Moody's, S&P's Apparent 'Stockholm Syndrome' Led to Financial Meltdown

April 14, 2011 11:34 AM EDT
Moody's Corp (NYSE: MCO) and McGraw-Hill's (NYSE: MHP) Standard and Poor's triggered the worst financial crisis in decades, according to a U.S. congressional report from Thursday.

One of the worst financial crises in decades unfolded as the two were forced to downgrade inflated ratings placed on complex mortgage-backed securities. The downgrades occured months after the U.S. housing market started to collapse, and the agencies still had high marks for the securities.

Moody's and S&P kept ratings high on MBSs following pressure from firms like Goldman Sachs (NYSE: GS), UBS (NYSE: UBS), and other banks.

According to a report from Senators Carl Levin and Tom Coburn, "Perhaps more than any other single event, the sudden mass downgrades of (residential mortgage-backed securities) and (collateralized debt obligation) ratings were the immediate trigger for the financial crisis." Through reliance on a mathematical model, Moody's and S&P's kept ratings on MBSs at AAA, deeming them as safe as government bonds. However, the report finds that "about 90 percent of AAA securities backed by subprime mortgages from 2006 and 2007 were later downgraded to junk status."

The Senate's Permanent Subcommittee on Investigations spent two years investigating the two agencies; no time was spent on Fitch Ratings.

Reforms called for by the report include putting a stop to the inherent conflict of interest whereby ratings agencies are paid by the companies they rate, and the potential for the U.S. SEC to rank the agencies based on the accuracy of their ratings.

Possibly the most unsurprising fact reported was that email exchanged by employees in 2006 and 2007 indicated they were aware of the potential trouble brewing in the housing market. One email states the agencies (and executives) were developing "a kind of Stockholm syndrome," which is defined as the paradoxical situation "wherein hostages express adulation and have positive feelings towards their captors," as they were relying more and more on issuers of structured financial products (and their deep pockets).

However, the report states "neither company had a financial incentive to assign tougher credit ratings to the very securities that for a short while increased their revenues, boosted their stock prices, and expanded their executive compensation."

The Dodd-Frank financial reform law does little to determine the outcome of the ratings agencies, though it suggests the SEC should write numerous regulations for raters. Most of the regulations have yet to be proposed.

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