Credit Rating Agencies Failed Us Money Magazine once characterized Fannie Mae as “America's safest stock,” with a bullet-proof business model that was “as clean as you'll get to an invincible earnings machine". In a matter of days, shareholders saw their shares plunge into the penny stock category.

The once highly-respected Lehman Brothers did not survive. The Wall Street Journal estimated that the 24,000 Lehman employees lost $10 billion in personal wealth with the collapse of the company’s shares.

Many in the financial industry believe that where there’s a boom, there will inevitably be a bust. The argument goes that with rapid growth, bad ideas that would ordinarily be dismissed are instead indulged, often propped up by misguided investors spurred by the prospect of quicker and bigger returns. Flawed businesses are sometimes sustained by the market's buoyancy alone.

When confidence begins to erode, the weaker businesses are exposed and crushed in a process that celebrated Austrian economist Joseph Schumpeter calls “creative destruction”. This vision of the free market is somewhat sullied by the fact that significant numbers of “sound” and “sensible” businesses also find themselves besieged for no reason other than bad luck.

Bear Stearns, Lehman, Washington Mutual, and a growing list of companies took too much risk and created their own demise. Each company decides its own business model, and, if high risk is their cup-o'-tea, then good luck to them. If they want to leverage up and roll the dice, great; but why should taxpayers pay the price when these companies go bust?

The larger problem, however, is not with any individual company, but with the credit rating system.

Many people believe a AAA rating has the same low-risk profile as a U.S. Treasury note. Jay Dhru, head of financial institutions rating at Standard & Poor's, was recently and rightfully questioned hard by Dylan Ratigan of CNBC. Ratigan noted, “Securities that you and your institution deemed very credit worthy… as it turns out, you were wrong, Sir. These are not AAA credits or AA credits”. After Dhru attempted to sidestep the question, Ratigan persisted that, “The decision to call the securities that you approved and rated as AAA… now you return to indict the securities you deemed to be credit worthy, at the expense of the entire financial system”.

Investment and commercial banks are sales organizations. Their objectives are to grow. Some do it conservatively, some aggressively. Some take on too much risk, some take on very little. However, the rating agencies – Standard & Poor’s, Moody’s, and Fitch – failed to properly identify, characterize, and categorize these varying risk profiles in the financial space. “If the credit rating agency simply admitted they didn't understand the full risk of all the assets on the books of some companies, and therefore declined to issue a rating, the market would have promptly adjusted the price of the debt and equity of the companies being rated”, says Larry Jeddeloh, Founder of the TIS Group. “It would have forced disclosure and adjustment, which could have avoided some of the severe excesses in the system that we are now seeing violently unwind".

The lynchpins of the system - the fail-safes, the backstops - were the credit rating agencies. They were the ones assuring us of unbiased, accurate reflections of that risk profile. Their ratings have become so engrained in the system that the Securities and Exchange Commission was using them as a Prudent Man standard for investment committees, both public and private.

The financial industry is getting a wake-up call for change.  10:18 AM •  0 Comments •