The risk of corporate bonds must be rated by government-approved rating agencies before their sale to investors. These ratings are very important to bond issuers and bond investors. For issuers, higher-rated (deemed lower-risk) bonds could offer lower yields. For investors, the ratings help them trade off risk against yield. Specifically, they might be willing to take higher risk if the yields are higher. Banks, on the other hand, are mostly interested in investment-grade bonds because they are acceptable to regulators as capital collateral. Similarly, many insurance companies, pension funds, and mutual funds are barred from buying bonds below investment grade. Thus, a lot of money is riding on how the bonds are rated. The rating agencies used slightly different labels to finely classify the risks of bonds. In the case of Moody’s (one of the three rating agencies approved by the SEC, the minimum investment grade is Baa3 (Wikipedia.com).

If bond ratings are so financially critical, it stands to reason that some parties might be tempted to game the system. Rating agencies are not above temptation since their revenues depend on the business from bond issuers. A subtle threat by bond issuers to take the business to competing rating agencies may be enough to change some borderline ratings in favor of the bond issuers (WSJ 10/23/2008). It is this subtle transformation of normally healthy market service into shady bribery that corrupted the integrity of the rating system.

And judging from the quantity of mortgage-backed securities successfully marketed by investment banks, the rating agencies must have closed their eyes to many questionable mortgage loans to subprime borrowers (see Bubble Economics). In 2006, subprime-mortgage origination amounted to 20% of total mortgage originations, up from only 7% in 2001. Rising loan defaults which precipitated the housing bust in 2007 attested to the shoddy jobs that the rating agencies have done. Ironically, although rating agencies were the hand-maidens of the housing bust, they did not make out big during the housing boom. It was the executives of the investment banks, commercial banks and hedge funds who pocketed most of profits even though they might have engineered the credit debacle (Fortune 9/17/2007).

There is, of course, enough blame to go around all the players. However much faith some people might have in the free-market system, the frailty of human nature will ensure that the circuit breakers will fail to perform once mob hysteria starts to spin out of control.

As a part of the financial regulation reform package, the US Senate has approved the creation of an SEC (Securities and Exchange Commission) board to independently match ratings agencies with bond issuers. It is hoped that this middleman board might reduce the conflict of interest inherent in the existing system of bond issuers choosing and paying an agency to rate their bonds (WSJ 5/14/2010).