Why the Ratings Agencies Flunked

Credit ratings agencies have acknowledged the potential for a conflict of interest in their business model, but have said they've taken strict measures to prevent such a conflict from ever taking root. They also acknowledge fundamental misjudgments on subprime debt issues, but say that in many cases, fraud was committed by borrowers and lenders.

Enron and WorldCom Were Red Flags

At the turn of the century, a bull market ended when a stock bubble burst and conflicts of interest for equity analysts were dragged into the limelight. This time around, a five-year bull market seems to have concluded with the bursting of a credit bubble, and credit analysts are in the crosshairs. That said, the fundamental flaw in how credit ratings work on Wall Street is hardly a recent epiphany.

The so-called Big Three ratings agencies -- Moody's Investors Service (MCO Quote), Fitch Ratings and McGraw-Hill's(MHP Quote) Standard & Poor's -- held investment-grade ratings on Enron only days before the company filed for bankruptcy in 2001. They also missed the boat on WorldCom and other flameouts from that era, leading to a series of hearings on Capitol Hill that shed light on what Lawrence White, professor of economics at NYU's Stern School of Business, calls "the best-kept secret in Washington, D.C."

In the mid-1970s, the Securities and Exchange Commission established capital requirements for banks, insurance companies and other financial institutions. Those requirements would depend on credit ratings from firms designated by the SEC as Nationally Recognized Statistical Rating Organizations, or NRSROs, and Wall Street's Big Three ratings firms were immediately grandfathered in.

Over the next quarter-century, the SEC extended the designation to only a handful of additional firms. It never defined standards for the designation, and it never acknowledged the receipt of an application from other players.