Criticism About The Policies of Credit Rating Agency

In the wake of the financial crisis of 2007–2010, the Financial Crisis Inquiry Report called the "failures" of the Big Three rating agencies "essential cogs in the wheel of financial destruction." SEC Commissioner Kathleen Casey complained the ratings of the large rating agencies were "catastrophically misleading", yet the agencies "enjoyed their most profitable years ever during the past decade" while doing so.
In their book on the crisis — All the Devils Are Here — journalists Bethany McLean, and Joe Nocera, criticized rating agencies for continuing "to slap their triple-A [ratings]s on subprime securities even as the underwriting deteriorated -- and as the housing boom turned into an outright bubble" in 2005, 2006, 2007. McLean and Nocera blamed the practice on "an erosion of standards, a willful suspension of skepticism, a hunger for big fees and market share, and an inability to stand up to" investment banks issuing the securities. The February 5th 2013 issue of Economist stated "it is beyond argument that ratings agencies did a horrendous job evaluating mortgage-tied securities before the financial crisis hit."
More generally, some of the criticisms credit rating agencies have been subject to include:

Failure to downgrade securities promptly and laxness

Critics have complained that credit rating agencies often times do not downgrade companies ratings until after or just before bankruptcy. While agencies have charts and studies demonstrating that their ratings are accurate a very high percentage of the time, according to journalists McLean and Nocera, the rating agencies
missed the near default of New York City, the bankruptcy of Orange County, and the Asian and Russian meltdowns. They failed to catch Penn Central in the 1970s and Long-Term Capital Management in the 1990s. They often downgraded companies just days before bankruptcy -- too late to help investors. Nor was this anything new: one study showed that 78% of the municipal bonds rated double A or triple-A in 1929 defaulted during the Great Depression.
In the case of Enron, though its stock had been in "precipitous decline" since October 2001 and credit rating agencies had been aware of the company's problems for months, its rating remained at investment grade until four days before the company went bankrupt on December 2, 2001. In the aftermath, "not a single analyst at either Moody's of S&P lost his job as a result of missing the Enron fraud". Management remained unchanged and Moody's stock price underwent no long term damage. McLean and Nocera quote one insider as saying `Enron taught them how small the consequences of a bad reputation were.`
Despite troubles in the mortgage industry, Freddie Mac's preferred stock was awarded the top rating by Moody's until mid-2008 when Warren Buffett told CNBC he had "passed on an opportunity to help the troubled mortgage giant". The next day Moody's downgraded Freddie to one tick above junk bonds. Some empirical studies have documented that rather than a downgrade by a CRA lowering the value and raising the interest rates of corporate bonds, cause and effect is reversed. Yield spreads of corporate bonds start to expand as credit quality deteriorates, preceeding a rating downgrade and casting doubt on the informational value of credit ratings. This has led to suggestions that financial regulators should instead require banks, broker-dealers and insurance firms (among others) to use credit spreads, not CRA ratings, when calculating the risk in their portfolio.

Cosy relationships with securities issuers

Originally rating agencies sold their service as a subscription to bond/debt buyers who wanted to know how safe the bonds they were considering buying were. In the 1970s first Fitch and then Moody's and S&P abandoned that model in favor of charging bond issuers directly. More revenue was earned this way because many investors wouldn't buy an unrated bond so issuers wanted to be rated, while subscriptions were "always going to be optional" for bond buyers because information about ratings changes from the larger CRAs could spread so quickly (by word of mouth, email, etc.). However the new model meant that the rating agencies "were potentially beholden to the same people whose bonds they were rating", possibly opening themselves to undue influence or the vulnerability of being misled.
In the structured finance boom of the mid-2000, high ratings of securities were vital because larger group of investors — money market funds and pension funds — were forbidden by their bylaws to buy securities not rated a triple-A. An incestuous relationship between financial institutions and the credit agencies developed such that, banks began to leverage the credit ratings off one another and 'shop' around amongst the three big credit agencies until they found the best ratings for their CDOs. Often they would add and remove loans of various quality until they met the minimum standards for a desired rating, usually, AAA rating. Often the fees on such ratings were $300,000–500,000, but ran up to $1 million. Subpoena emails later revealed issuers openly threatened to take their business to another rating agency if the agency's ratings were not high enough. As of 2011, more than half of the CDOs originally rated triple-A were "impaired"—either having lost principal or been downgraded to "junk" status. One study of "6,500 structured debt ratings" produced by Standard & Poor’s, Moody's and Fitch, found ratings by agencies "biased in favour of issuer clients that provide the agencies with more rating business."

Unwillingness to spend on human resources

While Moody's and other credit rating agencies were quite profitable — Moody's operating margins were consistently over 50%, higher than famously successful Exxon Mobil or Microsoft, and its stock rose 340% between the time it was spun off into a public company and February 2007 — its pay was low by Wall Street standards and its employees complained of overwork.
Journalist Michael Lewis argues that the low pay of credit rating agency employees allowed security issuers to game the ratings of their securities. Lewis quotes one Goldman Sachs "trader-turned hedge fund manager" telling him, "guys who can't get a job on Wall Street get a job at Moody's," as Moody's paid much less. This seemed surprising to at least one other Wall Street personality because the ratings produced by analysts at Moody's and other credit raters had considerably more effect on the markets than those of the higher paid analysts at investment banks. "Nobody gives a f**k if Goldman Sachs likes General Electric paper, if Moody's downgrades GE paper, it is a big deal. So why does the guy at Moody's [want to work at Goldman Sachs]"? However, this difference in pay meant that the "smartest" analysts at the credit rating agencies "leave for Wall Street firms where they could use their knowledge (of criteria used to rate securities) to manipulate the companies they used to work for." Consequently, it was widely known on Wall Street that the "inner workings" of the rating models used by the credit rating agencies, while "officially, a secret", "were ripe for exploitation." At least one other investment firm that bet against the agencies' credit ratings believed “there was a massive amount of gaming going on.”
When asked by the Financial Crisis Inquiry Commission about "the high turnover" at rating agencies the "revolving door that often left raters dealing with their old colleagues, this time as clients", Moody's president Brian Clarkson noted that investment banks paid more than his agency so retaining employees was always a challenge. Moody’s employees were prohibited from rating deals by a bank or issuer while they were interviewing for a job with that particular institution, but notifying management of any such interview was the responsibility of the employee. After getting a job at an investment bank former employees were barred from interacting with Moody’s on "the same series of deals they had rated while in its employ", but not on any other deals with Moody’s.
Lack of analysts also affected ratings quality according to journalists Bethany MacLean and Joe Nocera.
"The analysts in structured finance were working 12 to 15 hours a day. They made a fraction of the pay of even a junior investment banker. There were far more deals in the pipeline than they could possibly handle. They were overwhelmed. Moody's top brass ... wouldn't add staff because they didn't want to be stuck with the cost of employees if the revenues slowed down."

Soliciting business by threatening to downgrade

While often accused of being too close to company management of their existing clients, CRAs have also been accused of engaging in heavy-handed "blackmail" tactics in order to solicit business from new clients, and lowering ratings for those firms . For instance, Moody's published an "unsolicited" rating of Hannover Re, with a subsequent letter to the insurance firm indicating that "it looked forward to the day Hannover would be willing to pay". When Hannover management refused, Moody's continued to give Hannover Re ratings, which were downgraded over successive years, all while making payment requests that the insurer rebuffed. In 2004, Moody's cut Hannover's debt to junk status, and even though the insurer's other rating agencies gave it strong marks, shareholders were shocked by the downgrade and Hannover lost $175 million USD in market capitalization.

Downgrading that leads to a vicious cycle

The lowering of a credit score by a CRA can create a vicious cycle and self-fulfilling prophecy, as not only interest rates for that company would go up, but other contracts with financial institutions may be affected adversely, causing an increase in expenses and ensuing decrease in credit worthiness. In some cases, large loans to companies contain a clause that makes the loan due in full if the companies' credit rating is lowered beyond a certain point (usually a "speculative" or "junk bond" rating). The purpose of these "ratings triggers" is to ensure that the bank is able to lay claim to a weak company's assets before the company declares bankruptcy and a receiver is appointed to divide up the claims against the company. The effect of such ratings triggers, however, can be devastating: under a worst-case scenario, once the company's debt is downgraded by a CRA, the company's loans become due in full; since the troubled company likely is incapable of paying all of these loans in full at once, it is forced into bankruptcy (a so-called "death spiral"). These rating triggers were instrumental in the collapse of Enron. Since that time, major agencies have put extra effort into detecting these triggers and discouraging their use, and the U.S. Securities and Exchange Commission requires that public companies in the United States disclose their existence.

Conflict of interest in assigning sovereign ratings

It has also been suggested that the credit agencies are conflicted in assigning sovereign credit ratings since they have a political incentive to show they do not need stricter regulation by being overly critical in their assessment of governments they regulate.
As part of the Sarbanes-Oxley Act of 2002, Congress ordered the U.S. SEC to develop a report, titled "Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets" detailing how credit ratings are used in U.S. regulation and the policy issues this use raises. Partly as a result of this report, in June 2003, the SEC published a "concept release" called "Rating Agencies and the Use of Credit Ratings under the Federal Securities Laws" that sought public comment on many of the issues raised in its report. Public comments on this concept release have also been published on the SEC's website.
In December 2004, the International Organization of Securities Commissions (IOSCO) published a Code of Conduct for CRAs that, among other things, is designed to address the types of conflicts of interest that CRAs face. All of the major CRAs have agreed to sign on to this Code of Conduct and it has been praised by regulators ranging from the European Commission to the U.S. Securities and Exchange Commission.

Oligopoly produced by regulation

Agencies are sometimes accused of being oligopolists, because barriers to market entry are high and rating agency business is itself reputation-based (and the finance industry pays little attention to a rating that is not widely recognized). In 2003, the US SEC submitted a report to Congress detailing plans to launch an investigation into the anti-competitive practices of credit rating agencies and issues including conflicts of interest.
Of the large agencies, only Moody's is a separate, publicly held corporation that discloses its financial results without dilution by non-ratings businesses, and its high profit margins (which at times have been greater than 50 percent of gross margin) can be construed as consistent with the type of returns one might expect in an industry which has high barriers to entry. Celebrated investor Warren Buffet described the company as “a natural duopoly,” with “incredible” pricing power, when asked by the Financial Crisis Inquiry Commission about his ownership of 15% of the company.
According to professor Frank Partnoy, the regulation of CRAs by the SEC and Federal Reserve Bank has eliminated competition between CRAs and practically forced market participants to use the services of the three big agencies, Standard and Poor's, Moody's and Fitch.
SEC Commissioner Kathleen Casey has said that these CRAs have acted much like Fannie Mae, Freddie Mac and other companies that dominate the market because of government actions. When the CRAs gave ratings that were "catastrophically misleading, the large rating agencies enjoyed their most profitable years ever during the past decade."
To solve this problem, Ms. Casey (and other such as NYU professor Lawrence White) have proposed removing the NRSRO rules completely. Professor Frank Partnoy suggests that the regulators use the results of the credit risk swap markets rather than the ratings of NRSROs.
The CRAs have made competing suggestions that would, instead, add further regulations that would make market entrance even more expensive than it is now.

Regulatory reliance on credit ratings

Think-tanks such as the World Pensions Council have argued that European powers such as France and Germany pushed dogmatically and naively for the adoption of the so-called “Basel II recommendations”, adopted in 2005, transposed in European Union law through the Capital Requirements Directive (CRD), effective since 2008. In essence, they forced European banks, and, more importantly, the European Central Bank itself when gauging the solvency of financial institutions, to rely more than ever on standardized assessments of credit risk marketed by two private US agencies—Moody’s and Standard & Poor's, thus using public policy and ultimately taxpayers’ money to strengthen an anti-competitive duopolistic industry.