THE BLOG
03/18/2010 05:12 am ET | Updated May 25, 2011

Credit Rating Agencies and the Next Financial Crisis

I recently chaired an Oversight and Government Reform Committee hearing to examine the role credit rating agencies contributed to the financial crisis. Credit rating agencies play a powerful role in our economy and they played a starring role in the collapse of the financial system last year.

The main mission of credit rating agencies is to tell investors the risk level of bonds and other debt securities. Pension plans, banks, insurance companies, and other investors depend on these ratings to help them decide where to invest their funds.

Unfortunately, for the past decade, the credit rating system has not worked well at all. Last year, my committee learned that ratings did not capture the true risk of many deals, because the rating agencies were more concerned with their own bottom lines. In turn, millions of people have had their pensions wiped out, seen their life savings evaporate or lost their homes due to foreclosure.

A year after the collapse of Lehman Brothers and the massive government bailout of AIG, Bank of America, and others, it looks like not much has changed. During the hearing we heard compelling testimony from two senior employees at Moody's who described a culture of tainted ratings and lax regulatory compliance at the agency which helped contribute to the financial collapse.

Eric Kolchinsky, a former Managing Director in charge of rating residential mortgage backed securities at Moody's, testified that conflicts of interest, inadequate methodologies and lack of independence for the Credit Policy and Compliance groups significantly contributed to the shoddy performance of Moody's ratings. According to Mr. Kolchinsky, Moody's has adopted "new" methods that actually maintain the status quo and continue to undermine the reliability of their ratings.

We also heard testimony from Scott McCleskey, the former head of compliance at Moody's, who stated that the firm failed to take the problems within their municipal securities division seriously until after the credit crisis. Mr. McCleskey also testified that when he raised the issue with his superiors at Moody's, they repeatedly ignored his recommendations, and in some cases they "responded" by reducing his staff.

In addition, both witnesses described a workplace where the very act of putting things in writing was frowned upon. Can you imagine working at a place where the very act of writing a memo or sending an email is suspect?

Throughout the investigation we learned that the culture of secrecy extended to companies outside Moody's as well. Moody's told us they retained an outside law firm, Kramer, Levin, to investigate Mr. Kolchinsky's allegations of illegal conduct. But on the day of our hearing, we learned that this outside firm was given only oral instructions for this review. Moody's says no written statement of work was prepared and there was no contract specifying the work to be done -- and, this outside firm is not expected to produce any written report of its findings and has no schedule for completion.

Based on the witness testimony and the Committee investigation, it is clear that credit ratings agencies must shed the culture of secrecy and shady practices that is deep-rooted in their operations. The Moody's business model of "Leave No Fingerprints" might be alright if the credit rating agencies had not played a starring role in the collapse of the financial system. For that reason, this cannot continue. It is very clear to me at this point that effective legislation, which the House and Senate are currently working on, is needed, along with effective oversight. If not, the testimony we heard will just be the opening chapter of what promises to be a sordid story.