(2008-04-25) Lowenstein Subprime Rating Process

Roger Lowenstein gives an inside view of the Sub-Prime Credit Rating process. The Securities and Exchange Commission (SEC), faced with the question of how to measure the capital of broker-dealers, decided to penalize brokers for holding bonds that were less than investment-grade (the term applies to Moody's 10 top grades). This prompted a question: investment grade according to whom? The SEC opted to create a new category of officially designated rating agencies, and grandfathered the big three - S.&P., Moody's and Fitch. In effect, the government outsourced its regulatory function to three for-profit companies... Joseph Mason, of Drexel University, compared default rates for corporate bonds rated Baa with those of similarly rated collateralized debt obligations until 2005 (before the bubble burst). Mason found that the CDO-s defaulted eight times as often. One interpretation of the data is that Moody's was far less discerning when the client was a Wall Street securitizer... From 2002 to 2006, Moody's profits nearly tripled, mostly thanks to the high margins the agencies charged in structured finance. (Market Distortion)