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THE MORTGAGE MACHINE
they paid for the bonds); lower-rated bonds had to be reported at current market
prices, which might be lower. In , the National Association of Insurance Com-
missioners adopted higher capital requirements on lower-rated bonds held by insur-
ers. But the watershed event in federal regulation occurred in , when the
Securities and Exchange Commission modified its minimum capital requirements
for broker-dealers to base them on credit ratings by a “nationally recognized statisti-
cal rating organization” (NRSRO); at the time, that was Moody’s, S&P, or Fitch. Rat-
ings are also built into banking capital regulations under the Recourse Rule, which,
since , has permitted banks to hold less capital for higher-rated securities. For
example, BBB rated securities require five times as much capital as AAA and AA
rated securities, and BB securities require ten times more capital. Banks in some
countries were subject to similar requirements under the Basel II international capi-
tal agreement, signed in June , although U.S. banks had not fully implemented
the advanced approaches allowed under those rules.
Credit ratings also determined whether investors could buy certain investments at
all. The SEC restricts money market funds to purchasing “securities that have re-
ceived credit ratings from any two NRSROs . . . in one of the two highest short-term
rating categories or comparable unrated securities.” The Department of Labor re-
stricts pension fund investments to securities rated A or higher. Credit ratings affect
even private transactions: contracts may contain triggers that require the posting of
collateral or immediate repayment, should a security or entity be downgraded. Trig-
gers played an important role in the financial crisis and helped cripple AIG.
Importantly for the mortgage market, the Secondary Mortgage Market Enhance-
ment Act of permitted federal- and state-chartered financial institutions to in-
vest in mortgage-related securities if the securities had high ratings from at least one
rating agency. “Look at the language of the original bill,” Lewis Ranieri told the FCIC.
“It requires a rating. . . . It put them in the business forevermore. It became one of the
biggest, if not the biggest, business.” As Eric Kolchinsky, a former Moody’s manag-
ing director, would summarize the situation, “the rating agencies were given a blank
check.”
The agencies themselves were able to avoid regulation for decades. Beginning in
, the SEC had to approve a company’s application to become an NRSRO—but if
approved, a company faced no further regulation. More than years later, the SEC
got limited authority to oversee NRSROs in the Credit Rating Agency Reform Act of
. That law, taking effect in June , focused on mandatory disclosure of the
rating agencies’ methodologies; however, the law barred the SEC from regulating “the
substance of the credit ratings or the procedures and methodologies.”
Many investors, such as some pension funds and university endowments, relied
on credit ratings because they had neither access to the same data as the rating agen-
cies nor the capacity or analytical ability to assess the securities they were purchasing.
As Moody’s former managing director Jerome Fons has acknowledged, “Subprime
[residential mortgage–backed securities] and their offshoots offer little transparency
around composition and characteristics of the loan collateral. . . . Loan-by-loan data,
the highest level of detail, is generally not available to investors.” Others, even large
