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More Is Needed to Improve Credit Rating Agency Conclusions

Expert Witness: Fulcrum Inquiry
Ratings of debt instruments are an integral part of U.S. financial markets. Reliance on these ratings is increasing, but their reliability is pathetic. A Congressional commission held a recent hearing involving the credit rating agencies. Past and current Moody’s employees who testified provided shocking information.

Ratings of debt instruments are an integral part of U.S. financial markets. Reliance on these ratings is increasing, but their reliability is pathetic. Practically every issuer involved in a major unexpected financial collapse received high ratings immediately before the failure. The most recent and important example involves the failed AAA-rated collateralized debt obligations that set off the 2007 liquidity crisis and current recession. Other notable examples include Enron, Orange County, and Bear Stearns.

The Financial Crisis Inquiry Commission is a 10-member panel formed by the U.S. Congress to examine
the causes of the financial meltdown. On June 2, 2010, the Financial Crisis Inquiry Commission held a hearing involving the credit rating agencies. Warren Buffet, whose Berkshire Hathaway is the largest Moody shareholder, defended Moody’s. Mr. Buffett’s star power got practically all attention in the press, leaving the real story almost entirely unreported. The rest of the witnesses, who were past and current Moody’s employees, were far more interesting and insightful.

The staff report which accompanied this hearing described the problem with false credit ratings as follows:

“Inflated initial ratings on mortgage‐related securities by the RAs [credit rating agencies] may have contributed to the financial crisis through a number of channels. First, inflated ratings may have enabled the issuance of more subprime mortgages and mortgage‐related securities by increasing investor demand for RMBS and CDOs. If fewer of these securities had been rated AAA, there may have been less demand for risky mortgages in the financial sector and consequently a smaller amount originated. Second, because regulatory capital requirements are based in part on the ratings of financial institutions’ assets, these inflated ratings may have led to greater risk‐adjusted leverage in the financial system. Had the ratings of mortgage‐related securities not been inflated, financial institutions would have had to hold more capital against them. On a related point, the ratings of mortgage‐related securities influenced which institutions held them. For example, had less subprime RMBS been rated AAA, pension funds and depository institutions may have held less of them. Finally, the rapid downgrading of RMBS and CDOs beginning in July 2007 may have resulted in a shock to financial institutions that led to solvency and liquidity problems.

Moody’s Employees had Shocking Testimony

The June 2, 2010 hearing contained shocking testimonies from some of the Moody’s employees. Generally, this testimony indicated a nearly complete breakdown in a concern for getting the right answer. Instead, the companies were consumed with how much money could be made regardless of the correct answer. All this testimony came from highly skilled persons. We provide two examples, although additional employees testified similarly.

Eric Kolchinsky

“… during the majority of 2007, I was the Managing Director in charge of the business line which rated sub‐prime backed Collateralized Debt Obligations (also known as ABS CDOs) at Moody’s Investors Service. I have spent my entire career in structured finance and began working with CDOs specifically in 1998. In addition to spending 8 years at Moody’s, I have also worked at Goldman Sachs, Merrill Lynch, Lehman Brothers and MBIA. I hold an undergraduate degree in aerospace engineering from the University of Southern California, a law degree from the New York University School of Law and a Masters of Science in Statistics from NYU’s Stern School of Business. …

The rating agencies could generate billions in revenue by rating instruments which few people understood. The lack of guidance from the private and public users of ratings ensured that there was little concern that anyone would question the methods used to rate the products. The only negative factors to consider were some amorphous concepts of “reputational risk”. In other words, the rating agencies faced the age old and pedestrian conflict between long term product quality and short term profits. They chose the latter.

These asymmetric incentives caused a shift of the culture at Moody’s from one resembling a university academic department to one which values revenue at all costs. ... For senior management, concern about credit quality took a back seat to market share. While there was never any explicit directive to lower credit standards, every missed deal had to be explained and defended. Management also went out of its way to placate bankers and issuers. For example, and contrary to the testimony of a Moody’s senior managing director, banker requests to keep certain analysts off of their deals were granted.

The focus on market share inevitably lead to an inability to say “no” to transactions. It was well understood that if one rating agency said no, then the banker could easily take their business to another. During my tenure at the head of US ABS CDOs, I was able to say no to just one particularly questionable deal. That did not stop the transaction – the banker enlisted another rating agency and received the two AAA ratings he was looking for.

…Despite the increasing number of deals and the increasing complexity, our group did not receive adequate resources. By 2007, we were barely keeping up with the deal flow and the developments in the market. Many analysts, under pressure from bankers and their high deal loads began to do the bare minimum of work required. We did not have the time to do any meaningful research into all the emerging credit issues. My own attempts to stay on top of the increasingly troubled market were chided by my manager. She told me that I spent too much time reading research. “

Mark Froeba

“I am a 1990 graduate of the Harvard Law School cum laude. In 1997, I left the tax group at Skadden, Arps in New York, where I had been working in part on structured finance securities, to join the Derivatives (CDO) Group at Moody’s. I worked at Moody’s for just over ten years, all of that time in the CDO Group. I left Moody’s in 2007 as a Senior Vice President. At that time, I was Team Leader of the CLO team, co-chair of most CLO rating committees and jointly responsible for evaluating all new CLO rating guidelines. …

The story of Moody’s role in the financial crisis … begins sometime in the year 2000. This was the year that Dun & Bradstreet Corporation and Moody’s Corporation became separate independent publicly-traded companies, and, I might add, that Moody’s senior managers were first able to begin receiving compensation in the form of stock options and other stock compensation, interests directly in Moody’s Corporation.

Until this time, Moody’s had an extremely conservative analytical culture. Moody’s analysts were proud to work for what they believed was by far the best of the rating agencies. They viewed Moody’s competitors as a very distant second in quality and ratings integrity. …Unfortunately, by the time the bubble arrived, Moody’s had deliberately abandoned its stature and surrendered this power….

When I joined Moody’s in late 1997, an analyst’s worst fear was that he would contribute to the assignment of a rating that was wrong, damage Moody’s reputation for getting the answer right and lose his job as a result. When I left Moody’s, an analyst’s worst fear was that he would do something that would allow him to be singled out for jeopardizing Moody’s market share, for impairing Moody’s revenue or for damaging Moody’s relationships with its clients and lose his job as a result.

In both cases, there was certainly the fear of job loss. But in the former case it was theoretical and rare — you did not really know of anyone who had been fired for getting the answer wrong but it provoked a healthy anxiety that you had better be careful not to miss anything. Moody’s decades-old reputation for accuracy and integrity was in your hands. In the latter case, the fear was real, not rare and not at all healthy. You began to hear of analysts, even whole groups of analysts, at Moody’s who had lost their jobs because they were doing their jobs, identifying risks and describing them accurately.

Moody’s senior managers never set out to make sure that Moody’s rating answers were always wrong. Instead, they put in place a new culture that would not tolerate for long any answer that hurt Moody’s bottom line. Such an answer became, almost by definition, the wrong answer, whatever its analytical merit. As long as market share and revenue were at issue, Moody’s best answer could never be much better than its competitors’ worst answers. But arriving at an accurate answer was never objectionable, so long as that answer did not threaten market share and revenue. “

Background for the Current System of Credit Rating Agencies

As part of post-Great Depression changes, the U.S. Comptroller of the Currency ruled that Federal Reserve member banks could carry at cost any bonds that rating agencies had accorded investment-grade status, but would have to mark to market any that were rated below investment grade. A few years later, the Comptroller of the Currency ruled that Federal Reserve member banks could invest only in bonds considered investment grade by the established rating agencies of the day. In the following decades, state insurance regulators adopted minimum capital requirements for insurance companies and linked those regulatory capital calculations to bond ratings. Similarly, federal regulators instituted capital requirements for banks, broker-dealers, and pension plans that referenced credit ratings. Through these changes, regulated financial institutions, insurance companies and pension plans were required to consider the rating agencies' conclusions.

To guard against the use of bogus ratings, the Securities and Exchange Commission (SEC) specified that credit ratings be furnished by a "nationally recognized statistical rating organization" (NRSRO). Initially the SEC gave this status to just three firms (Moody's, S&P, and Fitch), who remain the dominant players today. Additional companies were recognized as credit agencies in subsequent years, but due to a combination of mergers and an inability of the new companies to gain market share, the same three remain the only important agencies. Fitch, which tended to provide more conservative (read, more accurate) ratings, lost market share to the two larger firms in recent years.

The Credit Rating Agency Reform Act of 2006 granted the SEC new authority to inspect credit-rating agencies and required that it report to Congress on credit-rating quality and conflicts of interest or inappropriate sales practices. Like the law Congress is now considering, the 2006 law change required the rating agencies to establish internal controls aimed at managing conflicts of interest. Few would argue that the 2006 changes have done anything meaningful to address the problems noted earlier in this article.

Limitations of the Credit Rating Agencies’ Liability

The credit agencies have been able to survive their terrible conclusions because the agencies are difficult to successfully sue. Some (including this author) suggest that the lack of monetary risk for bad conclusions provides the temptation to provide more favorable credit ratings in the first place. The difficulty in suing the credit agencies stems from:

1. Case law, which generally allows the conclusions rendered by the credit rating agencies to be protected as free speech by the First Amendment. Assuming the First Amendment protection applies, their “opinions” are protected from suit so long as the false statements do not involve “actual malice”.

2. The SEC’s Rule 436(g) - The Rule 436(g) exemption was adopted in 1982 to facilitate voluntary disclosure of credit ratings in registration statements. The rule allows references to the credit agencies without the consent of the agency. The existence of the consent would allow Securities Act liability against the consenting credit rating agency, just as already occurs for other experts and professionals.

Current Proposals for Financial Regulatory Changes Will Not Address these Issues

Gary Will, Former Managing Director, Moody’s Investors Service testified at the June 2, 2010 hearing of Financial Crisis Inquiry Commission regarding the underlying reasons for credit agency failure. His testimony included:

“Underwriters and/or issuers can and do change rating agencies at any time. They are also more than willing to use the threat of dropping an agency from a transaction to try to obtain leverage on whatever issue is of concern to them. … The important point to understand is that no single rating agency can address this problem. It can only be addressed through regulation. The Credit Rating Agency Reform Act of 2006 probably made the situation worse with its focus on increasing competition among rating agencies without any compensating mechanism to combat rating shopping.”

Congress appears ready to pass the most sweeping financial reform legislation since the Great Depression. However, the proposed legislation does little to change how the agencies operate.

The Wall Street Reform and Consumer Protection Act of 2009, passed by the House in December, calls for rating agencies to beef up their internal controls, and requires more disclosure about ratings methodologies. The Senate’s companion bill, the Restoring Financial Stability Act of 2010, calls for many of the same internal control changes, and gives the SEC authority to deregister any agency for providing bad ratings over time. The internal control changes sound nice, but actually change little from what is already required.

Both the House and Senate bills propose to strip away federal rules requiring financial-services firms and institutional investors to factor credit ratings into their investment decisions, paring back the government's implied endorsement of the agencies. While this would decrease the federal mandate of the use of the credit agencies, this change does nothing to improve the quality of the ratings. Whether mandated by the federal government of not, credit rating agency conclusions would remain important in many investment decisions.

Importantly, in the final House bill now in conference committee, Rule 436(g) (see preceding section of this article) is removed as follows:

SEC. 6012. Effect of rule 436(G).
Rule 436(g), promulgated by the Securities and Exchange Commission under the Securities Act of 1933, shall have no force or effect.

In contrast, the Senate did not include this provision from the House bill.

Here are our recommendations that the Securities and Exchange Commission and/or Congress should adopt. Most of these come from rules that are already working for certified public accountants who audit financial statements of public companies.

1. Each issuer should employ one rating agency. Once employed, the opinion of that agency is what gets reported. Issuers would no longer able to get as many ratings as desired, and then use the highest ratings.

2. Issuers and rating agencies should not be allowed to “opinion shop” regarding what the conclusions about what any real or hypothetical conclusion might be.

3. When a change in rating agency employment occurs, the fact of this change needs to be publicly reported by the issuer. The disclosure needs to include whether there was any substantive disagreement in the opinions issued by the rating agency in the last two years. The rating agency needs to read the issuer’s disclosure and state its agreement or disagreement with the issuer’s statements.

4. Credit rating agencies can be sued, just like other professionals who are involved with issuance and secondary trading of securities. The current rules and laws that provide otherwise should be changed.

The credit agencies perform a valuable service that make capital markets more efficient. It is nearly unthinkable that investors would want to perform the due diligence that credit agencies are hired to perform. Because of the importance of this rating function and the huge failure to deliver accurate conclusions, additional change is needed.

Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

Copyright Fulcrum Inquiry

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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