Why Did Bad Bonds Get Good Ratings?

When I was asked what was missing from the proposed financial reform legislation, I should have mentioned the lack of effective reform measures for ratings agencies, particularly the incentive to provide high ratings to encourage future business. 

As noted below, part of the reform legislation is directed at the ratings agencies, but it doesn’t get at the main problem, which is the incentive to tell its customers what they want to hear, i.e. the incentive to deliver higher ratings than deserved. For some reason ($$$???), the ratings agencies seem to be escaping the legislative and regulatory attention they ought to be receiving:

Senate to ask Moody’s chief why bad bonds got good ratings, by Kevin G. Hall, McClatchy Newspapers: …On Friday, Moody’s CEO Raymond McDaniel Jr. will face the Senate Permanent Subcommittee on Investigations, which is looking into the role the credit-rating agencies played in the … financial crisis…

McDaniel has yet to face the kind of congressional grilling already suffered by bank executives. However, an earlier hearing revealed a transcript in which McDaniel told his board of directors that his firm was constantly pressured to inflate ratings — and that sometimes Moody’s “drank the Kool-Aid.” …

Legislation to revamp financial regulations threatens to leave them more open to lawsuits for bad ratings, although not as open as consumer advocates hoped. …

The special role of the ratings agencies was underscored last Friday when the Securities and Exchange Commission brought civil fraud charges against Goldman Sachs. The SEC alleges that Goldman failed to disclose vital information to investors… Goldman’s alleged deception of investors may have extended to the ratings agencies. … However, even if the ratings agencies were duped, their participation in these complex deals gives the appearance of complicity. At minimum, Goldman and its competitors had a symbiotic relationship with the ratings agencies. …

[I]n a McClatchy investigation late last year, former Moody’s officials recounted how Wall Street investment powers like Goldman played the three major ratings agencies off each other to get the ratings they needed to attract investors. The carrot for the ratings agencies was a big reward, $1 million or more, for providing an investment grade to a complex deal.

Moody’s dominated the rating of “structured-finance products”… Chief among these were collateralized debt obligations and mortgage-backed securities … that were sold to investors. Institutional investors such as pension funds … are often restricted to purchasing only investment-grade securities, so Wall Street worked feverishly to win investment grades from Moody’s or its competitors, Standard & Poor’s and Fitch. …

Moody’s … ratings quality eroded as analysts were under intense pressure from … McDaniel to maintain market share and a “business-friendly” environment. …

Perhaps the Senate hearing on Friday will begin to raise awareness of the problems with ratings agencies and prompt legislative and regulatory remedies, but given the lack of scrutiny so far, I’m certainly not counting on it.


Originally published at Economist’s View and reproduced here with the author’s permission.
 
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