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Lawmakers turn to credit raters, prepare overhaul

by Daniel Wagner
| April 25, 2010 9:00 PM

WASHINGTON - Lawmakers rewriting financial regulations took aim Friday at credit rating agencies, whose analysts often gave safe ratings to risky investments that fueled the financial crisis.

Sen. Carl Levin, D-Mich., said the Senate's regulatory overhaul should go further to curb the industry's inherent conflicts of interest: The agencies are paid by the banks whose investments they rate. Banks generally want higher ratings to make the securities they offer more attractive to investors.

At a hearing Levin chaired Friday, former executives acknowledged that competition within the industry often led the agencies' analysts to rate high-risk securities as safe.

Levin suggested the co-dependent relationship between the agencies and the banks is a dangerous flaw in the financial system. He offered an analogy: "It's like one of the parties in court paying the judge's salary."

Levin was chairing a hearing of the Permanent Subcommittee on Investigations, which has been investigating the causes of the financial crisis.

The Senate next week is expected to take up a version of the financial regulatory legislation that would require only a study of the industry's conflicts of interest. A House-passed bill would go further. It would instruct the Securities and Exchange Commission to produce a policy that would either bar the conflicts or require the agencies to disclose their relationships with banks.

Levin wants the Senate bill to move closer to the House approach. He favors an expected amendment to force regulators to address the conflicts of interest.

In a report Thursday, Levin's panel said the agencies kept ratings too high in the run-up to the crisis even though they knew mortgage fraud and subprime loans were leading more homeowners to default.

Between 2002 and 2007, the top three credit rating agencies doubled their revenue, to more than $6 billion a year, the committee said. Most of that growth came from the complex investments that spread trillions of dollars in toxic debt through the financial system.

Banks pooled mortgages of varying degrees of risk and sold securities backed by the pools. The safest securities earned the highest ratings. But when most of the mortgages in a pool went bust, even the safest-rated securities became worthless.

The committee found that the rating agencies knew the investments were losing value but for months delayed downgrading individual securities. The agencies finally began responding in 2006 by downgrading some securities, the report said. The downgrades accelerated in 2007.

Some large investors, such as pension funds, are barred from holding assets below investment grade. The downgrades forced them to dump their holdings onto the markets. That killed demand for the billions in risky mortgage debt that remained on banks' books.

The mass downgrades by the agencies were the single greatest trigger of the financial crisis, Levin said.

Former executives of Moody's and Standard & Poor's testified that pressure from competitors and management pushed their analysts to award safe ratings to risky investments.

There was a "disconnect" between senior managers and the analytical managers responsible for assigning bond ratings, said Frank Raiter, a former managing director for Standard & Poor's. He said this helped lead agencies to award high ratings to risky investments.

Raiter said management placed increasing pressure on analysts to earn fees by attracting business from banks.

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