Ratings agencies dish it out, take it

Although word of mouth can do a lot for a movie's box office receipts, there's nothing like getting rave reviews from the critics to get off on the right foot on opening weekend. For publicly traded companies and bonds issuers, the critics are the ratings agencies -- Fitch, Standard & Poor's, and Moody's -- which lately have been getting some bad reviews themselves for their alleged lack of scrutiny of investments backed by subprime mortgage loans. 

Recently, the ratings agencies have been downgrading billions of securities backed by subprime loans, not to mention the debt of many companies involved in the housing industry. Housing Wire -- which has been providing comprehensive posts on the upheaval in mortgage banking industry of late -- notes an interesting spat between risk management firm Radian Group Inc. and Fitch Ratings.

Radian, you may recall, was headed for a merger with mortgage insurer MGIC Investment Corp. until questions about how much both companies stand to lose from their subprime mortgage investments through their C-BASS LLC subsidiary.

Miffed by the Sept. 5 decision by Fitch to downgrade the company's long-term debt ratings and the insurer financial strength ratings of all of the company's mortgage insurance and financial guaranty subsidiaries, Radian recently asked fitch to withdraw all of its ratings for the company. Fitch's new financial guaranty capital model -- Matrix -- "significantly diverges" from models used by other ratings agencies, Radian said.

Fitch acknowledged that its Matrix model "is often more conservative than other models," but argued that's good, because it "reinforces the value of multiple ratings, and multiple credit opinions, being provided to investors."

Up until now, most of the criticism directed at the ratings agencies has been of the opposite bent: That they weren't conservative enough in evaluating bonds backed by mortgage loans, because they were looking out for the interests of their clients -- the bond issuers -- more than investors.

New York Democrat Rep. Gary Ackerman's recent statement before the House Financial Services Committee epitomizes such views:

"If there had been full disclosure, smart and careful investors would have judged that these mortgage backed bonds carried a disproportionately high level of risk. In an effort to deliberately mislead investors, however, some originators and credit-rating agencies ... colluded. First, the credit-rating firms would consult, or maybe we should say collaborate, with the originators – receiving high fees, of course – to advise the originators how to design the packaged securities to ensure that the riskiest piece of the product was adequately masked. Then, for another fee, the credit raters would assign overly favorable ratings to these mortgage-backed bonds, giving investors the impression that a neutral, unbiased party with a proven track record of assessing risk thought highly of these volatile products.
...

"My strong view is that NRSROs conspired with financial institutions to fool investors by packaging and rating securitizations in a manner that was deliberately aimed at misleading them. This is the accounting firm telling shareholder companies how to fool their investors and then getting hired as independent auditors. That's not the free market at work. That's fraud. Fraud is a crime, not a correction."

Over on Calculated Risk, Tanta finds Ackerman's charges overblown.

"I can understand why there is a problem with the rating agencies combining consulting and rating roles, just as there is a problem with accounting firms combining consulting and auditing roles," Tanta writes. "Perhaps naively, though, I wonder why we think there is always such a bright line between the two. If the rating agencies publish their methodologies and due diligence criteria, in the name of full disclosure to investors, isn't this necessarily information that issuers can use to change their practices so that their securities achieve the highest ratings? Is that in and of itself a problem, or is it only a problem if the ratings criteria are faulty? And if they are, is it necessarily because of fraudulent intent?"

It's tempting to say that if nobody's entirely happy -- investors or the companies being rated -- then the ratings agencies must be doing something right. But there's also the possibility that they've gone from one extreme to the other, and have yet to find the correct balance between high tolerance for risk and excessive caution.

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