Credit rating agencies helped banks disguise the risks of investments they marketed before the financial crisis erupted, a Senate panel has concluded.
The rating agencies relied on hefty fees from banks, which wanted them to rate risky investments as safe, the Permanent Subcommittee on Investigations said in a report Thursday.
Panel chairman Sen. Carl Levin, said this system let banks "sell high-risk securities in bottles with low-risk labels" — spreading toxic debt through the financial system.
Once the crisis became apparent, Levin said, rating agencies failed to acknowledge the problems fast enough. That led to mass downgrades of billions in investments, shocking the financial system and triggering the crisis, Levin said.
"By first instilling unwarranted confidence in high risk securities and then failing to downgrade them in a responsible manner, the credit rating agencies share blame for the massive economic damage that followed," the Michigan Democrat said.
Levin said the Obama administration's proposed overhaul of financial regulation should address the "conflict of interest" for agencies that compete for bank fees. He said the Senate will vote on amendments that would do so when it takes up the bill, possibly next week.
Top executives of Moody's Corp. and Standard & Poor's, a division of McGraw-Hill, will answer questions from Levin's panel in a hearing Friday.
The subcommittee's report says the agencies used flawed data and allowed banks undue influence over the investments' ratings.
Investors rely on rating agencies for impartial analysis of financial products. Letter grades assigned by the agencies help determine whether the potential profit from an investment is worth the risk.
The subcommittee's 18-month investigation exposes cozy relationships between credit analysts and banks that were bundling pools of mortgages into complex investments. The banks wanted high ratings for the deals so investors would find them attractive, it found.
In 2006, the Standard & Poor's group that rated mortgage-backed securities had "become so beholden to their top issuers (investment banks) for revenue that they have all developed a kind of Stockholm syndrome which they mistakenly tag as Customer Value creation," a concerned S&P employee wrote in an e-mail excerpt released by the probe.
Part of the problem was the data agencies were using. They assumed homeowners would default at rates similar to those seen in the past. But the old data had been collected at a time when most mortgages carried fixed rates and went to borrowers with strong credit.
During the housing bubble, low interest rates and weak oversight created a fraud-riddled market for riskier mortgages. These loans often required little or no down payment and carried low teaser rates. The riskiest mortgages allowed borrowers to pay so little each month that their loan balances actually rose.
"For all our reliance on our analysis of historically rooted data that sometimes went as far back as the Great Depression, some of that data has proved no longer to be as useful or reliable as it has historically been," an S&P executive told a House subcommittee in 2007.
The executive was addressing concerns about the company's downgrades of billions of dollars of investments. Those investments had previously been marked as safe.
Some big investors, such as pension funds, are barred from holding assets that are below investment grade. When S&P and Moody's started downgrading mortgage-related investments in 2006 and 2007, these investors' assets flooded the markets. That killed demand for the billions in risky mortgage debt that remained on banks' books.
The downgrades by rating agencies, which picked up in July 2007, were the single greatest trigger of the financial crisis, Levin said.