Keep the arsonist away from the fire alarm

The stability of our financial system depends on credible, objective, conflict-free analysis of securities.

This past week I was invited to testify in Washington before the House Committee on Oversight and Government Reform. The topic was credit rating agencies and the role they played in the recent financial meltdown. Here’s what I told the committee.

The credit rating agencies failed to adequately protect the interest of the investing public, causing homeowners, small businesses and investors in mortgage-backed securities to suffer unnecessary financial loses.

Credit rating agencies were founded to provide legitimate investment tools that allowed investors to evaluate securities. Over time the system changed, and allowed issuers to pay rating agencies to rate their securities, setting the stage for trouble. Compounding the problem, only a select few rating agencies had the imprimatur of Securities and Exchange Commission recognition as Nationally Recognized Statistical Rating Organizations, or NSROs. They were Moody’s, Standard and Poor’s, and Fitch. This created a monopoly on their services, and the opportunity for bad results multiplied.

In effect, the credit rating agencies now had a virtual monopoly, and handed out triple-A ratings to the issuers because they wanted to keep their business, and were afraid that if they gave them poor ratings, the issuers would take their business elsewhere. It was simply a matter of greed: The issuers got the rating they wanted, and the rating agencies kept earning large sums by churning out these phony ratings.

CNBC aired a magnificent expose titled “House of Cards” that documented the shocking abdication of responsibility by the rating agencies. It became quite clear after an interview with Anne Rutledge, one of Moody’s own securities raters, that rating agencies looked the other way when giving faulty ratings because they were afraid to lose Wall Street’s business.