Lawmakers criticised the three largest credit rating agencies for their role in the worst financial crisis in decades, and the agencies admitted they didn't see it coming.

Representative Henry Waxman (D-CA), chairman of the House Oversight and Government Reform Committee said, "The story of the credit rating agencies is a story of colossal failure". Rep. Waxman blamed the rating agencies and federal regulators for putting the entire financial system at risk and betraying the public trust.

Rep. Waxman's committee is investigating the credit crisis and put much of the blame on those agencies. According to documents(Below)Waxman distributed at the hearing, Moody's Chief Executive Raymond McDaniel told directors that Moody's was facing a dilemma in trying to maintain both market share and ratings quality. McDaniel told directors that industry competition forces rating agencies to provide the lowest credit enhancement needed for the highest rating, which "can place the entire financial system at risk."

The three biggest ratings agencies, S&P, Moody's and Fitch, Inc.; made huge profits for giving top ratings to the securities.  The agencies apparently relied on ever increasing home prices for the confidence they placed in the mortgages.  Two of the agencies, S&P and Moody's, have now downgraded thousands of their previous top ratings.

Documents also revealed that a portfolio manager with big mutual fund company Vanguard Group Inc told Moody's over a year ago that the rating agencies "allow issuers to get away with murder." Though some say that the economic crisis could not have been foreseen (Moody's CEO McDaniel calls the last several weeks "unimaginable"), the committee cited E-mails and internal presentations revealing that at least some executives, employees, and investors voiced misgivings about the debts being evaluated. One S&P employee joked in an instant message exchange, "It could be structured by cows and we would rate it."

Below is a list of the documents that the House Oversight Committee reviewed, trust me when I say its some eye opening information. Click here for a preliminary hearing transcript.

For those who like to know.......How did we get here?

Between 1909, when John Moody set up shop, and the 1980s, most of the analysis that Moody's and S&P did was of securities issued by either corporations or governments. Unlike asset-backed securities, corporate bonds are dynamic -- there is an active management (usually with a visible track record of past behaviour) making decisions that can make it more or less likely that bondholders will be repaid.

If poor decisions are made early in the life of the bond, there is time and scope for different decisions to offset these.

Conversely, the amount of risk in a corporate or government bond remains fairly constant through its life -- a disastrous move that destroys the firm and makes repayment impossible is theoretically just as possible in the last year of its term as in the first.

Mortgage-backed securities, on the other hand, represent a vastly more complex valuation and risk-assessment challenge. While many mortgages are pooled together, there is very little information about the past behaviour of the borrowers -- the track record that an investor can infer from the resumes of a corporate issuer's CFO and CEO is absent.

Some of this data becomes available as the pool of mortgages gradually becomes "seasoned" and defaults take place. But then an additional problem arises -- the pool of mortgages underlying a security is static, and once money is lost from a default, it cannot be recovered from outperformance elsewhere. Most securitised mortgages or debt assets build in a buffer to cover defaults. But whether this is too little (or too much -- insurance is "wasted" because there are fewer defaults than expected) only becomes known over time, as variability lessens and value converges on a particular combination of defaults by some underlying borrowers, early repayment by others, and "normal" repayment by the rest.

The complex mathematics in any thorough attempt to model a mortgage-backed security becomes exponentially more daunting for CDOs, where returns are tiered, many different securities or elements of securities are combined and the equation is further complicated by an "active" manager with some scope to shuffle differently performing underlying assets between various tranches and issues.

It now seems fairly clear that the models the ratings agencies used to justify the lofty investment-grade credit ratings they gave to many mortgage-backed securities and CDOs were woefully inadequate, based as they were on the very different world of corporate and government bonds. This is why the rating agency models failed to detect any reason for the credit ratings for most mortgage-backed and debt-backed securities to be lowered until months after the sub-prime crisis had erupted. Traditional credit analysis will become more significant again.

By the time the music stopped last year, the ratings agencies were therefore major contributors to the opacity, confusion and lack of trust among participants in markets for debt-backed securities, rather than the providers of impartial fact-based opinion they aspire to be. That is why it is going to take years for Moody's and S&P to fully regain the confidence of the market.

Of course, none of this would have mattered had not a great many US investors, including some of the most illustrious names in finance, all been willing to believe that they really could get something for nothing, and not be left with any exposure to unpleasant underlying risks.

Roger Lowenstein, author of When Genius Failed, wrote a terrific article in this past weekend’s New York Times Magazine if you'd care to read more, but from my persepective I don't think people are going to blindly take the advice of the rating agencies anymore, how about you?