Executives at the country's leading credit-rating companies, whose optimistic assessments of risky investments helped fuel the financial meltdown, have privately acknowledged for more than a year that conflicts of interest contributed to the industry's failures, according to internal company documents released Wednesday.
The disclosures emerged at a heated congressional hearing where lawmakers grilled the heads of the three major rating companies, accusing them of betraying the public by letting corporate greed trump their responsibility to provide unbiased appraisals for investors.
“The story of the credit-rating agencies is the story of a colossal failure,” said Rep. Henry Waxman, D-Calif., chairman of the House Oversight and Government Reform Committee. “Millions of investors rely on them for independent, objective assessments. The ratings agencies broke this bond of trust, and federal regulators ignored the warning signs.”
In one of the confidential documents obtained by the committee, Raymond McDaniel, chief executive of ratings firm Moody's, said analysts and executives are “continually ‘pitched' by bankers, issuers, investors … whose views can color credit judgment.”
“We ‘drink the Kool-Aid,'” he wrote in a Oct. 21, 2007, memo to the board of directors. “Unchecked, competition on this basis can place the entire financial system at risk.”
The three major credit-rating companies — Standard & Poor's, Moody's and Fitch — assigned some of their highest ratings to mortgage-backed securities whose risks were grossly underestimated. As homeowners began defaulting on subprime mortgages, it became clear that many of those securities were overvalued. The agencies finally downgraded thousands of those securities over the past year, contributing to the collapse of major firms and heightening the economic crisis.
Lawmakers are looking at whether the business model of these companies was a key factor in their failure to accurately predict the risk of the securities.
The big credit-raters are paid by the issuers of the securities they evaluate, creating what executives acknowledge is an inherent conflict of interest. Some industry critics advocated banning the practice and replacing it with a model in which companies are paid by investors.
“When the referee is being paid by the players, no one should be surprised when the game spins out of control,” said Rep. Christopher Shays, R-Conn., reflecting the committee's unanimous bipartisan criticism of the industry. “You have so screwed up the ratings as to not be believable.”