The credit rating agencies (Moody's, S&P, Fitch) issue credit ratings for corporations as well as different debt products.
Their recent track record has been anything but stellar.
It was only four days before Enron filed for bankruptcy that Enron's credit rating was changed to be below "investment grade".
During the housing boom mortgages were purchased by special purpose vehicles (SPVs) which financed itself by issuing bonds which were rated by the agencies. The bonds issued by the SPVs were then purchased by collateralized debt obligations (CDOs) which also funded itself by issuing bonds that were rated by the agencies. A good explanation of the process is here.
What is most fascinating is this statement from this article:
In 2006 alone, Moody’s gave 9,029 mortgage-backed securities a triple-A rating,” said Angelides, whose panel was created to investigate the causes of the financial crisis as Congress debates the most sweeping overhaul of banking regulations since the Great Depression. “To put that in perspective, Moody’s currently bestows its triple-A rating on just four American corporations.
These triple-A and investment grade bonds were sold to banks and retirement funds and then downgraded less than a year later. Many from investment grade to junk.
Many high-level ratings had to be lowered. In 2006, 83 percent of triple-A products were downgraded and in 2007, 89 percent of those considered investment grade were reduced to junk, Angelides said.
This bond bonanza was great, however, for the credit rating agencies since they got paid for rating all the bonds that were issued:
S&P and Moody's earned as much as three times more for grading the most complex of these products, such as the unregulated investment pools known as collateralized debt obligations, as they did from corporate bonds.
I didn't realize until I read up on this that the issuer of the debt is the one who pays the rating agency. This seems like a conflict of interest. Meredith Whitney, a credit analyst at Citi, who predicted the banking crisis, is going to start a new credit rating agency. Unfortunately she is using the same payment scheme - the issuer of the debt pays the credit rating agency. It seems like there is a better model. I'm not sure what that is however.
There is a funny ending to all this: Moody's is now considering downgrading S&P. Let the cannibalism begin.
So do the credit rating agencies have any relevance?