Why the Ratings Agencies Flunked

"It was an exceedingly opaque approval process and an incredibly restrictive regulation for an important industry that created a barrier to entry and quite possibly affected the way the bond markets work," says White. "After all, the bond markets must pay attention to the NRSROs, because in addition to setting capital requirements, only their ratings will get a bond into a bank portfolio, so a good rating can dramatically raise demand for a bond in the market."

A Small Firm Provides a Model

Even as lawmakers became aware of this government-imposed oligopoly after the dot-com meltdown, they never got around to legislating on the matter until Congress finally passed the Credit Rating Agency Duopoly Relief Act of 2006, a bill designed to lower the barrier to entry and open up the NRSRO process to new firms that could increase competition.

Egan-Jones Ratings, a small but respected ratings firm that has been around for about 15 years, first applied for NRSRO designation in 1998, and was finally approved by the SEC on Dec. 21. Unlike the Big Three, Egan-Jones is paid for its ratings by investors -- not issuers -- and co-founder and President Sean Egan says it has made all the difference.

"It's lunacy to have a ratings system whereby the major ratings firms are paid by the issuers," says Egan. "The issuers' interests are diametrically opposed to the interests of investors, so the issuer-supported credit ratings agencies have no credibility in the market. There's no reason why all these structured finance securities were rated Triple-A. Those are false ratings, and it's becoming increasingly obvious as the mortgage crisis develops."