WASHINGTON, D.C. — Former credit rating industry executives told a Senate panel Friday that competitive pressures and poor internal communications led their analysts to award safe ratings to risky investments.
The highly rated investments turned out to be toxic, contributing to the financial crisis.
The chairman of a panel investigating the industry proposed Friday that Congress should address a conflict of interest that arises from credit rating agencies being paid by the same banks whose bonds they rate.
“It’s like one of the parties in court paying the judge’s salary,” said Sen. Carl Levin, D-Mich. He said the financial regulatory overhaul the Senate will take up Monday should include a solution to that problem.
Levin was chairing a hearing of the Permanent Subcommittee on Investigations, which has been investigating the causes of the financial crisis.
He said credit rating agencies gave high ratings to risky investments before the financial crisis in part because they were competing for business from the banks.
Frank Raiter, a former managing director for Standard & Poor’s, said there was a “disconnect” between senior managers and the analytical managers responsible for assigning bond ratings. He said that, along with weak government regulation, led agencies to award high ratings to risky investments.
Raiter said management placed increasing pressure on analysts to earn fees by attracting business from banks. He said many former colleagues had quit after clashing with management.
When analysts “show the benefits of higher-quality rating criteria, and they come back and say, ‘Revenues will go down,’ you either (drop the issue and) continue to work there, or you quit,” said former Standard & Poor managing director Frank Raiter.
Raiter also said weak government regulation led agencies to award high ratings to risky investments.
The Securities and Exchange Commission is prohibited by law from overseeing credit rating agencies. The agencies have escaped legal liability by claiming their ratings are protected by the First Amendment right to free speech.
Proposals to rein in rating agencies
Credit rating agencies, blamed for failing to provide adequate warning about risky investments, would come under greater regulation and scrutiny in both the House-passed financial regulation bill and in legislation pending in the Senate.
Ratings agencies analyze investments and offer scores based on analysts’ assessments of the investment issuer’s default risk. The higher the risk, the higher the interest the issuer must pay to sell its bonds.
A glance at what both pieces of legislation would do.
- Ratings agencies would have to register with the Securities and Exchange Commission. The Senate bill would create a new Office of Credit Rating Agencies within the SEC.
- Agencies would have to disclose their methodologies, how they used third parties to conduct due diligence on their assessments, as well as their own ratings track record.
- The House bill would require the SEC to issue rules that would either prohibit or require a ratings agency to disclose any conflicts of interest related to its assessments of investments. Conflicts would include how the agency is paid and whether it has business relationships with the issuer of an investment. The Senate bill would require a study of the independence of ratings agencies, including an examination of conflicts of interest. But the Senate also would require that at least half the members of agency boards be independent, with no financial stake in credit ratings.
- Investors could sue ratings agencies on the grounds of reckless failure to analyze an investment.
- Under the Senate bill a ratings agency could lose its SEC registration if it shows a record of providing bad ratings over a period of time.