Credit Rating Agencies: Revenge of the NINJA

[UPDATE: MarketWatch says S&P plans to change the methodology which it uses to rate structured finance products.] The Independent has a good 'un on the credit rating agencies falling under hard times as investors, regulators, and politicians are now breathing down their necks for their assorted shenanigans. Not so long ago, Timothy Sinclair described these agencies as the "new masters of capital" since their ratings are instrumental in determining who exactly is able to receive credit--and at what cost. Given their tumble in the wake of the subprime mess--does anyone still have faith in the ratings they give--these rating agencies now have a much-diminished standing. With a loss of confidence comes a loss of faith in their activities.

From the lofty status of "masters of capital," they have now turned into the "jesters of capital" by assigning AAA ratings to trashy securities containing NINJA loans (mortgages granted to those with no income, no jobs or assets) and the like. Here are some excerpts from the Independent on this fateful turn of events:

Warning: may contain nuts [good one!]. The credit-rating agencies, fingered early on as important villains in the unfolding credit crisis, have alighted on a new plan to shore up investors' confidence in their abilities and to head off potentially ruinous new rules from angry law-makers. They suggest putting a warning label on many of their credit ratings, alerting investors to the limitations of their research and the possibility that they may be wrong.

At this stage, that might look like a statement of the obvious. As Wall Street churned out more and more exotic financial instruments in recent years, agencies led by Standard & Poor's and Moody's stamped many with gold-plated triple-A credit ratings, signalling to investors that they were as safe as government bonds.

Only, that turns out to have been fantasy, and shocked investors who thought they had rock-solid portfolios have found themselves sitting on giant losses. From the retirement funds of tiny local authorities in the US, to the trading desks of the titanic Wall Street banks, more than $100bn (£50bn) of value has been wiped out because of the mushrooming numbers of defaults.

So there is no longer any doubt that the agencies have been very, very wrong in assessing the creditworthiness of exotic mortgage-related bonds and other credit derivatives, particularly the parcels of debt known as collateralised debt obligations, or CDOs.

Investigators are now looking to scoop up the dirt on these agencies:

Two Congressional committees and several attorneys-general across the US have launched formal investigations into whether the agencies gave artificially inflated ratings in order to win business from Wall Street banks, which paid for the ratings. "It is like a movie studio paying a critic to review a movie and then using a quote from his review in the commercials," one law-maker said at the time.

This week, at a meeting in Amsterdam, the International Organisation of Securities Commissions is discussing a co-ordinated regulatory response to the rating agencies' failings, while the European Union and the US Securities and Exchange Commission are pursuing parallel inquiries.

But all the agencies have insisted on their good faith, saying overly optimistic credit ratings stemmed not from conflicts of interest, but from deteriorating lending standards and fraud by mortgage brokers.

What will happen? Wait and see. It won't be very pretty, I think:

The outcome of these internal, regulatory and criminal reviews will have enormous consequences. Whether it be a bog-standard municipal government bond or a synthetically created parcel of derivatives and other complex financial instruments, the credit rating of a bond is vital to the price at which it trades.