Today, June 15

• Merging the Office of Thrift Supervision and the Office of the Comptroller of the Currency
• Provisions relating to insurance and private funds
• Reforming the credit rating agencies

Wednesday, June 16

• Investor protections and regulatory improvements
• Executive compensation and corporate governance
• An audit of the Federal Reserve, Fed governance and emergency liquidity provisions

Thursday, June 17

• Systemic risk regulation and resolution authority, including payments, clearing and settlement for counterparties of shuttered banks

Next week 

• The structure of the Consumer Financial Protection Agency
• Predatory lending
• Credit and debit card interchange fees
• Remittances
• Access issues
• Prudential regulation
• Derivatives

In practice, “[the] agencies allowed Wall Street to impact their analysis, their independence and their reputation for reliability,” Levin said this morning. “They did it for the money.” In short: The banks gamed the ratings agencies, and did it well. Here’s from the summary of the Levin report:

“Investors trusted credit rating agencies to issue accurate and impartial credit ratings, but that trust was broken in the recent financial crisis,” said Levin. “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 agencies issued those AAA ratings using inadequate data and outmoded models.  When they finally fixed their models, they failed for a year — while delinquencies were climbing — to re-evaluate the existing securities.  Then, in July 2007, the credit rating agencies instituted a mass downgrade of hundreds of mortgage backed securities, sent shockwaves through the economy, and the financial crisis was on.  By first instilling unwarranted confidence in high risk securities and then failing to downgrade them in a responsible manner, the credit rating agencies share blame for the massive economic damage that followed.”

From 2002 to 2007, the credit rating agencies earned record profits, reporting $6 billion in gross revenues in 2007.  They also allowed the drive for profits and market share to affect ratings.  Knowing that Wall Street firms might take their business elsewhere if they didn’t get investment-grade ratings for their products, the agencies were vulnerable to pressure from issuers and investment bankers.  As one Moody’s executive wrote in October 2007: “It turns out that ratings quality has surprisingly few friends: issuers want high ratings; investors don’t want rating downgrades; short-sighted bankers labor … to game the rating agencies.”

The credit rating agencies still, three years into the crisis, have a conflict of interest at the heart of their business. The financial firms that produce the financial products, not the financial firms that buy them, pay for the supposedly independent ratings. In a released email, one S&P employee describes colleagues in the company’s mortgage unit: “They’ve become so beholden to their top issuers for revenue they have all developed a kind of Stockholm syndrome which they mistakenly tag as Customer Value creation.” The Dodd bill creates an office of credit ratings within the Security and Exchange Commission, and increases oversight. But it does little to change the underlying problem.

Among the tidbits from the dump of documents at the hearing was this following IM exchange between two analysts for Standard & Poor’s, Ritholtz notes:

Rahul Dilip Shah: btw: that deal is ridiculous

Shannon Mooney: I know right … model def does not capture half of the risk

Rahul Dilip Shah: we should not be rating it

Shannon Mooney: we rate every deal

Shannon Mooney: it could be structured by cows and we would rate it

Hmm. A little acknowledgement there, perhaps, that the agency knew things were a little off with all those high-risk deals making everyone so much money?

Not from S&P President Deven Sharma, who, as Ritholtz explains, told the committee this:

S&P is not alone in having been taken by surprise by the extreme decline in the housing and mortgage markets. Virtually no one — be they homeowners, financial institutions, rating agencies, regulators, or investors — anticipated what is occurring. Although we highlighted to investors looming issues we saw in the housing market as far back as early 2006, the reality remains that in publishing our initial ratings on many of these securities we never expected such severe, negative performance in the housing and mortgage markets. There is no doubt that had we anticipated the extraordinary events that have occurred — and we did not — we would have utilized different economic forecasts and would not have assigned many of the original ratings that we did . . . (emphasis added)

I guess deals structured by cows don’t constitute an extraordinary event.

After reading Matthew’s coverage and The Big Picture, two thoughts occurred to me:

Why don’t these people just apologize?

And didn’t anyone ever tell the S&P analysts never to write an email they might have to explain in a deposition?

The panel, and most lawmakers on the committee, seem to agree that the failures of the big three credit-rating agencies — Moody’s, Standard & Poor and Fitch– is about more than just “gross incompetency,” as Rep. Mark Souder (R-Ind.) put it.

Frank Raiter, managing director and head, from 1995-2005, of the Standard and Poor unit that rated residential mortgage-backed securities, said that the credit agency didn’t understand credit default swaps when he was there. “Intuitively, if you can’t explain what these things are to us [people whose job is to evaluate mortgage securities], it was real curious why the product was enjoying financial success.”

Yet S&P, which controls 40 percent of the credit-rating market, routinely gave the swaps AAA ratings. Internal S&P and Moody documents reveal that the companies knew their rating systems were broken but their continued business depended on rating these swaps. One Moody’s memo says that, ideally, investors would come to Moody’s based on “ratings quality” and “service.” But they were actually looking for a AAA rating. And if Moody’s couldn’t deliver, the investor would go to S&P or Fitch.

Sean Egan, managing director of Egan Jones Rating Co., said CRA executives felt compelled to capitalize on the brave new world of swaps. “It’s not incompetence,” he told the committee. “If you are the manager of this public company, it’s your job to increase revenues and profitability.”

The CEO’s of Standard & Poor, Moody’s and Fitch will testify this afternoon.

Since the federal government didn’t have authority to regulate the secondary mortgage market, it was up to the big CRA’s, like Moody’s and Standard & Poor’s, to judge if the bonds were investment grade.

But an investigation by the Securities and Exchange Commission this July revealed that the CRA’s didn’t know how to rate credit default swaps. So, partly in order to keep doing business with the subprime lenders and investment banks, the CRA’s between 2002-06 often just rated the securities and swaps “AAA,” the best rating a bond can have.

Today the CEO’s from the three top credit rating agencies — Moody’s, S&P and Fitch — are testifying before the House oversight committee. Rep. Henry A. Waxman, (D-Ca.) the committee chairman, just noted that these CEO’s earned more than $80 million — despite the fact they were a “colossal failure” in stemming the mortgage crisis.

Rep. Chris Shays (R-Conn.), meanwhile, concocted an elaborate analogy about how the CRA’s were referees paid off by the players.

Will the committee tie their oversight into the larger congressional fight over how to revamp Washington’s policing of Wall Street? Will the Republicans stay monomaniacally focused on Fannie Mae and Freddie Mac?

Stay tuned for updates.