April 13, 2011 11:36:28 PM

By Rachelle Younglai and Sarah N. Lynch

WASHINGTON (Reuters) - Moody's Corp and Standard and Poor's triggered the worst financial crisis in decades when they were forced to downgrade the inflated ratings they slapped on complex mortgage-backed securities, a U.S. congressional report concluded on Wednesday.

In one of the most stark condemnations of the credit rating agencies, a Senate investigations panel said the agencies continued to give top ratings to mortgage-backed securities months after the housing market started to collapse.

The agencies then unleashed on the financial system a flood of downgrades in July 2007, the panel said.

``Perhaps more than any other single event, the sudden mass downgrades of (residential mortgage-backed securities) and (collateralized debt obligation) ratings were the immediate trigger for the financial crisis,'' the staff for Senators Carl Levin and Tom Coburn wrote in their report.

The findings come after the Senate's Permanent Subcommittee on Investigations spent two years poring over countless documents and holding hearings on the causes of the crisis. The probe only focused on the two largest rating agencies; it did not study Fitch Ratings.

The report calls for radical reforms to the industry that are authorized in last year's Dodd-Frank financial reform law, but may not be realized.

Dodd-Frank did little to change what some say is an inherent conflict of interest in credit raters' business model, in which the raters are paid by the companies whose products they rate.

The panel's suggested reforms include having the U.S. Securities and Exchange Commission rank the credit raters, based on the accuracy of their ratings.

``WATCHING A HURRICANE''

The Senate panel released internal documents showing how Moody's and S&P failed to heed their own internal warnings about the deteriorating mortgage market.

Emails in 2006 and early 2007 show employees were aware of housing market troubles, well before the massive downgrades in July 2007.

``This is like watching a hurricane from FL (Florida) moving up the coast slowly towards us. Not sure if we will get hit in full or get trounced a bit or escape without severe damage ...'' one S&P employee wrote in response to an article on the mortgage mess.

Senate investigators concluded that had Moody's and S&P heeded their own warnings, they might have issued more conservative ratings for the securities linked to shoddy mortgages.

``The problem, however, was that neither company had a financial incentive to assign tougher credit ratings to the very securities that for a short while increased their revenues, boosted their stock prices, and expanded their executive compensation,'' the report said.

Edward Sweeney, a spokesman for S&P, said in a statement on Wednesday that the Dodd-Frank Act, coupled with the company's own internal reforms, have significantly strengthened the oversight of the industry. He added that the 2007 and 2008 downgrades ``reflected the unprecedented deterioration in credit quality, but were not a cause of it.''

Michael Adler, a spokesman for Moody's, declined to comment ahead of the report's release.

NO REAL CHANGES YET SEEN

The SEC has been grappling with how to clamp down on the conflicts of interest embedded in the so-called ``issuer-paid'' model. Congress contemplated radical reforms for the agencies during the drafting of the Dodd-Frank law but in the end passed a sweeping financial regulation bill without them.

Wednesday's report includes emails from employees at both companies that illustrate the pressure that raters came under from investment banks.

An August 2006 email reveals the frustration that at least one S&P employee felt about the dependence of his employer on the issuers of structured finance products, going so far as to describe the rating agencies as having ``a kind of Stockholm syndrome'' -- the phenomenon in which a captive begins to identify with the captor.

The SEC did take some steps to address conflicts of interest at rating agencies in the past few years.

Although the Dodd-Frank law directs the SEC to write numerous additional regulations for raters, most have yet to be proposed.

And one key rule that did go into effect last July, subjecting credit raters to increased liability, was suspended after credit raters' refusal to include their ratings for asset-backed securities led to a freeze in the secondary market.

The reform has not been reinstated. (With additional reporting by Kim Dixon; Editing by Steve Orlofsky)

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