by Calculated Risk on 4/25/2010 11:59:00 PM

From Paul Krugman in the NY Times: Berating the Raters

[T]he e-mail messages you should be focusing on are the ones from employees at the credit rating agencies, which bestowed AAA ratings on hundreds of billions of dollars’ worth of dubious assets, nearly all of which have since turned out to be toxic waste. And no, that’s not hyperbole: of AAA-rated subprime-mortgage-backed securities issued in 2006, 93 percent — 93 percent! — have now been downgraded to junk status.

What those e-mails reveal is a deeply corrupt system.
...
The Senate subcommittee has focused its investigations on the two biggest credit rating agencies, Moody’s and Standard & Poor’s; what it has found confirms our worst suspicions. In one e-mail message, an S.& P. employee explains that a meeting is necessary to “discuss adjusting criteria” for assessing housing-backed securities “because of the ongoing threat of losing deals.” Another message complains of having to use resources “to massage the sub-prime and alt-A numbers to preserve market share.”

The rating agencies played a key role in the housing bubble. They used models based on historical performance for mortgages, and didn't account for the "innovations" in lending such as the entire chain of the originate-to-distribute model: automated underwriting, reliance on FICO scores instead of the 3 Cs (creditworthiness, capacity, and collateral), agency issues with the widespread use of independent mortgage brokers, expanded securitization, non-traditional mortgage products, etc.

Of course the rating agencies just offered "opinions", and unknown to investors, those valued opinions were apparently quite malleable.

How does the new financial regulation fix this problem?