The Bond Market's Shaky Foundation

But the subprime debacle has been big enough to disrupt the club. Buyers of packages of subprime mortgages and derivatives based on these packages that have been burnt by rising defaults on these mortgages and falling prices for the debt they hold have angrily wondered if banks issuing the debt disclosed all the risk. And the banks have passed the buck, saying that they relied on the ratings from the three agencies.

Big problems with recently rated issues have turned up the heat on the agencies another notch. For example, as late as March 14, 2007, the day that the New York Stock Exchange delisted New Century Financial, the second-largest subprime mortgage lender in the U.S., the ratings agencies had downgraded fewer than 1% of the subprime mortgage securities issued in 2006.

Buyers were asking why the agencies hadn't moved faster -- and indeed, why they hadn't caught the problem when these mortgage-backed securities hit the market in the first place.

One possible answer is that the ratings agencies have become so entwined with the banks that issue the debt they're called upon to rate that they really aren't independent any longer. A study by Joshua Rosner, a consultant at investment research company Graham Fisher, and Joseph Mason, an associate professor of finance at Drexel University, argues that in the age of increasingly complex derivatives, debt rating agencies often actively work with debt underwriters to ensure that the different pieces, called tranches, of the offering are crafted to earn the necessary credit quality ratings to appeal to investors with different appetites for risk.

Why is that important? Because the agencies have become active participants in structuring the deal so it will sell, the study concludes, and this has compromised the agencies' independence. (If you see a similarity with the accounting profession in the era of the Enron scandal, you aren't alone, and the comparison scares some people on Wall Street silly.)