Late last year, officials from Moody’s Investors Service gave a PowerPoint presentation to a group of mortgage lenders in Moscow. There were the usual arcana about what the ratings mean and how the agency creates them. Along with competitors Standard & Poor’s and Fitch Ratings, Moody’s serves as an unofficial umpire in major league finance, helping investors and underwriters gauge what to buy and what to avoid. Many big investors aren’t allowed to even touch bonds that don’t have the blessing of a good credit rating.

But midway through the presentation, Moody’s revealed a significant, and ultimately more dangerous, role that the agencies play in financial markets. The slides detailed an “iterative process, giving feedback” to underwriters before bonds are even issued. They laid out how Moody’s and its peers help their clients put together complicated mortgage securities before they receive an official ratings stamp. But this give-and-take can go too far: Imagine if you wanted a B-plus on your term paper and your high-school teacher sat down with you and helped you write an essay to make that grade.

The Russian lenders had just been let in on one of the dirtiest open secrets in the mortgage-ratings world, one that may have played a part in creating the housing bubble that’s now popping: The ratings agencies have had a bigger role in the subprime-mortgage meltdown than most people know. So far, irate investors have focused on—and upcoming congressional hearings and investigations will probe—the agencies’ overly optimistic ratings for packages of subprime mortgages, many of which are now ­blowing up. It’s becoming clear that the ratings agencies were far from passive raters, particularly when it came to housing bonds. With these, the agencies were integral to the process, and that could give regulators and critics the ammunition they’ve been looking for to finally force the Big Three to change. The credit-ratings agencies “made the market. Nobody would have been able to sell these bonds without the ratings,” says Ohio attorney general Marc Dann, who is investigating the agencies for possibly aiding and abetting mortgage fraud. “That relationship was never disclosed to anybody.”

The ratings that were ultimately assigned proved too generous, considering the state of the market. To make matters worse, the agencies were much too slow in downgrading the housing bonds, overlooking signs of excess that almost everyone else recognized. In July, in a last-ditch effort to make amends, Moody’s and S&P downgraded hundreds of mortgage bonds—the equivalent of slapping food-safety warnings on meat that’s already rotting in the aisles.

Ratings-agency officials concede that they work with Wall Street banks, even if they don’t exactly shout it from the rooftops. “You start with a rating and build a deal around a rating,” explains Brian Clarkson, Moody’s co-C.O.O. But the agencies reject the accusation that they take an active role in structuring deals.

The problem is that the deals the agencies helped build are falling apart, and the raters are emerging as one of the main reasons. The market for mortgage derivatives is seizing up. Losses on subprime mortgages are far greater than expected. And fears are growing that a credit crisis could spread, spilling over into structured corporate and commercial-real-estate bonds, also rated by the agencies. In late July, Countrywide, one of the biggest players in the mortgage market, reported that it was seeing a sharp rise in defaults—and not just among home­owners with bad credit.

Critics are piling on. Joseph Mason, a Drexel University finance professor, and Josh Rosner, managing director of the independent research firm Graham Fisher, outline in a report how the agencies have become actively ­involved in structuring the subprime-mortgage business. They’ve presented a series of papers to the Hudson Institute, a right-leaning Washington think tank. Separately, a collection of Italian and European Union lawmakers sent a letter to German ­chancellor Angela Merkel suggesting that the E.U. consider breaking the credit-ratings cartel.

John Moody introduced credit ratings in 1909, with railroad bonds. Demand for an independent financial review of railroads was growing because of the industry’s volatility. Moody later moved into corporate bonds and made his mark in the wake of the 1929 stock market crash, when none of Moody’s top-rated bonds defaulted. Over the next several decades, his (and his ­competitors’) ratings became knit into the nation’s financial and regulatory fabric.

Moody’s and S&P dominated for decades, and their business model was straightforward: Investors bought a subscription to receive the ratings, which they used to make decisions. That changed in the 1970s, when the agencies’ opinions were deemed a “public good.” The Securities and Exchange Commission codified the agencies’ status as self-regulatory entities. The agencies also changed their business model. No longer could information so ­vital to the markets be available solely by subscription. Instead, companies would pay to be rated. “That was the beginning of the end,” says Rosner.

It might come as a surprise, but rating credit is a heck of a business to be in. In fact, Moody’s has been the third-most-profitable company in the S&P 500-stock index for the past five years, based on pretax margins. That’s higher than Microsoft and Google. Little wonder that Warren Buffett’s Berkshire Hathaway is the No. 1 holder of Moody’s stock.

McGraw-Hill’s most recent financial report shows that S&P has profit margins that would put it in the top 10. Fitch Ratings, owned by the French firm Fimalac, is a distant third in ­market share but nevertheless has an operating margin above 30 percent, about double the average for companies in the S&P 500.

In 2006, nearly $850 million, more than 40 percent of Moody’s total revenue, came from the rarefied business known as structured finance. In 1995, its revenue from such transactions was a paltry $50 million.

The agencies argue that most investors still see them primarily as information providers. “I think it’s fine that people actually rely on ratings, but it’s not a recommendation to buy or sell. . . . We are just looking at the credit,” Clarkson says. And Moody’s claims that it has strong systems in place to prevent conflicts of interest. “There is no transaction or line of business that’s worth our reputation,” Clarkson says. S&P and Fitch, through their spokespeople, contend much the same thing.

But the agencies know that if they crack down too hard, by toughening standards, it won’t be good for business—theirs or their customers’. Securitization is the art of bundling loans and slicing them up into differently rated pieces called tranches. The investors in the lowest-rated—and potentially most-profitable—tranches take on the most risk, because they’re on the hook for the first losses. The tranches can then be sliced up again into new bundles. By this alchemical process, risky loans, such as subprime mortgages, can be converted into triple-A-rated securities. An investment bank’s goal is to have the highest percentage of its deals rated triple-A and to keep returns high for the investors who take on the lowest, riskiest tranches.

If the ratings agencies prevent the creation of a high percentage of triple-A paper, the deal won’t sell. The ratings agencies’ customers—the investment banks—will be unhappy, and the ratings agencies’ bottom lines will suffer. “Bankers get paid a lot of money. The ratings-agency people get pushed,” says a hedge fund manager who is betting that the securitization market will continue to sour. The agencies “never stopped to question” this, he says, “because they had zero economic risk.”

While the agencies haven’t entirely neglected the investors who ultimately buy these complex products, “the ratings agencies were very banker-, manager-, and market-friendly,” says Eileen Murphy, who, before taking a job on Wall Street, worked at Moody’s for five years, including three years as co-head of structured derivatives. “They spent a lot of time developing new methodologies. We can argue how that turned out. It was enlightened self-interest. They created a huge moneymaker for themselves.”

That’s putting it mildly. The value of new structured-finance deals hitting the market has grown 27 percent a year for the past four years, to more than $3 trillion in 2006, up from about $1.1 trillion in 2002. Today, the securitization market as a whole is worth about $11 trillion, according to the Japanese securities firm Nomura.

At an investor presentation in June, Moody’s showed that in 1992, it provided ratings on only three credit-­derivative products. By 2006, that had soared to 61.  And 23 of those had been introduced in the past two years. “This business enabled loans that have never been made before,” says Simon Mikhailovich, who runs a fixed-income hedge fund. “There’s fairly little ability to second-guess or independently establish whether the ratings are correct, because the complexity is so high.”

So how did the agencies help create the securities that are now causing so much trouble? A 2001 lawsuit sheds some light. In 1999 and 2000, the American Savings Bank of Hawaii asked PaineWebber, now owned by UBS, to create a product that would generate a higher return than it was getting through its typical, safe investment choices like municipal and corporate bonds. PaineWebber created a structure called a collateralized loan obligation, made up of the risky portions of other transactions. A French insurance company guaranteed A.S.B.’s principal. The bankers worked with Fitch, the ratings agency, to put the deal together. Moody’s also vetted it.

A.S.B. bought $83.5 million worth of the securities, but then federal bank regulators disallowed the purchase, unconvinced by the ratings that the investments were safe.  A.S.B. tried to return the securities to Paine­Webber, but the investment bank refused them. So A.S.B. was forced to sell the securities at a loss. It then did what firms do in such cases: It sued.

In defending itself against A.S.B.’s accusations, PaineWebber made an interesting claim: It said that Fitch had been intimately involved in the structuring of the deal and that it had relied on Fitch’s representations for assumptions about the performance of the underlying assets. The U.S. Court of Appeals for the Second Circuit agreed, writing that A.S.B. had discovered that “PaineWebber and Fitch had extensive communications about the structure of the transactions [that] concerned what PaineWebber needed to do to earn an investment-grade rating from Fitch.” The ruling also said the claim that “Fitch plays an active role in structuring the transaction is extremely credible.”

The case is notable in part because ratings agencies are rarely sued or even ensnared in other parties’ lawsuits. In the A.S.B. case, Fitch refused to turn over documents, claiming protection under the New York State shield laws that allow journalists to guard their sources and methods—a claim the court didn’t buy. Credit-ratings agencies still maintain that their ratings are simply published opinions, which investors are free to heed or ignore.

But as a result of the subprime-mortgage mess, pressure is building to rein in the agencies. Mason and Rosner, for instance, are convinced that the agencies are hopelessly conflicted. They argue that there are “fundamental flaws” in the rating process for mortgage-backed securities, suggesting that the entire world of structured finance could be suspect.

Mason estimates that direct losses from mortgage securities and other complex structures called collateralized debt obligations are already between $70 billion and $100 billion. And the damage could spread to other markets, such as the high-flying private equity world, which depends on the agencies to stamp dependable ratings on the bonds of companies that private equity firms want to acquire. “The reason this works is because the ratings agencies have said it works,” said Bill Ackman, a hedge fund manager who has about $6 billion under management, in a speech at a charity-investment conference in May. “The big point here is that everyone in the chain gets paid up front. The rating agencies get their fee . . . if they say the deal works. If they say the deal doesn’t work, well, you just go across the street” to another agency to get the rating you want.

The 2006 vintage of subprime mortgages was troubled from the start, coming as it did when real estate prices began their ­descent. Consumers were offered loans that, at times, exceeded the entire value of the homes they were about to buy. Some borrowers didn’t have to verify their income before ­receiving mortgages. These are denigrated as “liar loans” in the industry, and not surprisingly, they are going bad at a rapid pace.

While the agencies say they have tightened up their standards in recent years, the data suggest otherwise. The ABX index, which tracks the ­subprime business, shows that, beginning in the last half of 2005—long before the scope of the crisis became widely known—subprime securities were already starting to get shaky. The amount of protection for the riskiest investment-grade tranches was going down. Yet the agencies continued to assign high ratings to a big percentage of subprime deals, collecting fees along the way.

The recent crisis has led the agencies to make a series of embarrassing tweaks. In April, Moody’s said it would start doing what it should have done long ago: more aggressively scrutinizing new mortgage loans. The company acknowledged that its models, created in 2002, were out-of-date. “Since then, the mortgage market has evolved considerably, with the introduction of many new products and an expansion of risks associated with them,” a Moody’s report said. In hindsight, it seems astounding that the most influential rater of mortgage bonds wouldn’t be upgrading its models regularly to account for the growth in exotic mortgages.

The changes may be too little, too late. Last year, President Bush signed a law to have the S.E.C. monitor and regulate credit-ratings agencies, taking what has been a free-market free-for-all and putting it under the microscope. The S.E.C. formalized its rules this summer.

Other ideas for reform are flowing in. Rosner suggests that ratings for structured securities use a different scale—say, numbers instead of letters—to differentiate them from ratings for corporate and municipal bonds. He believes the agencies need to step up the training for analysts and should be compelled to re-rate transactions regularly rather than monitor them haphazardly. Furthermore, he thinks efforts should be made to distance the agencies from Wall Street. He proposes that any ­ratings-agency employee involved with a structured-finance deal for a Wall Street firm should have to wait a year before being able to join that firm. Such a waiting period already exists for auditors.

Murphy, the ex-Moody’s executive, doesn’t blame the ratings agencies alone. “But in the end,” she says, “it’s supposed to be the ratings agencies that are the purest of them all. They should be held to the highest standard. Maybe we should fundamentally rethink their position in the markets.”