Federal Reserve policy makers including Chairman Ben S. Bernanke voiced alarm in August 2007 over a loss of investor confidence in ratings companies, warning that the declining credibility could worsen market turmoil.
"There is an information fog" that "is very much associated with the loss of confidence in the credit-rating agencies," Bernanke said at a meeting on Aug. 7, 2007. The firms' "credibility has been shot" and "it is much harder to see that this market will unwind itself in a rather kind and comforting environment," said Kevin Warsh, then a Fed Governor.
The 2007 transcripts of the Federal Open Market Committee, released last month, open a window onto how Fed officials viewed ratings companies during the end of the period that is the focus of a U.S. Justice Department lawsuit against McGraw-Hill Cos. and its Standard & Poor's unit.
The Justice Department filed a civil complaint yesterday in Los Angeles accusing McGraw-Hill and S&P of three types of fraud, the first federal case against a ratings company for grades related to the credit crisis. The U.S. is seeking as much as $5 billion in penalties in punishment for inflated credit ratings that Attorney General Eric Holder said were central to the worst financial crisis since the Great Depression.
The "egregious" conduct "goes to the very heart of the recent financial crisis," Holder said today at a news conference in Washington. The complaint "is an important step forward in our ongoing efforts to investigate and punish the conduct that is believed to have contributed to the worst economic crisis in recent history."
In June 2007, William C. Dudley, then the head of the markets desk of the Federal Reserve Bank of New York, warned of the risk to broader financial markets from flawed credit ratings. That April, New Century Financial Corp., once the second-largest U.S. subprime mortgage lender, had filed for bankruptcy.
"High credit ratings don't fully capture measures of risk," Dudley said during the FOMC's June 27-28, 2007 meeting.
"The ratings are based on the risk of default, not the market risks associated with illiquidity," said Dudley, who became president of the New York Fed in January 2009. The flawed ratings may veil "significant market risk" posed by "highly leveraged portfolios of highly rated but illiquid assets."
Source: Bloomberg | Joshua Zumbrun & Jeff Kearns