updated 9/26/2007 3:00:22 PM ET 2007-09-26T19:00:22

Executives from major credit rating agencies on Wednesday were accused by senators of being hampered by conflicts of interest that may have contributed to the mortgage market turmoil rattling investors worldwide.

The biggest rating agencies — Standard & Poor’s, Moody’s Investors Service and Fitch Ratings — are under fire from critics who say they failed to give investors adequate warning of the risks associated with mortgage-backed securities. Those securities are now plummeting in value as home-loan defaults soar, particularly among borrowers with weak, or subprime, credit histories.

Several members of the Senate Banking Committee questioned rating agency executives about whether they provided advice to investment banks that issue complex mortgage securities tied to subprime home loans.

“It seems to me that credit rating agencies are playing both coach and referee,” said Sen. Robert Menendez, D.-N.J.

The rating agencies’ seal of approval effectively concealed the true risks of those investments, lawmakers said. Several senators compared the agencies’ lack of foresight about the risks inherent in the subprime mortgage market with their failure to anticipate the collapse of Enron Corp. and WorldCom.

Democratic and Republican senators said they were particularly concerned with a key aspect of the agencies’ business models: they get paid by the companies whose bonds they rate. That’s like a film production company paying a critic to review a movie, and then using that review in its advertising, Sen. Jim Bunning, R-Ky., said.

Executives from S&P and Moody’s said their methodology for monitoring the risk of mortgage-backed bonds was sound. But they also pledged improvement.

Vickie Tillman, executive vice president of credit market services for S&P, a subsidiary of McGraw-Hill Cos., said there is no collaboration between S&P and banks that issue debt, but acknowledged that the agency has an “open dialogue” with the investment banks that package and sell mortgage securities.

The Securities and Exchange Commission has started an examination of the agencies’ practices, including whether conflicts of interest were created if rating agencies gave advice to issuers of mortgage-backed securities.

“We have as yet formed no firm views on any of the reasons put forth by the credit rating agencies, but are carefully looking into each of them,” SEC Chairman Christopher Cox said.

The agencies are subject to SEC oversight enacted last year amid a push to encourage more competition in the ratings business. Along with federal scrutiny, attorneys general in Ohio and New York are examining the rating agencies.

Lawmakers also discussed what can be done to reform the ratings market. Columbia University law professor John Coffee said the SEC should calculate default rates for each rating agency and make that information public. In addition, rating agencies that are especially inaccurate could have their SEC recognition revoked, he said.

Sen. Charles Schumer, D-N.Y., raised the idea of developing a new business model for the rating agencies by promoting competitors that would be paid by investors in securities rather than their issuers. Or, he said, the existing agencies should move to that funding model.

“To say nothing went wrong, that ain’t going to fly,” Schumer said.

Moody’s said it supports some mortgage-market reforms. Underwriters of mortgage securities, the company said, should be required to use a third-party reviewer to ensure information on loans given to investors is accurate. Also, the company said investors should receive more information on loan performance throughout the life of a mortgage.

At the hearing, senators also wondered whether workers at rating agencies should have a specified waiting period before they go to work for investment banks — to avoid any incentive for bond raters to assign overly positive ratings. Michael Kanef, a managing director at Moody’s, said his company would be willing to consider that idea.

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