Despite the regulatory response to

Despite the regulatory response to the Enron crisis, the credit rating agencies found themselves amidst controversy again when, in 2008, many subprirne residential mortgage-backed securities began to default and were subjected to rating downgrades. Although many participants share responsibility for the crumbling financial market, regulators have cited credit ratings in general and credit rating agencies in particular, as having failed the marketplace.
Despite the reforms made to the regulation of capital markets in the early part of the decade, the current turmoil in the financial markets has left regulators and government entities struggling to determine what went wrong and why. Indeed, the President's Working Group on Financial Markets ("President's Working Group") has considered the issue at length and drawn several conclusions. They point out that investors were relying excessively on credit ratings, which contributed to [the investors') complacency about the risks they were assuming in pursuit of higher returns. This stemmed, in large part, from the increasingly complex products in the financial industry, which in turn, forced investors to rely more heavily on the assessment of the experts. The credit ratings produced by credit rating agencies, however, were not as reliable, and thus were more likely to default than in previous years. For example, a study by financial economists showed that the five-year cumulative default rate on corporate bonds rated "Baa" by Moody's between 1983 and 2005 was 2.2%, but the rate between 1994 and 2005 on collateralized debt obligations comparably rated was 24%. Thus, when corporate bonds and collateralized debt obligations received identical ratings, those ratings represented vastly different opinions of creditworthiness. Because financial products were becoming increasingly complex, the relative risk associated with a particular credit rating increased. Investor behavior, however, was not correspondingly more prudent, and it is rational to conclude that investors imputed the relative risk to the rating itself, rather than the product itself. The trouble materialized when confidence in credit ratings on some products, namely subprime RMBS, began to erode. The seeds of doubt sown, confidence fell in the entire asset-backed commercial paper market because the NRSROs issued extensive downgrades even on newly rated securities. Downgrading newly rated securities sends the message to the market and to investors that these securities, and perhaps others, were not effectively rated from the outset. Such messages can only serve to create additional anxiety, an emotion that does not contribute to growing capital markets.
In response to the market crises, the President's Working Group issued many recommendations. These recommendations include improving the integrity and transparency of the credit rating agencies processes and practices and taking steps to ensure that the world's financial institutions manage risk more effectively. Specifically, the President's Working Group recommends that credit rating agencies disclose the nature of the qualitative reviews they perform on originators; require the underwriters of asset-backed securities to disclose the due diligence performed on the underlying assets; manage conflicts of interest; assist investors in understanding credit ratings by making public information regarding their rating methodologies; employ different models for rating structured products from corporate and municipal securities; make rating performance statistics available; and more effectively monitor and update ratings.