An 18-month investigation by the Senate Permanent Subcommittee on Investigations, led by Senator Carl Levin has revealed that credit organizations played a major role in worsening the economic downturn.
Credit rating agencies (CRAs) such as Moody’s Investors Service and Standard and Poor’s Ratings Services have been accused of grave irresponsibility and unethical practices. Several internal emails exchanged among the internal employees of these agencies show that the agencies were perfectly aware of the consequences of their actions.
It has been alleged that CRAs contributed significantly to the financial crisis in many ways. They gave higher ratings to dubious products under pressure from banks, failed to reveal the risks on existing products on time, and used inefficient models to gauge risks.
Pressure from banks
Credit rating agencies are often hired by investment banks to assign a rating for their products. It is in the best interests of CRAs to give the banks the ratings they are looking for, as otherwise they risk losing their clients to competing agencies. Levin asserted that the agencies often gave unreliable ratings to products being marketed by investment banks.
Top executives from the two agencies testified in court that their agency was under great pressure to give decent ratings even if the products seemed risky. Many internal emails circulated among their employees suggest that the agencies gave into pressure from Goldman Sachs to give favorable ratings to mortgage backed securities.
Inefficient risk assessment models
Credit agencies have also been accused of using poor models for assessment of risk. The Subcommittee said that the agencies kept using these models because they feared that changing them would pull down the ratings and invite the ire of investment banks. These defective models were exposed when the real estate market went down and mortgage defaults rose sharply. The consequence was a crisis in the housing market, which quickly spread to the whole economy.
Delayed rating downgrades
As the housing market began declining in 2007, the agencies eventually realized their serious mistakes and started switching to new risk models. Many mortgage based securities, which had earlier been given favorable ratings, were assigned extremely low ratings. Such mass downgrades led to a further fall in the market.
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