On April 23, 2010, Connecticut Attorney General Richard Blumenthal gave written testimony during to a hearing held by the U.S. Senate’s Permanent Subcommittee on Investigations regarding the nation’s financial rating agencies. According to Attorney General Blumenthal, the three large financial rating agencies skewed their ratings of structured finance securities in order to garner more fee-based ratings business from the very same clients that were marketing those financial instruments.
This testimony follows on the heals of a lawsuits filed by the Connecticut AG’s office in March against the McGraw Hills Companies, Inc., Standard & Poor’s Financial Services LLC, and its business unit Standard & Poor’s Rating Services (collectively, “S&P”) and Moody’s Corporation and Moody’s Investors Service, Inc. (collectively, “Moody’s”), two of the major credit rating agencies, which allege that they would routinely give the highest quality credit ratings to structured finance securities they knew were very risky in order to earn large fees for rating those securities.
The suits are brought under the Connecticut Unfair Trade Practices Act. The structured finance securities in question are complex debt instruments backed by pools of residential mortgages, many of which are subprime loans to home buyers with poor credit. As mortgage defaults have risen over the past few years, these structured finance securities have lost much of their value.
As in the complaints filed in those cases, the Attorney General again alleged in his written testimony that those two rating agencies deceived investors and thus helped cause the financial meltdown of 2008. The Attorney General went as far as labeling them, “enablers of the wrongdoing that brought our nation to the brink of economic catastrophe,” by essentially providing “the best ratings money could buy.”
At the crux of the Attorney General’s case is the allegation that these rating agencies are aware that investors rely on their ratings of structured finance securities, and that they continuously tout their independence and objectivity, but in realty are neither independent nor objective in the ratings that they assign. Rather, according Attorney General Blumenthal, the rating agencies are beholden to their clients, who first pay S&P and Moody’s to favorably rate their financial instruments and then sell those financial instruments to investors.
Attorney General Blumenthal’s written testimony cited specific financial instruments that were rated as investment grade by the rating agencies and then, within months of issuance, were devalued greatly and considered toxic assets. According to the Connecticut Attorney General, without “meaningful and systematic reform, our country will be left with more of these ticking time bombs.”
Attorney General Blumenthal’s written testimony suggests such systemic reform as banning the “issuer pays” business model, as it creates a severe conflict of interest for rating agencies. According to the testimony, under the “issuer pays” system, rating agencies are incentivized to use “weaken[ed] criteria for evaluating these investments so that a high credit rating was more readily given,” in order to please large issuers of structured financial products who are repeat customers. With a higher credit rating, the issuer can charge investors a larger premium for its products.
To the extreme, the Connecticut Attorney General’s testimony alleges that this practice leads to “ratings shopping,” where raters are pitted against each other and ratings business is awarded to the rater who will give the highest rating to a specific financial security.
