Credit rating agencies were accused 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 investments 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.
The rating agencies' seal of approval effectively concealed the true risks of those investments, lawmakers said, comparing 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.
Senators 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, said Sen. Jim Bunning.
Executives from S&P and Moody's Corp. said their methodology for monitoring the risk of mortgage-backed bonds was sound, but 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 investment banks that issue debt, but acknowledged that the agency has an "open dialogue" with sellers of mortgage securities.
The Securities and Exchange Commission has been examining whether the rating agencies were prodded by investment banks to publish higher ratings for mortgage securities, 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.
Lawmakers are discussing overhauling the agencies business model. One idea, proposed by Columbia University law professor John Coffee, is for the SEC to calculate default rates for each rating agency and make that information public. Rating agencies that are especially inaccurate could have their SEC recognition revoked.
Sen. Charles Schumer suggested a new business model for the rating agencies by having the existing agencies paid by investors in securities rather than their issuers of debt. But Stephen Joynt, chief executive of Fitch, was skeptical about that concept.
"Changing from our present business model to an investor one, based on a law or requirement, I think is problematic," he said in an interview, saying that rating agencies need revenue from issuers of mortgage debt to pay their employees competitive salaries.
Also Wednesday, Moody's said it supports some mortgage-market changes. 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. And Moody's said investors should receive more information on loan performance throughout the life of a mortgage.
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