With debt grades baked into hundreds of rules, laws and private contracts that affect banking, insurance, mutual funds and pension funds, the three credit-rating companies enjoy near-monopoly status complicated by a conflict of interest created by the fact that all who are required to be rated have to hire one of the raters.

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Ron Grassi says he thought he had retired five years ago after a 35-year career as a trial lawyer.

Now Grassi, 68, has set up a war room in his Tahoe City, Calif., home to single-handedly take on Standard & Poor’s, Moody’s Investors Service and Fitch Ratings. He’s sued the three credit-rating firms for negligence, fraud and deceit.

Grassi says the companies’ faulty debt analyses have been at the core of the global financial meltdown and the firms should be held accountable. Exhibit One is his own investment. He and his wife, Sally, held $40,000 in Lehman Brothers bonds because all three credit raters gave them at least an A rating — meaning they were a safe investment — right until Sept. 15, the day Lehman filed for bankruptcy.

“They’re supposed to spot time bombs,” Grassi says. “The bombs exploded before the credit companies acted.”

As the U.S. and other economic powers devise ways to overhaul financial regulations, they have yet to come up with plans to address one issue at the heart of the crisis: the role of the rating firms.

That’s partly because the reach of the three big credit raters extends into virtually every corner of the financial system. Everyone from banks to the agencies that regulate them is hooked on ratings.

Debt grades are baked into hundreds of rules, laws and private contracts that affect banking, insurance, mutual funds and pension funds. Securities and Exchange Commission (SEC) guidelines, for example, require money-market fund managers to rely on ratings in deciding what to buy with $3.9 trillion of investors’ money.

State regulators depend on credit grades to monitor the safety of $450 billion in bonds held by U.S. insurance companies. Even the plans crafted by Federal Reserve Chairman Ben Bernanke and Treasury Secretary Timothy Geithner to stimulate the economy count on rating firms to determine how the money will be spent.

“The key to policy going forward has to be to stop our reliance on these credit ratings,” says Frank Partnoy, a professor at the San Diego School of Law who has written four books on modern finance. “We’ve become addicted to them like a drug, and we have to figure out a way to wean regulators and investors off of them.”

After the 1929 stock-market crash, the government decided it wasn’t able to determine the quality of the assets held by banks on its own, Partnoy says. In 1931, the U.S. Treasury started using bond ratings to analyze banks’ holdings, and restricted banks to buying only securities that were deemed high-quality by at least two credit raters.

Critical role

Just how critical a role ratings firms play in the health and stability of the financial system became clear in the case of American International Group (AIG), the giant insurer that’s now a ward of the U.S. government.

On Sept. 16, one day after the three credit-rating firms downgraded AIG’s double-A score by two to three grades, private contract provisions that AIG had with banks around the world based on credit-rating changes forced the insurer to hand over billions of dollars of collateral to its customers. The company didn’t have the cash.

Trying to avert a global financial cataclysm, the Federal Reserve rescued AIG with an $85 billion loan — the first of four U.S. bailouts of the insurer.

Investors, traders and regulators have been questioning whether credit-rating companies serve a good purpose ever since Enron imploded in 2001. Until four days before the company filed for what was then the largest-ever U.S. bankruptcy, its debt had investment-grade stamps of approval from S&P, Moody’s and Fitch.

“Abjectly failed”

“Ratings agencies just abjectly failed in serving the interests of investors,” SEC Commissioner Kathleen Casey says.

S&P President Deven Sharma says he knows his firm is taking heat from all sides — and he expects to turn that around.

“Our company has always operated by the principle that if you do the right thing by the customers and the market, ultimately you’ll succeed,” Sharma says.

Moody’s Chief Executive Officer Raymond McDaniel and Fitch CEO Stephen Joynt declined to comment, but said at an April 15 SEC hearing that they were “committed” to “highest standards.”

Role in recovery

Notwithstanding the role the credit companies played in fomenting disaster, the U.S. government is relying on them to help fix the system they had a hand in breaking.

The Federal Reserve’s Term Asset-Backed Securities Loan Facility, or TALF, will finance the purchase by taxpayers of as much as $1 trillion of new securities backed by consumer loans or other asset-backed debt — on the condition they have triple-A ratings.

And the Fed has also been buying commercial paper directly from companies since October, only if the debt has at least the equivalent of an A-1 rating, the second highest for short-term credit.

The Fed’s financial rescue also is good for the bottom lines of the three rating firms, Connecticut Attorney General Richard Blumenthal says. They could enjoy as much as $400 million in fees that come from taxpayer money, he says.

S&P, Moody’s and Fitch, all based in New York, got their official blessing from the SEC in 1975, when the regulator named them Nationally Recognized Statistical Ratings Organizations (NRSRO).

Seven companies, along with the big three, now have SEC licensing.

The SEC relies on ratings from the NRSROs to evaluate the bond holdings of those firms.

Conflict of interest

At the core of the rating system is an inherent conflict of interest, says Lawrence White, New York University economics professor. Credit raters are paid by the companies whose debt they analyze, so the ratings might reflect a bias, he says.

“So long as you are delegating these decisions to for-profit companies, inevitably there are going to be conflicts,” he says.

As lawmakers scratch their heads over how to come up with an alternative approach, the rating firms continue to pull in rich profits.

Moody’s, the only one of the three that stands alone as a publicly traded company, has averaged pretax profit margins of 52 percent over the past five years. It reported revenue of $1.76 billion — earning a pretax margin of 41 percent — even during the economic collapse in 2008.

Monopoly benefit

S&P, Moody’s and Fitch control 98 percent of the market for debt ratings in the U.S., according to the SEC. The noncompetitive market leads to high fees, says Casey, appointed by President George W. Bush in July 2006 to a five-year term. S&P has profit margins similar to those at Moody’s, she says.

“They’ve benefited from the monopoly status that they’ve achieved with a tremendous amount of assistance from regulators,” Casey says.

Sharma says S&P has justifiably earned its income.

“Why does anybody pay $200, or whatever, for Air Jordan shoes?” he asks, sitting in a company boardroom high over the southern tip of Manhattan. “It’s the same. People see value in that. And it all boils down to the value of what people see in it.”

Connecticut AG Blumenthal says raters shouldn’t be getting money from federal financial-rescue efforts.

“It rewards the very incompetence of Standard & Poor’s, Moody’s and Fitch that helped cause our current financial crisis,” he says.

Blumenthal has subpoenaed documents from the three companies to determine if they improperly influenced the TALF rules to snatch business from smaller rivals.

S&P and Fitch deny Blumenthal’s accusations. Moody’s Senior Vice President Anthony Mirenda declined to comment.

CDO bonanza

The rating companies reaped a bonanza in fees earlier this decade as they worked with financial firms to manufacture collateralized debt obligations (CDO).

Those creations held a mix of questionable debt, including subprime mortgages, auto loans and junk-rated assets.

S&P, Moody’s and Fitch won as much as three times more in fees for grading structured securities than they charged for rating ordinary bonds. The CDO market started to crash in mid- 2007, as investors learned the securities were jammed with bad debt.

Financial firms around the world have reported about $1.3 trillion in write-downs and losses in the past two years.

Alex Pollock, a resident fellow at the American Enterprise Institute, says more competition among credit raters would reduce fees.

“The rating agencies are an SEC-created cartel,” he says. “Usually, issuers need at least two ratings, so they don’t even have to compete.”

Pollock was president of the Federal Home Loan Bank in Chicago from 1991 to 2004. The bank was rated triple-A by both Moody’s and S&P. He says he recalls an annual ritual as he visited with representatives of each company.

“They’d say, ‘Here’s what it’s going to cost.’ I’d say, ‘That’s outrageous.’ They’d repeat, ‘This is what it’s going to cost.’ Finally, I’d say, ‘OK.’ With no ratings, you can’t sell your debt.”

Like auditors, lawyers and investment bankers, rating firms serve as gatekeepers to the financial markets. They provide assurances to bond investors.

Unlike the others, ratings companies have generally avoided liability for errors.

Grassi, the retired California lawyer who is suing the rating companies, wants to change that.

Failed to downgrade

Grassi says in his complaint that the raters were negligent for failing to downgrade Lehman Brothers debt.

The day Lehman filed for bankruptcy, S&P rated the investment bank’s debt as A, which according to S&P’s definition means a “strong” capacity to meet financial commitments. Moody’s rated Lehman A2 that day, which Moody’s defines as a “low credit risk.” Fitch gave Lehman a grade of A+, which it describes as “high credit quality.”

The rating companies haven’t yet filed responses. They’ve asked the federal court in Sacramento to take jurisdiction from the state court.

S&P and Fitch say they dispute Grassi’s allegations. Mirenda at Moody’s declined to comment.

S&P included a standard disclaimer with Lehman’s ratings: “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.”

Grassi isn’t deterred.

“They’re saying we know you’re going to rely on us and if you get screwed, you’re on your own because our lawyers have told us to put this paragraph in here,” he says.