Introduction

The California Public Employee Retirement System requires that bonds it holds be rated by one of the top three credit raters even after it sued those companies for issuing “untrue, inaccurate and unjustifiably high credit ratings.”

Key findings: Despite contributing to the 2008 financial crisis by rating bonds made up of toxic mortgages as ‘AAA,’ the big credit rating companies are as powerful as ever.

State pension funds are suing credit raters, yet they still depend on ratings from the firms to guide investment decisions.

Most industry reforms haven’t been fully implemented or have failed outright, setting up the markets for another possible fall.

The Securities and Exchange Commission has promised not to enforce part of the Dodd-Frank law that would make credit raters liable for bad ratings.

The credit rating system is rife with the same conflicts of interest that caused distorted ratings before the financial crisis.

“These credit ratings were false at the time they were initially assigned, and continued to be false during the existence of the” investments, Calpers, the nation’s biggest pension fund, claims in its 2009 lawsuit against Moody’s Corp., Fitch Inc. and the parent company of Standard and Poor’s. The state pension fund says the bad ratings cost it as much as $1 billion.

That Calpers still depends on S&P, Moody’s and Fitch to rate its investments shows how much power these companies continue to wield in the global financial industry even after several investigations concluded their AAA ratings on mortgage bonds and other complex investments helped lead directly to the 2008 financial collapse. Calpers settled with Fitch without receiving payment, and the suit against S&P and Moody’s is pending.

Calpers, which manages $288 billion in assets, isn’t alone. Most major pension funds, insurance companies and mutual funds require investments in corporate bonds, mortgage bonds or collateralized debt obligations be rated by one of the three major ratings agencies.

Pimco, the world’s largest bond investor, also requires many of its investments to be rated by S&P and Moody’s even after its chairman, Bill Gross, in 2007 vividly thrashed the two companies for giving high ratings to trash investments.

“What was chaste and AAA years ago may no longer be the case today,” Gross wrote in his weekly investment outlook. “You were wooed, Mr. Moody’s and Mr. Poor’s, by the makeup, those six-inch hooker heels and a ‘tramp stamp.’ ”

The ratings industry has mostly escaped reform despite its central role in the financial crisis because the Securities and Exchange Commission has failed to implement many proposed changes and the companies themselves have fought off others.

The Dodd-Frank financial reform law, which passed in 2010 in response to the crisis, devoted an entire section to fixing the broken credit rating industry.

The changes were supposed to boost oversight, increase competition, reduce investor reliance on credit ratings, and make the companies liable for negligent practices. The law also required the SEC to consider changing the entire business model to eliminate the conflicts of interest that arise when credit ratings are paid for by the companies issuing the securities.

Four years after President Barack Obama signed Dodd-Frank into law, many of the reforms to the credit rating industry have not been implemented, and the private sector continues to rely on the same companies for investment opinions.

While lawmakers who worked on Dodd-Frank agreed the system needed a fix, they disagreed on how to do it, according to congressional staffers involved in writing the law. The result is a mishmash of vague mandates with contradictory goals that try at once to diminish the importance of credit ratings while increasing competition in the industry, to diminish conflicts of interest while failing to eliminate the central problem, and to create an oversight office with little authority.

“The change has been minuscule,” said former Pennsylvania congressman Paul Kanjorski, D-Pa., who was an author of the credit rating section of the Dodd-Frank law. “I have to be honest. It was the most disappointing section in the bill.”

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Rating inflation

Undeserved triple-A credit ratings were one of the major accelerators of the financial meltdown of 2007 and 2008. Wall Street firms created wildly complex securities based on junk subprime mortgages and sold them to pension funds, insurance companies and other Wall Street banks because they carried the golden seal — AAA.

In early 2007, S&P and Moody’s were rating mortgage bonds at record speed, putting their AAA stamp of approval on hundreds of billions of dollars of securities tied to home mortgages in a declining market. The two dominant companies, along with the smaller Fitch, controlled roughly 95 percent of the ratings market, according to various estimates.

In the first two weeks of July, the companies issued investment grade ratings on more than 2,000 mortgage bonds and CDOs. Then, on July 10, 2007, Moody’s downgraded $5.2 billion in mortgage bonds, and S&P put $7.35 billion-worth on credit watch. Over the next few months the companies cut their ratings on thousands more mortgage bonds and collateralized debt obligations that depended on those bonds. The foundation of the U.S. financial system began to crumble.

Banks at the time owned trillions of dollars worth of the bonds and couldn’t sell them as investors realized they weren’t as safe as the credit raters had claimed.

The “massive ratings correction that was unprecedented in U.S. financial markets,” caused “an economic earthquake from which the aftershocks continue today,” said the Senate Permanent Subcommittee on Investigations in a 2011 report.

Post-crisis investigations revealed that the rating companies had grown so focused on increasing their market share and boosting their profits that they apparently threw out most analytical standards and gave their seal of approval to bonds whose underlying mortgages would never be repaid.

Mortgage bonds are made up of hundreds of individual loans that are pooled together. Investors are paid interest from the cash flow that comes from individual homeowners’ monthly payments. Those who buy the AAA-rated portion of the bond are first in line to get paid, but earn the lowest interest rate. Those who buy the lower-rated portions of the loan pool get a higher return but run a greater risk of not getting paid at all.

The entire system was predicated on homeowners’ making their monthly payments. However, during the height of the housing bubble, in 2006 and 2007, mortgage companies were making enormous loans on overvalued homes without verifying borrowers’ income. Credit raters ignored the declining standards and increasing foreclosures, according to several investigations, and continued to deem home mortgages a safe investment.

President Barack Obama applauds after signing the Dodd Frank-Wall Street Reform and Consumer Protection Act in a ceremony in the Ronald Reagan Building in Washington, D.C, July 2010. (Pablo Martinez Monsivais/AP)

Ratings are ‘opinions’

Just one day after President Barack Obama signed the Dodd-Frank act into law on July 21, 2010, the credit ratings section began to crumble.

Ford Motor Credit asked the SEC that day for special permission to sell $22 billion in securities backed by car and truck loans without including credit ratings in its prospectus. The credit raters who had reviewed the deal were refusing to give Ford permission to include the ratings in their SEC filings, a move that would have amounted to them accepting legal liability for their work.

“While we will continue to publish credit ratings, given the potential legal consequences, we cannot consent to the inclusion of ratings in prospectuses or registration statements without further study,” Moody’s said in a document published on July 15, 2010. S&P and Fitch made similar statements.

Until Dodd-Frank, credit rating agencies were specifically excluded from being liable for any ratings they issue. But lawmakers including Sen. Jack Reed, D-R.I., and Rep. Mary Jo Kilroy, D-Ohio, specifically wanted ratings agencies to face the threat of lawsuits if their ratings are bad because these same companies, according to several investigations, ignored their own analysis and issued AAA ratings to investments that didn’t merit them.

The new law removed the liability exemption and the companies cried foul. S&P, Moody’s and the others argue their ratings are merely opinions, protected under the First Amendment, and not subject to the rigorous standards of an expert assessment such as that of a company auditor. As forward-looking statements, they argued, ratings cannot be right or wrong.

SEC rules require bonds backed by loans to include credit ratings in their initial filings. So when Ford went to the SEC complaining that no ratings agency would allow the automaker to include a rating in its filings, many analysts predicted the market would freeze, making it impossible for Ford and other companies to raise the capital they needed to operate.

“They [credit rating companies] basically threatened to blow up the financial system if they didn’t get their way,” said Micah Hauptman of the Consumer Federation of America.

Ford spokeswoman Margaret Mellott declined to say whether the company had asked every qualified rating agency to analyze their securities, and the SEC declined to say whether the agency had verified that no raters were willing to accept the liability.

The SEC acquiesced immediately, saying it wouldn’t enforce the rule for six months. It then followed up four months later with a letter saying it would ignore the mandate indefinitely.

It was the first clear of example of the power the ratings agencies continued to wield in the financial industry even after the crisis and subsequent investigations tarnished their image.

The major credit rating companies make money by essentially assessing the likelihood that corporations, municipalities, school boards and national governments will pay off their debts. The ratings from S&P, Moody’s and others determine whether these entities will get credit and what interest rate they’ll pay.

When Moody’s downgraded Greece’s bond rating to junk status in June 2010, investors demanded 6.08 percentage points more for their money than they did for German bonds. In the summer of 2011, S&P downgraded the debt of the U.S. government for the first time in history from AAA to AA+ when lawmakers threatened not to raise the debt ceiling.

When it comes to structured securities such as mortgage bonds the rating is a judgment of whether those who invest in the safest part of the deal area likely to get all their money back, plus interest.

SEC Chairwoman Mary Jo White and three other commissioners declined or ignored requests to be interviewed for this story.

In a July 2011 hearing, John Ramsey, the agency’s deputy director of the Division of Trading and Markets, declined to say whether the agency intended to alter the conflicting rules so that credit raters would face liability, as lawmakers had required.

“We haven’t done anything to alter [the rules] or what was done in the statute. The only thing that we did was to issue a no-action letter,” he said in response to questions.

The SEC proposed eliminating the credit rating requirement and instead requiring issuers of mortgage bonds to make details of the individual loans publicly available. That plan was delayed in February, however, because of concerns that consumers’ private financial information would be made public.

The Dodd-Frank law did make it somewhat easier for an investor to sue over a bad rating, if they could prove that the company “knowingly and recklessly” ignored evidence that their opinion was wrong.

It’s a hard standard to meet, but it’s easier than before the law passed, when courts often ruled that the companies were protected by the First Amendment because their ratings were simply opinions.

Commissioner Luis Aguilar said in an email that the agency still has a lot of work to do to fix the problems identified in the credit ratings industry during the financial crisis.

“There are significant issues that require the commission’s attention,” he said.

Conflicts of interest still in place

While the liability reform was the first part of the law to die, another initiative designed to reduce conflicts of interest withered even before the law was signed.

Several investigations into the causes of the financial crisis concluded that S&P and Moody’s wanted to gain market share and boost profits so badly that they gave AAA ratings to investments — particularly mortgage bonds — that didn’t deserve the high marks.

“It was not in the short term economic self-interest of either Moody’s or S&P to provide accurate credit ratings … because doing so would have hurt their own revenues,” said the report by the Senate Permanent Subcommittee on Investigations.

The investigations, including a Justice Department inquiry that ended in a lawsuit against S&P, found that the companies issuing securities would shop their deal between S&P and Moody’s in particular and see which company would give them the AAA rating on the most favorable terms. Issuers — including huge Wall Street banks such as JPMorgan and Goldman Sachs — paid as much as $150,000 for a rating on a mortgage bond offering, according to the Justice Department. A CDO rating could fetch as much as $750,000.

Sen. Al Franken, D-Minn., tried to eliminate one major conflict by creating an independent agency that would assign the job of rating a new security to the agencies on a rotating basis.

Franken’s amendment would have reduced “ratings shopping” by creating a system for assigning ratings rather than having issuers bid for them. The Senate approved it in May 2010 by a vote of 64-35. Then-Senate Banking Committee Chairman Christopher Dodd, D-Conn., and House Financial Services Chairman Barney Frank, D-Mass., opposed the bill, however, and opposition from the big-three firms was fierce.

Lobbying by S&P, Moody’s and Fitch peaked in 2010, with the three companies spending a combined $3.6 million to influence lawmakers. That’s 59 percent more than the $2.1 million the three companies spent in 2007, just as the housing market began to teeter.

Still, it’s just a fraction of the total spending on financial reform. The securities and investment industry spent nearly $106 million on lobbying in 2010, according to the Center for Responsive Politics.

When the House and Senate got together to reconcile their versions of financial reform, the assigned ratings system disappeared. The law instead ordered the SEC to study the issue and change the system if it considered it to be in the public interest.

The SEC published that study in December 2012, in which it described a variety of methods for assigning credit ratings but offered no opinion. S&P, Moody’s and Fitch all opposed a ratings assignment system in comment letters to the agency.

The study concluded by recommending a roundtable on the issue, which was held in May 2013. An agency spokeswoman said the SEC staff is developing a recommendation for the commission but declined to say when that would come, and refused to say whether the agency believes it must act at all.

Congress also mandated, as an alternative to the Franken amendment, that issuers of structured bonds make all the offering information available to every credit rating agency so those that aren’t hired to do the rating can publish one independently, without pay.

Such unsolicited ratings could impose some discipline on credit raters that won the business, who would presumably not want to look like they were too generous with their AAAs. The system would also allow smaller companies to build a reputation in the market by issuing good ratings on their own.

Since the law was passed four years ago, not one company has issued an unsolicited rating.

S&P said in comments to the SEC that bond issuers designate all the deal information confidential, making it nearly impossible for the rater not officially hired to analyze the bond to publish an opinion without violating that confidentiality.

The rule “was designed to address, among other things, the ‘issuer pay’ conflict of interest and to improve the quality of credit ratings,” the SEC’s Aguilar said. “The Commission should assess why this rule has failed to accomplish its goals and what else should be done.”

Even with the evidence that competition for market share led to a “race to the bottom” in ratings standards, some lawmakers and advocates argued that boosting competition in the ratings industry — and diluting the power of the S&P-Moody’s duopoly — was the answer to fixing low-quality credit ratings.

With that in mind, lawmakers also urged the SEC to increase the number of qualified credit raters by designating more companies Nationally Recognized Statistical Ratings Organizations. Now ten companies carry that title, but the industry is still dominated by S&P, Moody’s and to a lesser degree Fitch because private investors such as Calpers and Pimco still demand ratings from them.

“You have the SEC granting a designation — an anointment … that has nothing to do with the quality of their ratings,” said Dan Alpert, managing partner at the investment bank Westwood Capital in New York.

The Congress also tried to diminish the clout of the raters by ordering all federal agencies to delete any references to credit ratings – such as in rules on how banks measure the quality of their capital — from federal regulations. Government agencies such as the Federal Reserve, the Securities and Exchange Commission and the Federal Housing Finance Agancy are busy coming up with alternative ways to measure creditworthiness.

The change may make ratings less important in some fields, but as long as private investors continue to rely on them, the ratings firms will continue to hold sway in the markets, analysts and investors said.

Today, credit ratings for mortgage bonds and other complex debt securities are issued exactly as they were before the crisis. Bond issuers ask several raters their opinions and then choose which they want to rate the deal.

When Redwood Trust, the largest post-crisis issuer of mortgage bonds, sought ratings for an offering last year, it provided information to Moody’s, S&P, Fitch and Kroll Bond Rating Agency, a relatively new and growing company.

Redwood then dropped Moody’s from the group “because the sponsor disagreed with the preliminary assessment by Moody’s of the risks,” the company said in its SEC filing.

When Goldman Sachs Group Inc. in March wanted to sell commercial mortgage bonds, it sought ratings from six companies and eventually chose three, Moody’s, Fitch and Kroll, and acknowledged in its filings that the other companies might not have given the deal the same ratings.

In another offering, however, Redwood chose Moody’s, Fitch and Kroll over S&P even though S&P appeared to be giving it the most favorable rating terms.

Redwood says it now has a policy of alternating between S&P and Moody’s since so many investment funds require a rating from one of those two.

“A large number of the deals being brought to market have not only two, but generally three or four ratings,” said Guy Cecala, CEO of Inside Mortgage Finance, a trade publication that tracks mortgage-backed securities. “You never saw that in 2006 or 2007.”

Cecala said companies may be getting several ratings to reassure investors that the ratings are credible after the reputational beating the ratings firms took during the financial crisis.

With companies getting so many ratings, it’s hard to identify “ratings shopping” in the pre-crisis sense. Still, there are no regulatory or legal backstops in place to prevent the raters from lowering their standards to attract business.

Good ratings equal good business

While Dodd-Frank gave the SEC a way to avoid revamping the industry’s business model, the law did require the SEC to “prevent the sales and marketing considerations” from influencing credit ratings. The law says the SEC can revoke a credit rater’s federal registration if it violates that law.

The SEC took a narrow view of this mandate however and wrote rules that simply prohibit sales personnel from being involved in the ratings process, a restriction that would do little to prevent the kinds of abuses that happened before the crisis, such as pressure from top management to boost market share or face consequences if an issuer went with a competitor with lower standards, according to Barbara Roper of the Consumer Federation of America.

During the housing boom, mortgage bonds generated huge revenue and profits for credit raters. S&P’s 2006 revenue was $2.75 billion, primarily due to growth in so-called structured finance ratings, the company said in its annual filings.

Structured finance products accounted for 44 percent of Moody’s $2.04 billion in revenue in 2006, according to the company’s annual report. “As in 2004 and 2005, U.S. structured finance was the largest dollar contributor to Moody’s revenue growth,” the company said. By 2008, Moody’s revenue had plummeted to $1.76 billion, with structured finance accounting for the biggest decline.

The Senate report showed that during the boom years Moody’s managers threatened to fire analysts who were too conservative in their ratings of mortgage bonds.

One manager told Moody’s senior analyst Richard Michalek “how he had previously had to fire [another analyst] … because of numerous complaints about [that analyst’s] extreme conservatism, rigidity and insensitivity to client perspective,” Michalek testified at one hearing. “He then asked me to convince him why he shouldn’t fire me.”

Richard Michalek, former VP/senior credit officer for Moody’s as he testified before an April 2010 Senate Subcommittee on Investigations on Capitol Hill in Washington, D.C. (Harry Hamburg/AP)

Roper of the Consumer Federation says the SEC’s rule wouldn’t address that type of influence because Michalek’s manager was likely not considered a “marketing” employee.

One Dodd-Frank reform that has been effective is that the credit raters are required to publish their ratings methodologies and standards on their websites. That means investors can look at how Moody’s or S&P analyzes a security before giving it a rating, and can determine whether that method is adequate.

The rating companies have to disclose every change in their ratings methods, or reaffirm each year that they are continuing to follow the previously published analysis.

Investors, however, cannot independently confirm whether the raters are actually following those methodologies or deviating from them, as they often did when rating mortgage bonds before the financial crisis.

The SEC has also been gentle in its oversight, taking another Dodd-Frank reform and strolling with it, rather than running.

The agency set up an Office of Credit Ratings, as the law required, to ensure companies publish their ratings criteria for each type of investment, from corporate bonds to commercial mortgage securities to collateralized debt obligations.

That Credit Ratings Office is barred from offering an opinion on the companies’ ratings methods. Rather, its job is to ensure the companies have effective systems in place so they don’t — as happened during the housing boom — simply throw out those criteria if their customers want a better rating than the models offer.

That office has spent the last three years examining the practices of the companies that are registered as Nationally Recognized Statistical Ratings Organizations.

In each of the annual reports, the SEC details a variety of ways the companies are not complying with their own internal rules and with government regulations. The problem: The SEC doesn’t name the companies in its reports, so investors cannot determine which companies actually follow the law and operate in the manner that they publicly claim to.

“The staff found that a larger NRSRO did not maintain written procedures for certain key aspects of the rating process,” the report said, in one of several instances where it found problems at a company it didn’t name.

S&P spokesman Ed Sweeney said the annual reports have shown that the industry has made progress in complying with the slew of new Dodd-Frank rules. He also said the reports show a greater degree of reporting than most regulated industries.

“There aren’t many industries that have the reporting requirements with the SEC that our industry has,” Sweeney said.

By keeping the companies’ names out of the reports, the SEC is undermining its own effectiveness, said Gene Phillips, a director at PF2 Securities, which evaluates CDOs for private investors. Phillips, who used to work at Moody’s, said companies would feel compelled to correct problems if the SEC identified them in the reports.

“I think you’d start to see very significant changes if they made just a minor public announcement,” he said.

An SEC spokeswoman said the agency doesn’t disclose the companies’ names because of “fairness and due process.”

Quiet times for raters

Credit rating companies’ revenues and profits have largely rebounded since the financial crisis, with Moody’s $2.97 billion in revenue last year far outstripping its 2007 pre-crisis peak. Revenue for S&P ratings, a subsidiary of McGraw Hill, reached $2.3 billion last year. The company has changed how it reports earnings by business so its 2013 revenue numbers don’t compare with those from earlier years.

Ratings agencies have been on good behavior since the financial crisis, when they took a major beating from members of Congress, private investors and even the Justice Department, which is suing Standard & Poors, accusing it of knowingly giving fraudulent AAA ratings to risky mortgage-backed securities.

S&P says it’s become much harder for an issuer to get those three As.

Most residential mortgage bonds today require more so-called credit enhancement to earn a triple-A rating than they did pre-crisis. That means issuers have to set aside a larger portion of the loan pool for excess collateral. Today most mortgage-backed securities have to “subordinate” more than 7 percent of the bond sale to absorb losses and protect the AAA-rated portion, compared to about 4 percent in 2006.

“Credit enhancement has gone up by at least 50 percent to achieve a triple-A rating,” S&P’s Sweeney said. “And there are concentration limits for each major geographic market.”

However, there are almost no new rules or regulations that would prevent S&P or others from allowing their standards to slide as memories fade and profits increase.

“There’s no question in my mind that people will stop looking back to this era, and the ratings will start to fail again,” Kanjorski, the former congressman, said.