2008 crisis still hangs over credit-rating firms

• Credit-rating agencies blamed for role in the financial crisis
• Issuers of debt securities still pay agencies for their ratings %u2014 a conflict of interest%2C critics say
• Firms say reforms have been made since 2008

Lehman Bros. wasn't the only storied name on Wall Street to get sullied when the investment bank filed for bankruptcy protection five years ago.

The big three credit-rating agencies — Standard & Poor's, Moody's Investors Service and Fitch Ratings — are still trying to repair their reputations as being a level-headed, sharp-penciled bunch following the collapse of Lehman. These agencies are roundly criticized for not only failing to warn investors of the dangers of investing in many of the mortgage-backed securities at the epicenter of the financial crisis, but benefiting by not pointing out deficiencies.

S&P is being sued by the Department of Justice over its role. Some academic financial experts say that credit-rating agencies haven't changed. But the rating agencies strongly disagree, saying they've learned from the debacle and have made meaningful adjustments to their due diligence.

"They (credit-rating agencies) understood that they were pushing the envelope on these products, but they didn't care," says John Griffin, professor of finance at the University of Texas-Austin. "They were focused on the profit they were getting from the deal."

The agencies' ratings played a critical role in the marketing of risky mortgage-backed securities, such as collateralized debt obligations, which helped bring the U.S. financial system to its knees.

Investment banks had bundled collections of individual mortgages, which by themselves can be hard to trade, into baskets that could be bought and sold like any bonds. These financial instruments were then sold to investors. But in order to sell them, the investment banks counted on them receiving stellar ratings from the agencies to tempt investors starved for return.

Commanding a top price for the securities wasn't the only reason. High ratings were critical in allowing the investment banks to sell them at all. For instance, many money market funds are only allowed to invest in debt that fits the highest ratings categories.

"We conclude the failures of credit-rating agencies were essential cogs in the wheel of financial destruction," according to the report submitted by the Financial Crisis Inquiry Commission in January 2011. "The three credit-rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval."

But despite the lessons learned from the financial crisis, analysts say that shortcomings with credit-rating agencies still exist, and the problems could happen again because of:

• Analyses that rely too much on the recent past. Credit-rating agencies make the classic mistake of thinking recent financial history is likely to repeat, says Bonnie Baha, portfolio manager at DoubleLine Capital.

Lehman Bros.' own debt still had an investment grade rating when it filed for bankruptcy protection, Baha says. Credit-rating agencies and investors made the mistake of thinking that because the federal government intervened with Bear Stearns, it would do the same with Lehman. Bear Stearns was sold to JPMorgan Chase in a government engineered takeover that protected Bear's debt holders. Investors betting the same would be done with Lehman lost big, she says.

The agencies made a similar error in rating structured debt products whose value was tied to mortgages, such as collateralized debt obligations, or CDOs. The rating agencies looked at recent trends in housing and decided to base their worst-case analysis on a 10% decline in the housing market, Baha says. But home prices fell by more than that, demonstrating their models were way too conservative, she says.Even today, many credit-rating agencies continue to pay too much attention to recent history rather than using human judgment to determine how a market might change, she says.

"Recent history is not a particularly good indicator for the future in real estate," she says.

• A profit incentive to be uncritical. Credit-rating agencies are paid by the companies that issue debt. This model creates a big incentive for agencies to "bend their standard to gain business," Griffin says. Structured debt products were especially vulnerable to ratings inflation for the sake of business. These products would most likely fail if the economy short-circuited, allowing credit-rating agencies the ability to say that the economic downturn changed the facts, he says.

Additionally, the products were being created and the ratings paid for by investment banks, which were focused on boosting short-term profitability, he says. Despite roughly 75% of the debt securities getting the top AAA rating from agencies, ultimately more than 70% of CDOs defaulted, Griffin says.

• Over-reliance on ratings. One of the biggest reasons why credit ratings held so much sway is because investors relied on them too much. Rather than doing their own due diligence, many investors simply looked at a bond's rating and used that as their guide, Baha says. That's a mistake, as investors found. But investors often had no alternative. Many debt products were so complicated only the credit-rating agencies had access to the details about the individual loans in the portfolios, Griffin says. Additionally, 86% of CDOs had ratings from two agencies, giving them more perceived credibility when they scored top ratings, Griffin says.

There have been some reforms.

Moody's, for instance, now factors into its ratings "systemic support" or the chances that a bank could get bailed out if it got into trouble. The Dodd-Frank Wall Street Reform and Consumer Protection Act also adds new regulation, including continuing on-site oversight of the agencies. Additional disclosures are required for ratings of asset-based securities. Changes are also being phased in that would allow investors to buy certain securities, even if they do not meet certain credit ratings, such as the top credit ratings.

"S&P has taken to heart the lessons learned from the financial crisis. In the past five years, we have spent approximately $400 million to reinforce the integrity, independence and performance of our ratings. We also brought in new leadership, instituted new governance and enhanced risk management. Based on what we learned, we changed the way we rate almost every type of security that was affected by the financial crisis," said Standard & Poor's in a statement.

But little has changed in how credit-rating agencies operate, potentially setting them up for being a part of the next financial problem, Griffin says.

"Have there been any admissions of guilt by credit-ratings agencies? The answer seems to be no," he says, adding that the next problem will likely be something other than mortgage-backed securities. "It could definitely happen again."