A story in the Wall Street Journal looks at the role the major rating agencies — Fitch, S&P, and Moody’s — have played in aiding and abetting the current mortgage market crisis. (The WSJ story focuses just on subprime, but why stop there?) From the Journal:

It was lenders that made the lenient loans, it was home buyers who sought out easy mortgages, and it was Wall Street underwriters that turned them into securities. But credit-rating firms also played a role in the subprime-mortgage boom that is now troubling financial markets. S&P, Moody’s Investors Service and Fitch Ratings gave top ratings to many securities built on the questionable loans, making the securities seem as safe as a Treasury bond. Also helping spur the boom was a less-recognized role of the rating companies: their collaboration, behind the scenes, with the underwriters that were putting those securities together. Underwriters don’t just assemble a security out of home loans and ship it off to the credit raters to see what grade it gets. Instead, they work with rating companies while designing a mortgage bond or other security, making sure it gets high-enough ratings to be marketable.

You’ll want to subscribe to read the full story, which looks at how potential conflicts of interest have come into play throughout the ratings process — according to the story, Moody’s raked in roughly $3 billion between 2002 and 2006 off of its structured finance activities (which includes structuring RMBS deals). Bloomberg also ran a similar story, looking at the rating agencies’ role in one of the newest esoteric derivatives — CPDOs, which are essentially structured credit default swaps:

The New York-based ratings firms last month gave a new breed of credit derivatives triple-A ratings, indicating they were as safe as U.S. Treasuries. Now, investors are being offered as little as 70 cents on the dollar for the constant proportion debt obligations, securities that use credit-default swaps to speculate that companies with investment-grade ratings will be able to repay their debt.

Obviously, the agencies have taken some pretty dramatic steps to revise their rating criteria in the mortgage space; part of the reason this is being done is because it has to be done. But the question now from many is why none of the agencies seemed to have seen it coming earlier and reacted then; frankly, it’s a question that I’d expect regulators and legislators to look into in more depth in coming months. Of course, the answer here is a simple one: because everybody with skin in this game — and I mean everybody — had something big to lose. For the rating agencies, a move to change rating criteria would not only undermine a large chunk of revenue, but it would take a large part of the market’s confidence in the ratings process with it. Further, the first agency to move likely would forfeit market share — witness what’s taken place at Moody’s in terms of its commercial ratings business. Investors will take their business to the agency that gives them the most favorable criteria. Further, it’s not as if investors really wanted to see any changes in the first place — I know of plenty of money managers who knew all along they were sitting on trash, but were more than happy to rake in their fees so long as the ratings held up. I’ve even posted a story about it. Why give up an easy million or two if someone isn’t forcing you to do so? It’s no wonder, then, that the agencies chose to sit on their hands. And any money manager indignantly feigning anger over why the rating agencies failed to act already knows the real reasons why.