For years, credit rating agencies—the referees of Wall Street—insisted they were an impartial source of information, despite their financial reliance on the companies they rated. Then came the market meltdown—and a chorus of accusations that firms had artificially inflated their risk ratings to please their clients and gain a competitive edge. And now there's plenty of evidence to suggest the "referees" were unduly influenced by the players.
According to internal documents released at a congressional hearing Tuesday, while rating agencies strenuously defended their independence publicly, some of their top executives acknowledged privately that they faced fundamental conflicts. As one executive at Moody's, a major credit rating agency, put it following an internal discussion on the implosion of the subprime mortgage market, "These errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue." The documents lend credibility to charges by Wall Street executives that the rating agencies deserve part of the blame for the current financial crisis. "The story of the credit rating agencies is a story of colossal failure," said Henry Waxman (D-Calif.), the chairman of the House Committee on Oversight and Government Reform, which is holding a series of hearings to investigate the causes of the market meltdown. (Mother Jones also covered hearings on Lehman Brothers and AIG.)
The central problem that confronted the rating agencies, according to witness testimony and internal documents, was a fundamental conflict of interest, one that is inherent to the business model that many agencies adopted in the 1970s. At the time, they moved from charging investors for ratings information to charging companies to rate their products. Since issuers, not investors, are now the major profit center for the "big three" rating firms (Moody's, Fitch, and Standard & Poor's), the rating firms have an incentive to deliver good ratings for the issuers, whether or not the financial products in question actually deserve them.
Raymond McDaniel, the CEO of Moody's, explained the problem in a confidential presentation to his board of directors in October 2007. Under the heading "conflicts of interest," he wrote, "the market
It turns out that ratings quality has surprisingly few friends: issuers want high ratings; investors don't want ratings downgrades; short-sighted bankers labor short-sightedly to game the ratings agencies."
In the same presentation, McDaniel noted, "Analysts and MDs [managing directors] are continually 'pitched' by bankers, issuers, investors
[and sometimes] we 'drink the kool-aid.'" Employees at Standard & Poor's also recognized that being paid by issuers often led to overly optimistic ratings for complex—and risky—financial products. "It could be structured by cows and we would rate it," Shannon Mooney, an analyst in the company's structured finance division wrote in an April 2007 instant message to a colleague. Another Standard & Poor's employee remarked in a 2006 email, "Let's hope we are all wealthy and retired by the time this house of cards falters."
They weren't alone in believing the ratings were unreliable. Some of the investors who relied on those ratings also had doubts, and told the agencies as much. A manager at mutual fund giant Vanguard told Moody's last year that the company and its competitors "allow issuers to get away with murder." Other big investment firms, including PIMCO, repeatedly criticized the rating agencies' practices. And a top executive at Fortis Investments asked a Moody's official in a July 2007 call, "If you can't figure out the loss ahead of the fact, what's the use of your ratings?...If the ratings are b.s., the only use in ratings is comparing b.s. to more b.s."
Dean Baker, an economist and the codirector of the Center for Economic and Policy Research, said in an interview that the agencies' conflicts of interest have long gone unaddressed. "It is remarkable that this has never become much of an issue before," Baker said. "The agencies want to get hired, and they're well aware of the fact that if they're not giving acceptable ratings, they may not be called back." But Baker also emphasized that sometimes the rating agencies may have just been incompetent. Unfamiliar with the new financial instruments issuers were asking them to rate, the firms went ahead and rated them anyway, he said.
Not all rating agencies use the issuer-pays business model that the Moody's and S&P employees acknowledged was so problematic. Testifying on Tuesday, Sean Egan, a managing director at Egan-Jones Ratings, which still uses the investor-pays system, was a fierce critic of his competitors, calling their conflicts of interest the "single greatest cause" of the financial crisis. "The current credit rating system is designed for failure," Egan argued, saying that all the major financial companies that have "failed or nearly failed" have done so "to a great extent because of
unsound, and possibly fraudulent" ratings. Unsurprisingly, Egan suggested that the market should rely more on companies like his. "We should go back to a model that's worked since biblical times
[and] represent those who invest in securities, not those who issue them," he said.
Baker said the best way to solve the conflict of interest problem is to take away issuers' right to choose which company rates their products. Instead, he suggested, the exchange that the product is listed on should select the rating agency. The issuer would just pay the bill.
On Tuesday, the top executives of Moody's, Standard & Poor's, and Fitch argued that there was no way they could have anticipated the collapse in the subprime market. The CEOs also disputed the conflict of interest charges, arguing that an investor-pays model could potentially involve just as much conflict, since investors have much at stake in ratings as well. "Potential conflicts exist regardless of who pays," said McDaniel, the Moody's CEO. But he said that his company "will adopt whatever additional policies and procedures may be necessary" to implement the Securities and Exchange Commission's forthcoming revised rules on conflicts of interest.
Despite Egan's warning that action is needed, Rep. Darrell Issa (R-Calif.) asked the witnesses how to keep Congress from "doing what we do best: either doing nothing or overreacting." But Issa focused mostly on a fear of overreaction, noting that conflicts of interest exist in many other business situations—accounting, Sarbanes-Oxley compliance, and underwriting, among others. Egan pointed out that in most of those situations, the entities with conflicts still have something to lose. They can be held criminally liable or sued if they issue false or misleading statements. But ratings are treated as opinions and protected under the First Amendment, so there's little downside for misrating financials. Indeed, since issuers want good risk ratings, the agencies could conceivably attract more business by rating products too highly.
Rep. Stephen Lynch (D-Mass.) emphasized the impact of the rating agencies' failures on individual investors. Lynch explained that most everyday investors have no way of understanding the actual composition of the complicated financial products. Instead, they rely on the ratings to let them know the level of risk an investment carries. "People in my district knew what 'triple A' meant and they relied on that," he said. "And now a lot of people in my district feel that they have been defrauded."
Photo from flickr user woodleywonderworks used under a Creative Commons license.