Can Rating Agencies Plead Ignorance?

Were the credit rating agencies a cause of the financial crisis or a victim? The Financial Crisis Inquiry Commission (FCIC) addresses this question today as it examines the role the agencies played. The hearing focuses on Moody's -- the agency accounts for all of its witnesses. The star of the show is likely to be one who doesn't even work for Moody's, but owns a major stake: Warren Buffett. Predictably, Buffett indicated that he doesn't think the agencies deserve too much blame for getting the housing market wrong.

During the question and answer period, Buffett was asked whether the agencies should have caught the housing bubble. Buffett responded that it's hard to blame them for missing it, because everyone else did too. In a sense, he's right: almost no one expected the housing bubble to cause so much destruction.

But the rating agencies weren't just any market participant. They were responsible for grading the mortgage securities that drove the bubble. Investors become comfortable with these bonds based on the ratings the agencies provided. The market's appetite grew based on so many seemingly high-quality bonds being offered, which perpetuated a cycle bringing forth more supply and inflating the bubble further and further.

At one point Buffett used a colorful and apt analogy. He said that rising home prices became like a narcotic. The entire industry was addicted. So were American homeowners. But then FCIC Chairman Phil Angelides responded cleverly, "We don't want the police trading in crack."

And therein lies the major rating agency problem. They act as sort of pseudo-regulators. They are provided protected status by federal laws that make the Big-3 agencies virtually bulletproof, from both outside competition and lawsuits. Moreover, some federal statues refer to agency ratings for some regulatory purposes. Capital requirements are guided in part by ratings. These grades are also important within private investment funds, as policies and procedures often require certain ratings are in place for buying bonds.

Yet, these agencies act as profit-seekers, rather than as unbiased surveyors of market risk. They make money based on volume, not based on how much risk they ultimately succeed in evaluating. In a sense, the agencies suffered from the same problem as the government-sponsored entities Fannie Mae and Freddie Mac. The raters also had a sort of government-charter, but worried more about maximizing profit than keeping risk in check.

Of course, some people will complain that investors should have done their own due diligence, rather than rely on the agency ratings. That's undoubtedly true, but it also misses the point. No matter what investors should have done, everybody knows that ratings were extremely important in the world of investing, for the reasons described above. Whether ratings should have as much of an impact is somewhat irrelevant: the fact is that they did -- and the agencies knew the importance their ratings were given by the industry.

Given all of this, rating agencies should be held to a higher standard. Their role in the financial crisis isn't a sob-story of business lost due to the collapse of housing; it was causal. If the agencies hadn't lost sight of prudent due diligence and had relied on sound assumptions, then they would have refused to allow the subprime mortgage bubble to grow as large. Then, the housing bubble may have been more contained. That isn't to say the agencies were the only cause, but it's crazy to say that they shouldn't be blamed for playing a major part.