Credit Ratings Agencies: What Were They Thinking?

Today Standard & Poor’s, the credit ratings agency, downgraded its ratings for several thousand bonds that invested in mortgage related debt in 2007. Of these securities, more than several dozen were even rated of the highest quality triple AAA and thus least likely to default (Source: New York Times).

However, as the recent credit crisis continues to play out and develop in greater and greater significance, one must ask: Why were these bonds rated so highly before? Investment banks are the result of such shoddily rated investments. Merrill Lynch posted a writedown of $7.9 billion in mortgage related securities this month; Citigroup posted a $3 billion writedown; and Morgan Stanley posted a $940 billion writedown also related to subprime mortgages. These record losses are phenomenal compared to past earnings due to trading at financial services firms. This is indeed exemplified by the mass number of layoffs taking place across Wall Street, such as the firing of Merrill Lynch CEO Stan O’Neal.

However, not all the blame rests upon the executives at these investment banks, hedge funds, and private equity funds. Investigation of credit ratings firms such as S&P and Moody’s must take place immediately. These firms rated as extremely safe thousands of securities related to the subprime mortgages whose values have plummeted in a matter of weeks. Nobody knew how to value these investments and now that firms have been forced to sell their investments to raise cash, the values of these debt instruments are literally reaping $0.20 on the dollar.

As the New York Times illustrates today:

"The action provides further evidence that lending standards remained loose even as default rates on home loans made in 2005 and 2006 were raising alarms among investors and regulators this year. A recent investment bank report showed that loans made to borrowers with weak, or subprime, credit this year had higher default rates than similar loans in 2006 did at the same time in their lives.

S.& P. downgraded bonds worth $23.4 billion, or about 6 percent of mortgages classified as subprime and Alt-A that it has rated through June; Alt-A loans are made to borrowers with better credit. The bonds that were downgraded included 39 securities that had been rated AAA, the highest grade awarded by the agency; some of these were downgraded several notches to A. (Bonds rated at BBB and above are considered investment-grade securities.)”

Hopefully these companies are held accountable and mistakes of this magnitude occur less frequently in the future.