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Rating Agencies Raced to the Bottom

The House oversight committee released a smattering of documents today from two big credit-rating agencies– Moody’s and Standard & Poor — on how they evaluated mortgage-backed securities and credit default swaps. One letter shows that S&P decided to lower its standard in rating mortgage-backed securities simply to compete with Moody’s.

In May 2004, a managing director at S&P, Yu-Tsung Chang, wrote a letter to a company executive complaining that S&P lost a “huge” mortgage-backed security deal because of a “huge difference in the credit support level.” Moody’s gave the mortgage-backed security a top rating apparently because it chose to ignore interest-rate risk. The S&P executive said that, “…we need to address this now in preparation for future deals.”

The letter (availabe in PDF) shows that there was no consideration of whether S&P’s rating system was correct on the merits.

The committee has focused on how the rating agencies didn’t appear to understand the financial instruments, derived from the subprime mortgage market, it was evaluating. But, more scandalously, they never developed new models to help understand them.

In the short term, this was beneficial: the combined profits of Moody’s and S&P went from less than $300 million to more than $600 million from 2002 to 2006. Now, however, the credit rating agencies may have “lost their brand,” as Rep. Chris Shays (R-Conn.) put it– and possibly their future role in evaluating financial instruments.

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