US Senate finds rating agencies influenced by banks

The two largest rating agencies were excessively influenced by banks into giving instruments too high ratings and delaying downgrades, a damning investigation by the US Senate has said.

A report by the Senate Permanent Subcommittee on Investigations, published on Friday, found the relationship between credit rating agencies, Standard & Poor's (S&P) and Moody's, and the banks undermined the impartiality of credit ratings and delayed downgrades in the mortgage markets. The report also accused the rating agencies of using outdated models and inadequate data on high risk loans in the lead-up to the financial crisis.

Credit rating agencies are paid by the creators of instruments to rate them. The dangers presented by this conflict of interest have been underlined by the financial crisis, during which the quality of some instruments was found to be far poorer than their ratings suggested. Rating agencies came under scrutiny during the crisis particularly for failing to identify risks in collateralised debt obligations and other securities linked to the housing market.

According to the report, 91% of the AAA subprime residential mortgage-backed securities issued in 2007, and 93% of those issued in 2006, have since been downgraded to junk status.

"Investors trusted credit rating agencies to issue accurate and impartial credit ratings, but that trust was broken in the recent financial crisis," said Carl Levin, a Senator on the subcommittee said on Friday. "A conveyor belt of high risk securities, backed by toxic mortgages, got AAA ratings that turned out not to be worth the paper they were printed on."

The report found that instead of sending an early warning signal to the market in July 2006 of the deepening problems with high-risk mortgages, the agencies waited until July 2007 to begin a series of mass downgrades.

Moreover, even after Moody's and S&P adjusted their models, documents collected by the subcommittee show they declined to re-evaluate the riskiest products on request from the banks.

The report follows an 18-month investigation into some of the causes and consequences of the financial crisis as the US government attempts to overhaul regulation of the US financial sector.

The subcommittee is due to examine evidence from emails between the US credit rating agencies and Wall Street firms on Friday, citing cases when rating agencies used their position in financial markets as bargaining power over dealings with their clients.

Some of the evidence presented during the testimony will include comments from former employees of the rating agencies.

In one excerpt an S&P employee said "[T]here has been rampant appraisal and underwriting fraud in the industry for quite some time as pressure has mounted to feed the origination machine." Another employee of the firm is quoted as saying: "It's telling us that underwriting fraud, appraisal fraud and the general appetite for new products among originators is resulting in loans being made that shouldn't be made."

Witnesses from rating agencies are expected to testify at the hearing. Frank Raiter, a former managing director of mortgage-backed securities at S&P, and Richard Michalek, a former vice president of the structured derivative products group at Moody's, will be among those called.

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