tracker, officials from Standard & Poor’s met with SEC officials on Oct. 20, 2010, and April 17, 2011, to discuss various issues relating to oversight of credit ratings agencies. Standard & Poor’s sent a 84-page response to the SEC’s proposed rules governing NRSROs, arguing that, while neither Dodd-Frank nor the 2006 Credit Agency Reform Act intended to tamper with the independence of the agencies, the SEC’s rules could. In one passage, Deven Sharma, president of S&P, argued that the SEC’s attempt to define what is a significant error would substitute the judgment of regulators for those of S&P. “Credit ratings reflect the subjective opinions of committees of rating analysts and incorporate both quantitative and qualitative factors, we believe it would be difficult, if not impossible, for the Commission to establish a principled definition of what might constitute a ‘significant error.’” The Treasury Department claimed that S&P made a $2 trillion error when evaluating U.S. budgets and debt; S&P disputed

Fitch Ratings had one meeting with the SEC, on Oct. 12, 2010, and filed three pages of comments in response to the SEC’s proposed rules for oversseing NRSROs. Moody’s did not have a meeting with the SEC.