INVESTING: Rating agencies not alone in missing subprime mess

The business of rating debt securities is dominated by three firms: Moody’s, Standard & Poor’s, and Fitch. Their practices now are under fire with the subprime meltdown.

Two weeks ago, we discussed securitization, a process whereby mortgages are pooled together, sliced up into securities, and sold to investors. The job of the rating agencies is to attach a rating to these securities that is based on their analysis of the risk of the underlying mortgages. Many investors, including pension plans, hedge funds and individual investors, rely on these ratings when selecting securities.

Rating securities is a lucrative business. The value of “structured finance” deals, which encompasses securitizations, has grown 27 percent a year for the past four years, reaching more than $3 trillion in 2006. Moody’s received 44 percent of its revenue from ratings in structured finance and has collected $3 billion in revenue from this activity since 2002. The pretax profit margins of the credit rating agencies are among the highest in corporate America.

Yet these agencies now are the subject of much finger-pointing as the subprime fiasco escalated and eventually crippled the credit markets. Investors who have seen the value of their mortgage securities plunge-some of which originally were high-rated bonds-are crying foul, arguing that the agencies gave high ratings to risky securities.

Additionally, many are complaining that the rating firms were far too late in downgrading the ratings on securities that were sinking in value. It wasn’t until July that Moody’s and Standard & Poor’s conducted a massive round of rating downgrades on nearly 1,000 subprime mortgage securities.

The debacle has attracted the attention of regulators who are looking into conflicts of interest in the ratings business. To begin with, there is some collaboration between the issuer and the rating firms when these securitizations are designed, to make sure the pool of securities is of high enough quality to get a marketable rating. The rating firms then are paid by the issuer to attach a rating to the securities.

So now everyone-including Congress and the Securities and Exchange Commission-is investigating the rating firms.

For their part, the credit-rating firms maintain they have strong systems to prevent conflicts of interest. They claim their ratings are merely published opinions that investors are free to heed or ignore. And they point to the public warnings they issued in 2006 and early 2007, in which they stated they were seeing deterioration in subprime mortgages. Yet, during that time, few securities were downgraded.

There is plenty of blame to go around for the subprime mess, including to the lenient lenders, the Wall Street firms issuing the securities, and even some home buyers who sought the easy mortgages. And the ratings firms do share some responsibility, which may lead to reform in their business practices. However, the professional investors, who bought the risky mortgages with loads of leverage, and whose job it is to know what they are buying, do not deserve our sympathy.