Domestically, the controversy during the summer regarding the raising of the federal debt ceiling and the downgrade of the U.S. long-term credit rating by one of the major rating agencies contributed to the financial turbulence that occurred around that time.

The number of NRSROs is expanding, and partly for that reason we are conducting a broader review of our approach to using rating agencies.  That review encompasses the ratings of securities of all types accepted as collateral at all our recently established credit facilities as well as collateral accepted to secure regular discount window loans.  However, as we conduct this analysis, the Federal Reserve will need to keep two key considerations in mind: first, as noted above, the NRSRO designation is not a reflection of the quality of an entity's ratings; and second, as agreed by organizations such as the Group of 30, best practices dictate that lenders and investors have the independent capacity to evaluate their exposure to risk without sole reliance on rating agencies.

There is a real difficult issue here, because the incentives are out of line. I'm a rating agency, you're going to pay me to rate you. So how do you deal with that? Should we open the market? ... Either get those incentives aligned or you're going to have to oversee them.

From Q&A as reported by Market News International

I believe it is fair to say that the creation of new, innovative financial products outstripped banks' risk-management capabilities. As I noted earlier, some banks that chose to hold super senior CDO securities did so because they trusted in an external triple-A credit rating. Because some banks did not fully understand all aspects of these exposures, once the risks crystallized last year in a weak house price environment, compounded by widespread liquidity pressures in many markets, banks had to scramble to measure and hedge these risks.

Part of our work list for regulations is to reexamine the extent to which we ourselves rely on rating agencies (to measure) the risks that you guys are taking.

There was far too much reliance on credit rating agencies all around.

From Q&A as reported by Market News International 

More transparency about the risks and other characteristics of securitized credits on the part of their sponsors would obviously help. But more generally, investors must take responsibility for developing independent views of the risks of these instruments and not rely solely on credit ratings.

Improving the performance of the credit rating agencies is another key priority. As I mentioned, analytical weaknesses and inadequate data underlay many of the problems in the ratings of structured finance products. Beyond improving their methods, however, the credit rating agencies would serve investors better by providing greater transparency. Credit rating agencies should, for example, publish sufficient information about the assumptions underlying their rating methodologies and models so that users can understand how a particular rating was determined. It is also important for the credit rating agencies to clarify that a given rating applied to a structured credit product may have a different meaning than the same rating applied to a corporate bond or a municipal security. Indeed, some have suggested that the agencies use different rating nomenclatures for different types of products. Transparency about methods should also help to reduce concerns about conflicts of interest that might arise from the fact that issuers of securities pay the rating agencies for their work in rating those securities.

The credit rating agencies themselves clearly appreciate that concerns about the quality of ratings and potential conflicts of interest represent a fundamental challenge to their business model, and they have begun to address these issues. The SEC, which has regulatory responsibility for the credit rating agencies, is conducting a broad review of issues regarding potential conflicts of interest at the rating agencies and is likely to identify further measures that should be implemented.

[The originate-to-distribute system] broke down at a number of key points, including at the stages of underwriting, credit rating and investor due diligence ... These problems notwithstanding, the originate-to-distribute model has proven effective in the past and with adequate repairs could be so again in the future.

From Q&A as reported by Reuters

In contrast to corporate securities, corroborating information on mortgage securities is not as readily available. There is no equivalent to equity analysts and equity prices to give investors updated market information. The information needed to analyze the individual mortgages in the pool can be expensive to obtain. So investors are more reliant on rating agencies than they are with corporate securities.

The problems in the mortgage market highlight the need for caution where there has been limited ratings history, where the underlying characteristics that drive the asset’s price may not be fully understood or anticipated, and where evaluations cannot be easily corroborated by others such as equity analysts.9 Certainly one way to highlight these differences is to differentiate ratings on corporate securities from ratings on assets like mortgage-backed securities.

I do think there is an issue with credit rating agencies. I've spoken on this recently. I wouldn't go far as to say banks have outsourced it lock, stock and barrel but I think in the recent rounds that we've seen that the very high credit ratings for a certain class of securities, the collaterized debt obligations based on a prime asset backed securities which were not only rated triple-A but were considered senior to Triple-A securities. I think there was an over reliance generally on that rating, but even with the banks - with some of the most sophisticated banks, as they packaged these there was an undue reliance on the credit ratings and that shouldn't happen, particularly with larger institutions that have the where with all and are in the business of making credit assessment. And I think there is a very fundamental lessons that has come out of this.

From Q&A as reported by Market News International

I would argue that root causes of problems in the subprime market brought into question some fundamental practices, incentives, and even institutions of other markets. By fundamentals, I mean the integrity of origination (that is, the quality of assets that went into securitization pools), the structure of the securities into which loans and individual securities were packaged, and the value of these securities as collateral for margin financing.

Also, rating agencies had greatly underestimated the risk of many mortgage-backed securities. This led to a loss in confidence in the ratings assigned to other complex financing structures with further reductions in liquidity and increases in the volatility of prices across a variety of debt markets.

Through this spread of suspicion, subprime losses exposed related problems elsewhere, such as the syndication market for leveraged loans. Some leveraged lending underwriting was in its own way very aggressive in the period before the markets turned rocky starting last summer.

Finally, the subprime crisis generated a thicket of doubts concerning counterparties. Uncertainty about valuations of securitized debt fed uncertainty regarding the exposure of large banks and other market participants, which led to concerns about executing trades with these counterparties.

The credit rating agencies got it wrong. Badly. I think some of the investors didn't understand that a triple-A (rating) for a corporate bond really has a different meaning. A corporate bond that's triple-A will act in a different way than a triple-A tranche of subprime mortgages will act, and so when markets moved and markets changed, people got surprised by the extent to which there was downgrading.

From audience Q&A, as reported by Market News International

The originate-to-distribute model for loans has been a successful model for some time; I think that's a very successful thing; it's worked very well in a number of areas -- consumer loans, auto loans, all kinds of things for a long time. In the case of mortgages, it just got too complicated. People made wrong assumptions. I think these instruments need to be simpler, more transparent. People need to be able to look through and make a judgment about whether the credit rating agency has done the right job or not.

From audience Q&A as reported by Market News International 

Market participants must ensure that they do not make valuation decisions based solely on excessive reliance on external ratings or evaluations, but that they also undertake their own assessment. And I would suggest that the value of independent due diligence on the part of market participants is especially high for newer and more-complex products.

The rating agencies did a good job on the plain vanilla type of ratings. That was not the problem. 

There were these securities which people were using that were using very complicated financial engineering, and very complicated legal documents, to basically, supposedly, decrease risk by diversification.

It turns out that people then realized that the rating agencies were not able to rate these things properly.  There is obviously now a recognition that depending completely on rating agencies without doing due diligence yourself may be problematic.'

From the audience Q&A as reported by Bloomberg News