Let the Blame Begin

Everyone played some role—the Street, lenders, ratings agencies, hedge funds, even homeowners. Where does responsibility lie?

by Roben Farzad

Who's responsible for the subprime mess? Not us, say the lenders that made risky mortgage loans to consumers. Similar denials come from the Wall Street firms that bought, packaged, and sold the loans to investors; the bond-ratings agencies that said those investments were safer than they turned out to be; and the hedge funds that gorged on them. As the allegations fly, various players are busy issuing disclaimers and pointing fingers at everyone else.

At the center of the controversy are the big bond-rating agencies—Moody's Investors Service (MCO), Fitch Ratings, and Standard & Poor's, which, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP). These firms are paid by companies to grade their bonds, and investors use those grades when deciding whether or not to invest. The two biggest agencies, S&P and Moody's, have also profited handsomely in recent years by rating collateralized debt obligations (CDOs), or complicated bonds, backed by tens or hundreds of loans and other kinds of debt, that are structured in a way to offer investors higher yields than similarly rated corporate bonds. Sales of CDOs have quintupled since 2001, though neither Moody's nor S&P break out the revenues they receive from rating them. Without the agencies' stamp of approval, many big investors like pension funds and university endowments wouldn't be allowed to buy CDOs. The market, for all practical purposes, wouldn't exist.

Too Little, Too Late?

But recently certain CDOs backed by shoddy loans plunged in value as defaults in the mortgages they're based on surged. In July, Moody's and S&P placed on negative review $5.2 billion and $7.3 billion, respectively, of subprime-backed securities, and subsequently downgraded the bulk of them. The actions applied to less than 3% of the total issues in the past year and a half. Critics allege the downgrades were too small and came late. And they claim that cozy ties between the ratings agencies and CDO issuers is the reason. Ohio's Attorney General is looking into potential conflicts of interest.

A key issue is one that applies to many of the agencies' dealings: They are paid by bond issuers, not by the investors who use their ratings. Agencies also help the issuers by telling them what they need to do to garner the highest rating, triple-A. What's more, critics note, when agencies decide on their ratings they don't perform what's known as due diligence—looking at the individual loans that make up the CDOs to make sure those loans are up to snuff. Instead, they base their decisions in large part on the due diligence provided by the issuers themselves.

The result of this arrangement is that everyone has a financial incentive to keep deals coming. Christian Stracke, an analyst with CreditSights, an independent bond research firm that isn't paid by the companies it covers, argues that taking CDO issuers at face value is a mistake. "With trillions at stake," he says, "you have to collect enough data to accurately analyze the product, not just make an educated bet." Stracke says the agencies should have held back some triple-A ratings and declined to rate some of the bonds at all.

Both agencies vigorously deny the conflict-of-interest charges. Says Moody's Managing Director Warren Kornfeld: "Our role is to provide the best independent opinion of credit risk. We will not forbear from taking action."

The agencies stress that they can't possibly keep track of every single loan that makes up a CDO. But they make a point of being as open as possible with their methodology. "We engage in conversations with issuers so that they can better understand our criteria," says S&P spokesman Chris Atkins. Says Moody's Kornfeld: "We obviously have dialogue with everybody and our process is transparent." More fundamentally, they argue their CDO ratings are editorial opinions covered by the free speech protections in the U.S. Constitution, and shouldn't be used to govern investment decisions.