The New Paradigm – The Role of Rating Agencies

Through the entire sub-prime problem and credit crunch the rating agencies have kept a relatively low profile. Problems with the agencies bubble up from time to time, but they are not in the news as much as Countrywide, Citigroup, or some of the others. This may not continue to be the case forever. As the wheels of the investigation of the mortgage crisis grind slowly on it will be interesting to see the role the rating agencies played. I can’t prove it at this point, but I think their world will change significantly over time. The article below is a little more like an editorial, but it makes some interesting points. Text in bold is my emphasis. From Market Watch:

The watchdogs of investment, Standard & Poor's and Moody's Investors Service are tweaking the way they scrutinize securities.

At S&P, for instance, no longer will they hand out triple-A's to issuers who pay them boatloads of fees. They now will employ an ombudsman to listen to complaints about the agencies handing out triple-A's to issuers who pay them boatloads of fees.

What if General Motors built cars that didn't run, or your local dairy produced sour milk? What if your bank said it didn't deposit your paycheck because it lost it, or the electric company just quit supplying your neighborhood?

Then, in response to it all, those companies said: good news, we're hiring an ombudsman. The ratings agencies in the same fashion have failed on their intrinsic purpose: to judge the likelihood that a debt will default. As of Tuesday they're about 0 for a few billion.

When . . . . . Andrew Cuomo, New York State Attorney General, calls it "window dressing," you know it's not a good plan. (The original article makes comments about Andrew Cuomo, but I do not know anything about Mr. Cuomo.)

"The supposed reforms...are too little too late," Cuomo said in a statement. "Both S&P and Moody's are attempting to make piece-meal change that seem more like public relations."

Cuomo's right when he suggests that Moody's, S&P and Fitch Ratings are taking actions that don't go to the heart of the matter. It's a pattern with these guys.

The big two, S&P, a division of McGraw Hill Cos. and Moody's , have knowingly operated with deep conflicts in how they are paid. Nowhere was this more obvious than its structured-products group, the place where collateralized-debt obligations and mortgage-backed securities were evaluated.

Nearly half of Moody's revenue in 2006 came from this side of the business. During the most recent quarter, revenue from structured securities fell by nearly half.

Part of the problem is that ratings -- the three-letter system with pluses and minuses -- just don't fit with structured products. Values of these securities move too fast for ratings firms, which are notoriously slow to react to market changes, to make useful determinations, according to Richard Portes, a professor of economics at London Business School.

A more serious part of the problem was S&P and Moody's didn't just rate the final product. They sold advice on how to structure these securities - the kind that are now responsible for eviscerating the debt markets and nearly pushing U.S. banks into the arms of foreign ownership.

That's why the industry can't be counted on to reform itself and why investors need to be willing to foot the bill for independent analysis: profit from the issuer needs to be taken out of the equation.

Though the federal government has been aware of the problem, it hasn't made effective policy to stimulate competition. In 2006, lawmakers tried to force S&P and Moody's to disclose more about how it issued ratings. Congress also voted to make it easier for companies to enter the ratings business.

Ratings firms have their defenders. Some say the industry's efforts at reform go deeper than they appear. There are more than two dozen reforms. Analysts won't work alone. Likelihood of default will be the sole criteria in ratings analysis. The track record of analysts will become public, and they will have more education.

Four analysts have buy ratings on Moody's. Citigroup Inc.raised its rating on Moody's to buy on Friday. Citi's analysts wrote, "Moody's could see headline risk over the next few months, but we believe that Moody's is taking the necessary steps to restore confidence."

Yes, this analysis from a company that's written down more than $20 billion, in part, because firms such as Moody's couldn't tell that jobless borrowers with second or third mortgages for overvalued homes might be an investment risk. (Seems a little chummy to me.)

This is the same kind of talk we heard after the ratings firms failed us in the Enron-WorldCom era.

Unfortunately, the one area where real reform can be made -- who pays for ratings -- is being ignored. A new proposal being considered at the Securities and Exchange Commission would require more disclosure of past ratings. The idea is to make the track records of the firms and analysts comparable.

But Christopher Cox, the SEC chairman, hasn't spelled out enough details, even though he wants to reward firms with good track records. That's only going to happen if the parties who benefit the most from accurate ratings, investors, pay for accurate analysis.