Raters See Windfall in Bailout Program

By SERENA NG and LIZ RAPPAPORT

(See Correction & Amplification below.)

Credit-rating agencies, widely assailed for their role in fueling the financial crisis with overly rosy debt ratings, stand to earn a few hundred million dollars in the government's latest attempt to heal the credit markets.

The new rescue effort, run by the Federal Reserve, kicked off Thursday with bond deals totaling more than $7 billion. Each bond issue will need to be blessed by at least two of the three big rating firms: Moody's Investors Service, Standard & Poor's Ratings Services and Fitch Ratings.

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Federal Reserve Chairman Ben Bernanke testifies before the House Banking Committee Feb. 25, 2009 on Capitol Hill in Washington, D.C.

These firms dominate the credit-ratings business, and their imprimatur is considered crucial for investors that buy bonds and asset-backed securities. They have been vilified in recent months because their ratings on mortgage securities were widely off base.

Now the government is in the uncomfortable position of rewarding these same firms through a new program that will result in numerous companies issuing securities. If the ratings companies are wrong this time around, the Federal Reserve and the Treasury -- and therefore taxpayers -- will be on the hook for some losses.

A Federal Reserve spokesman declined to comment. At a Senate hearing in Washington earlier this month, Fed Chairman Ben Bernanke said the central bank has looked at the models of the major rating companies and is "comfortable" they can rate securities eligible for the new program "in an appropriate way."

Under the so-called Term Asset-Backed Securities Loan Facility, or TALF, the Federal Reserve will lend money to investors who buy securities backed by such things as auto, student, small-business and credit-card loans. But the government, hoping to protect itself from losses, will allow its money only to be used to buy securities rated triple-A by the ratings services.

Rating services typically charge $30,000 to $120,000 for every $100 million in so-called structured-finance securities they rate. For large asset-backed securities deals, they cap their rating fees at certain maximums. Depending on the ultimate size of the TALF program and the kinds of securities issued, the industry could earn anywhere between tens of millions and hundreds of millions of dollars, based on Wall Street Journal estimates.

Rating services typically charge $30,000 to $120,000 for every $100 million in so-called structured-finance securities they rate. For large asset-backed securities deals, they cap their rating fees at certain maximums. If the TALF program is extended to $1 trillion as the government plans, the industry could earn anywhere between tens of millions and hundreds of millions of dollars.

Critics say Moody's, S&P, a unit of McGraw-Hill Cos., and Fimalac SA's Fitch have made few fundamental changes to the way they assess debt. Officials at all three firms say they have taken steps to avoid a repeat of past mistakes in assigning ratings.

They are still paid for their ratings by the companies whose bonds they rate, a potential conflict of interest. And much-anticipated competition for the three companies has failed to materialize so far.

"Until the rating firms bite the bullet and develop forward-looking signals and methods, it's going to be same old, same old, and their models can be gamed," says Ann Rutledge, principal of New York structured-finance advisory firm R&R Consulting and a former credit-rating analyst.

Last year, roughly 30,000 structured-finance securities had their ratings downgraded by credit-rating services. About 3,000 of them were originally rated triple-A.

"This credit crunch started off as a structured-finance crisis, when the market lost confidence in credit ratings and realized that risk had been massively underpriced," says Ed Grebeck, chief executive of debt strategy firm Tempus Advisors. "Now the government is relying on rating models for structured-finance asset purchases even though some of those have demonstrably failed."

At Moody's Investors Service, a unit of Moody's Corp., committees that oversee policies and ratings of structured-finance securities -- so named because they are "structured" to earn specific credit ratings -- consist mostly of people who work in business units that generate revenue for the rating service. A Moody's spokesman says the firm's structured-finance credit committee "isn't the final arbiter" on ratings methodologies.

The ratings firms acknowledge that their models still rely largely on historical data, though they say they have updated their assumptions and analyses to reflect current economic stresses. In the mortgage sector, historical loan performance trends proved to be all but useless in the past year amid the unprecedented market slide.

The first TALF deals include $1.3 billion in bonds backed by auto loans made by Nissan Motor Co., $3 billion from Ford Motor Co. and $3 billion in credit-card loans made by Citigroup Inc. The loans were pooled together and their risks allocated to different securities. Some carry little risk and pay low interest rates; others have greater risk, but promise higher yields.

The ratings services bless the low-risk slices with their highest Triple-A ratings, just as they did with pools of mortgages during the housing boom. The possibility of a default on a Triple-A rated security is considered remote. But during the housing bust, billions of dollars worth of securities with these ratings defaulted soon after they were issued.

A spokesman at S&P says that ratings for asset-backed securities that are not tied to mortgages have largely performed in line with its expectations, given current economic conditions.

A Fitch spokesman said its methods and criteria are "regularly reviewed, tested and updated."

The fees from the new program could make a big difference to the bottom line of ratings firms as fees elsewhere tumble. Last year, structured-finance revenues at Moody's Investors Service slumped 53% to $411 million, according to its financial statements. Revenue from structured-finance securities once made up almost half of Moody's revenues, but its contribution has shrunk to about 34%.

One of the biggest concerns surrounding TALF is the seemingly arbitrary nature of ratings decisions. Many of the ratings firms, for example, changed their view of one part of the auto-financing sector, deciding that loans made to auto dealers were far riskier than they previously thought.

Their downgrades meant that bonds backed by loans to those dealers would be unlikely to get triple-A ratings, effectively shutting them out of the TALF.

Write to Serena Ng at serena.ng@wsj.com and Liz Rappaport at liz.rappaport@wsj.com

Correction & Amplification

Credit-rating companies cap their fees for rating asset-backed securities. An earlier version of this article failed to cite the fee caps and incorrectly estimated that individual firms could earn $1 billion in revenues from rating securities under the Term Asset-Backed Securities Loan Facility. Depending on the kinds of securities issued and the ultimate size of the program, the industry could earn tens of millions to a few hundred million dollars, based on Wall Street Journal estimates. For the initial $7 billion in TALF-eligible deals mentioned in the article, Standard & Poor's says it was paid less than $700,000.