Rating Agencies Begin to Come Clean

In the wake of one of the biggest blowups in market history -- the subprime meltdown, which continues to wreak havoc on the financial industry -- homeowners, investors, and politicians alike are starting to ask a tough question that will undoubtedly cause some finger-pointing: Who's to blame?

Insert quivering industry here
Surely, many different realms of the market played a hand in the giddy real estate run-up at the core of our current problem. Homeowners paid nosebleed prices, mortgage brokers like Countrywide (NYSE: CFC) were far too lax in their lending practices, and banks like Merrill Lynch (NYSE: MER) and Citigroup (NYSE: C) were naive to issue and hold subprime bonds that were ultimately worth less than a can of beans.

But if any group deserves the most blame for shady practices that gave credence to subprime debt, it might be the rating agencies.

Moody's (NYSE: MCO), McGraw-Hill's (NYSE: MHP), Standard & Poor's, and Fitch Ratings are the three major rating agencies in charge of analyzing the soundness of debt products. They give each product an easy-to-understand rating that investors use to determine risk level. These agencies must now explain whether conflicts of interest skewed the ratings they gave on mortgage-backed debt.

As the fog clears, and more and more ratings get slashed to more realistic levels, it seems that the lure of easy profits may have been the culprit here.

Easy money
These companies made a bundle of money from rating subprime debt products. Moody's, for example, derived almost half of 2006 revenue from rating structured finance. On top of that, the profit margins these agencies could make on structured debt were nearly three times higher than those made by rating boring old municipal bonds.

The benefits were clear: More structured mortgage debt meant big-time profits.

Yeah ... forget what we said in the past ...
Since the start of the subprime downturn last summer, hundreds of billions worth of subprime-backed securities have been downgraded by the same agencies that initially deemed them sound. As it becomes more apparent how far off some of these ratings were, it appears that the ratings agencies are starting to admit their mistakes, and they've begun taking steps to overhaul their practices.

Moody's, for example, announced a new rating system designed specifically for CDOs; rather than the current letter grades, it would rate each product on a numerical scale between one and 21.

In a more broad admission of defeat, Moody's is even considering placing warning labels on ratings -- essentialy acknowledging that you might want to take their analysis with a grain of salt.

Things might get ugly for the rating agencies going forward. When your business model rests on the your reputation for accuracy -- as it does with rating agencies -- losing the investment community's respect could put you in quite a pickle.

Moody's has lost more than half of its value in the past year; McGraw-Hill isn't too far behind. As the financial industry gets back on its feet and determines how much overkill took place in the debt market over the past decade, we'll get more information on how much business rating agencies might stand to lose.

Until then, check out this related Foolishness:

• What a Rating Downgrade Really Means
• The Ratings Game
• The Subprime Soap Opera Continues