Credit rating agencies are now under scrutiny for having given investment-grade ratings to CDOs and MBSs based on subprime mortgage loans. These high ratings were believed justified because of risk reducing practices, including over-collateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. However, there are also indications that some involved in rating subprime-related securities knew at the time that the rating process was faulty. Emails exchanged between employees of rating agencies, dated before credit markets deteriorated and put in the public domain by USA Congressional investigators, suggest that some rating agency employees suspected that lax standards for rating structured credit products would result in major problems.[81] For example, one 2006 internal Email from Standard & Poor's stated that "Rating agencies continue to create and [sic] even bigger monster—the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters."[82]
High ratings encouraged investors to buy securities backed by subprime mortgages, helping finance the housing boom. The reliance on agency ratings and the way ratings were used to justify investments led many investors to treat securitized products — some based on subprime mortgages — as equivalent to higher quality securities. This was exacerbated by the SEC's removal of regulatory barriers and its reduction of disclosure requirements, all in the wake of the Enron scandal.[83]
Critics allege that the rating agencies suffered from conflicts of interest, as they were paid by investment banks and other firms that organize and sell structured securities to investors.[84] On 11 June 2008, the SEC proposed rules designed to mitigate perceived conflicts of interest between rating agencies and issuers of structured securities.[85] On 3 December 2008, the SEC approved measures to strengthen oversight of credit rating agencies, following a ten-month investigation that found "significant weaknesses in ratings practices," including conflicts of interest.[86]
Between Q3 2007 and Q2 2008, rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities. Financial institutions felt they had to lower the value of their MBS and acquire additional capital so as to maintain capital ratios. If this involved the sale of new shares of stock, the value of the existing shares was reduced. Thus ratings downgrades lowered the stock prices of many financial firms.[87]
In December 2008 economist Arnold Kling testified at congressional hearings on the collapse of Freddie Mac and Fannie Mae. Kling said that a high-risk loan could be “laundered” by Wall Street and return to the banking system as a highly rated security for sale to investors, obscuring its true risks and avoiding capital reserve requirements.[88]
