Credit Crunch Characters (6) - Credit Rating Agencies

Margins on mortgage lending are tight, so the best way to extract more profit is to reduce the cost of funding by reducing risk. The credit rating agencies, like Moody’s and Standards and Poor’s had developed sound reputations over many years of assessing the creditworthiness of corporations and financial institutions. They started assigning their rating to Mortgage Backed Securities and Collateralised Debt Obligations.

An AAA rating from one of these agencies increases the value of a security and reducing the cost of borrowing, because investors just assumed that these AAA rated securities would never lose value. The increase in profit received by the investment bank more than covered the cost of obtaining the credit rating.

The credit rating agencies earned enormous fees and the investment banks gained more profit. Everyone was happy… until houses prices dropped and foreclosures increased. Suddenly, the risk attached to the mortgage based securities has increased significantly. Now it is becoming clear that the credit rating agencies had totally misunderstood the quality of the securities they were assessing. Many of these securities still have an AAA credit rating, but everyone knows that they not a safe investment.

The credit rating agencies were naïve or devious.