California, one of the hardest-hit states in the mortgage meltdown, has launched an investigation into credit rating agencies' role in fueling the financial crisis.
California Attorney General Edmund G. Brown Jr. today issued subpoenas to Standard & Poor's, Moody's and Fitch to determine whether the firms violated California law when they gave stellar ratings to assets that turned out to be shaky.
"Standard & Poor's, Moody's and Fitch put their seal of approval on high risk mortgage-backed securities, recklessly giving stellar ratings to shaky assets that proved toxic to the entire financial system," Brown said. "This investigation is meant to determine how these agencies could get it so wrong and whether they violated California law in the process."
Moody's Investors Service, Standard & Poor's, and Fitch Ratings grade the creditworthiness of corporations and municipalities and the financial instruments, including bonds and securities, they issue. Investors depend on these ratings to gauge risk and make investment decisions.
At the peak of the housing boom, these agencies gave their highest ratings to complicated financial instruments -- including securities backed by subprime mortgages -- making them appear as safe as government-issued Treasury bonds.
In rating these securities, Brown maintains the agencies worked behind the scenes with the same Wall Street firms that created them. For their work, he says the firms earned billions of dollars in revenue, at a rate nearly double what they earned for rating other financial products.
Banks, pension funds and other investors relied on these ratings when they purchased trillions of dollars of securities backed by subprime mortgages because of the high returns and apparent low-risk. Those purchases helped fuel the housing bubble by providing funding for lenders to issue ever-riskier subprime and other toxic mortgages. When the bubble burst, however, those risky mortgages defaulted in record numbers and investors were left holding worthless securities, unable to sell them.
Subsequently, the agencies downgraded the credit ratings of $1.9 trillion in residential mortgage backed securities, a tacit acknowledgement of their failure to adequately assess the risks of the debt they rated. The rating agencies either ignored or did not understand the risks of the debt they rated.
Given the role the rating agencies' played, Brown is directing the agencies to provide by October 19, 2009 information that will help answer questions designed to establish whether the rating agencies failed to conduct adequate due diligence in the rating process.