Commentary from CNBC Producer David Russell:

In a famous episode of Monty Python's Flying Circus, members of the Spanish Inquisition ridiculously attempt to torture a woman by making her sit in a comfy chair and prodding her with soft cushions. Needless to say, she doesn't suffer.

Securities and Exchange Commission Chairman Christopher Cox seems to have taken a page from the same book with yesterday's proposed rules to deal with Moody's Investors Service and Standard & Poor's.

AP

Never mind that these companies contributed to the greatest financial crisis since the Great Depression with their wildly optimistic assumptions about home prices and mortgages. Never mind that these companies enjoy a special designation from the government that allows them to take a cut of almost every dollar borrowed in the multi-trillion dollar bond market. Never mind that some critics wanted to force the credit-rating firms to separate the ratings of complex structured products from that of traditional securities like corporate bonds and munis.

Instead of punishing them or suggesting any significant reforms, the SEC is responding with little more than slaps on the wrist. They will be prohibited from advising issuers on how to structure debt and then rating the same deals. They're also required to disclose more information about their ratings and analysts are prohibited from receiving gifts worth more than $25 from issuers.

"What the SEC has done, again, is window-dressing," said Janet Tavakoli of Tavakoli Structured Finance, who says the companies should lose the government's stamp of approval for rating structured products. "Houses were over-appraised and people were taking out things like stated-income loans. These weren't surprises or hidden risks, but they seemed to show a lack of intellectual curiosity about them."

The problem is that rating agencies aren't paid for intellectual curiosity; they're paid for issuing ratings. And, not all ratings are equal: Mortgage-backed securities were much more profitable than traditional kinds of bonds.

They don't disclose fees per se, but Moody's does report how much they earn from different kinds of debt. Combining this data with global issuance volumes from Dealogic, one finds Moody's took an average 0.0296% cut on structured debt issued between 2000 and 2007, compared with 0.0185% on corporate bonds. That translates into an extra $110,590 of revenue for every billion dollars brought to market, a pretty nice incentive to keep the structured machine running at full speed.

Thanks to Moody's and S&P's willingness to rate securities in this new market, it grew like wildfire. Spearheaded by mortgage-backed securities, structured debt issuance grew 286% to $2.8 trillion from 1998 to 2006, according to Dealogic. Traditional corporate issuance rose a mere 112% during the same period. Structured finance wasn't only a high-margin -- it was also a high-growth business.

While they don’t stress it now, Moody’s and S&P were proud of the structured business during the boom times. As Moody's Chief Financial Officer Linder Huber gushed on a July 25, 2005, conference call: "Moody's benefited from continued robust activity in the residential mortgage and home equities securitization sectors, reflecting continued strength in the housing market combined with high ratings coverage." And you probably hadn't heard of CDOs back in 2005, but she was well acquainted: "We also generated strong revenue growth from rating U.S. commercial mortgage backed securities and collateralized debt obligations."

Every year that structured revenue grew as a proportion of Moody's overall business, the bottom line grew fatter. The company’s profit margin rose from 26% in 2000 to a high of 37% at the peak of housing bubble in 2006. It's a bit like movie theaters breaking even showing films, yet making huge profits on the concessions stand. Product-mix matters.

"The agencies were supposed to be the gatekeepers and became the enablers," said Chris Whalens, managing director at Institutional Risk Analytics. Whalens points to the rating agencies unusual place in the U.S. economy and legal system: On one hand, they're like investment bankers, taking a cut of deal volume. But unlike Wall Street, their ratings are considered mere journalistic opinion. That reduces their danger of getting sued for bad calls.

And finally, there are the insidious links between the rating agencies and Wall Street. It’s a long-running practice for analysts to leave Moody’s and S&P for much more lucrative jobs at investment banks, giving them an incentive to “play ball” with the powers that be. S&P apparently felt this was a problem because they instituted a rule governing such relationships earlier this year.

This combination of incentives and government endorsement has helped bring us to the current crisis. The big question is whether anyone can take the SEC seriously if they don’t start examining some of these underlying conflicts.

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David Russell is a segment producer for CNBC's Closing Bell. Before joining CNBC, he worked as a reporter for Bloomberg News and Informa Global Markets.

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