The role the Nationally Recognized Statistical Rating Organizations (NRSROs) played in the 2007-2009 Financial Crisis was nefarious to say the least and we must make certain this behavior is never repeated in any fashion.  NRSROs are agencies that rate the creditworthiness of a company or a financial product.  Because they help investors determine the risk of a security, they are extremely influential in the financial markets.  

 

Thankfully, the Dodd-Frank Wall Street Reform and Consumer Protection Act put several accountability measures in place, including those concerning annual reports on internal controls; conflicts of interest with respect to sales and marketing practices; “look-backs” when credit analysts leave the NRSRO; disclosure of performance statistics; application and disclosure of credit rating methodologies; form disclosure of data and assumptions underlying credit ratings; disclosure about third party due diligence; analyst training and testing; consistent application of rating symbols and definitions; and specific and additional disclosure for ratings related to ABS products.

​

In addition, Dodd-Frank requires "every federal agency to review existing regulations that require the use of an assessment of the credit-worthiness of the security or money market instrument and any references to credit ratings in such regulations; to modify such regulations identified in the review to remove any reference to, or requirement of reliance on credit ratings; and substitute with a standard of credit worthiness as the agency shall determine as appropriate for such regulations."

​

Why is all of this important? 

​

Before the 2007-2009 Financial Crisis, Wall Street was busy engineering new, complicated financial instruments.  The deadliest of these was an extremely complex security called the collateralized debt obligation (CDO).  Originally the CDO mirrored a mortgage bond, which aimed to redistribute risk associated with home mortgage lending and make the financial markets more efficient.

​

In a mortgage bond, thousands of home loans are gathered together and then resold in bits and pieces to investors.  The assumption is that it’s extremely unlikely all of the home loans grouped together will repay or default at the same time.  This structure depends largely on securitization, with thousands of loans being divided into what are called tranches (generally, the riskiest loans are in the bottom tranche and receive the highest interest rate, whereas the loans in the top tranche are the least risky and receive the lowest interest rate).

​

In this new world, the CDO gathered one hundred mortgage bonds and used them to create an entirely new pyramid of bonds.  The bonds used in this set-up were usually Triple-B-rated bonds, some of the riskiest of the bunch.  Not only were these bonds risky, they sometimes weren’t even tied to actual home mortgages.  Financial firms soon discovered they didn’t need an actual home loan as the origination.   Like Vegas, they only needed someone to take the other side of their bet.  In these “synthetic CDOs,” short-sellers – pessimists who believed the CDO market would eventually crash and therefore bet against it – happily served as the counterparty.  This new market made the risk associated with subprime mortgage lending endless. 

​

To make matters far worse, many financial firms borrowed heavily against these securities to increase their returns.  This is known as leverage, or using borrowed money as a source of financing.  This multiplied the pain exponentially when the market collapsed.

​​

Enter the credit agencies.

​

The next little trick is where Wall Street got either really creative or really criminal depending on your take (our take is really criminal).  Instead of carrying over the Triple-B-rating to the new tranches, financial firms simply got the low-rated bonds re-rated as Triple-A. 

 

Who in the world would do this for them?  Answer:  Nationally Recognized Statistical Rating Organizations (NRSROs) named Moody’s, Standard and Poor’s and Fitch Ratings. With just one word from these agencies, the risk of these horrid loans simply disappeared – that is, on paper anyway.

 

At the time, an epic conflict of interest existed in the NRSRO model.  For years, investors paid the bill for the risk assessments given by the rating agencies, but this changed over time.  Eventually the issuers of the securities were responsible for paying for their own ratings.   

​

To say this arrangement was lucrative for the credit agencies is quite an understatement.  When Moody’s went public, its stock multiplied by six and its earnings increased 900%.  During the mortgage boom, Moody’s rated $4,700 billion of residential mortgage-backed securities and $736 billion of CDOs in just seven years.  Yet over and over they completely missed – or, more accurately, blatantly overlooked – enormous risks being taken by those who paid them huge amounts of money. 

 

In 2017, Moody's reached an agreement with the "U.S. Department of Justice and the attorneys general of 21 U.S. states and the District of Columbia to resolve pending and potential civil claims related to credit ratings that Moody’s Investors Service assigned to certain structured finance instruments in the financial crisis era."  They agreed to pay a $437.5 million civil penalty to the Department of Justice, and $426.3 million to the participating states and the District of Columbia.

​

In August 2018, the SEC charged Moody’s with "Internal Controls Failures and Ratings Symbols Deficiencies."  Of the charges, Antonia Chion, Associate Director of the SEC’s Division of Enforcement, said:  “Rating agencies play a critical role in our capital markets and need to have effective controls over their rating processes.  As our order notes, the SEC put Moody’s on notice about its internal controls obligations yet it did not develop an effective process to ensure the accuracy of the models it relied upon when rating residential mortgage-backed securities.”

​

We have to watch these guys like a hawk, especially when the SEC still reports conflicts of interest in the NRSRO model.  Read the entire report here: