Why the Ratings Agencies Flunked

Editor's note: The credit markets have been the epicenter of volatility on Wall Street throughout the second half of 2007. Falling home prices and subsequent defaults on mortgage-backed securities led to a liquidity crisis that's expected to get messier in 2008. The outlook for companies in the financial sector and beyond is dim as corporate profits weaken amid a weakening economy and rising inflationary pressures. This is the fourth installment in an ongoing series about how the tumult in the credit markets will affect the economy and the markets in 2008. Earlier stories looked at mortgage lenders, banks and brokerages.

Here's a New Year's resolution for Wall Street: Stop letting credit ratings agencies get paid by debt issuers for grades that can make or break their products.

In the mortgage debacle that plunged U.S. financial markets into crisis last year, there's no shortage of culprits. Snake oil-selling lenders, naive borrowers, delusional investment bankers and snoozing regulators all fit the bill, but the major credit rating agencies stand out as the chief enablers.

Blessed by government regulators with their unique and exclusive authority, the ratings firms institutionalized the notion that securities backed by subprime loans were basically risk-free.

In other words, rather than fulfilling their proper role in the market by warning investors about the obvious risks involved in these securities, they instead opened the floodgates to all those bad actors and created a systemic problem.

Why did the credit ratings agencies fail so spectacularly? There's one simple reason: They were paid handsomely for their stamp of approval by the very financiers who were packaging up the bad loans and selling them around the world.

Moody's Investors Sue Over Subprime

"It's as if movie studios hired film critics to review their movies, and paid them only if the reviews were positive enough to get lots of people to see a movie," former Labor Secretary Robert Reich wrote on his blog. "The whole thing rested on a conflict of interest analogous to that of stock analysts who, before the dotcom bubble burst, advised clients to buy stocks their own investment banks were issuing."

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