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Richard (RJ) Eskow Headshot

Wall Street Noir: Moody's "Double Agent" Ratings

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What happened to Moody's is what happens to every "agent" who thinks he can serve two masters. The sad thing is that it keeps happening, even though we've seen this movie before.

Credit rating agencies are supposed to monitor debt that's issued by financial institutions and governments. It's their job to protect investors from purchasing financial instruments that are misleadingly packaged or are riskier than the buyer can afford. These "agencies" hold extraordinary power -- to destroy companies, to make people fabulously rich, even to influence governments.

The problem is they're not "agencies" at all. They're for-profit companies who have their palms outstretched to the big banks for revenue even as they're "policing" the soundness of their portfolios.

Consider the recent checkered past of Moody's, which holds a 40% market share in the worldwide credit rating business. Allegations have been raised about its CEO's stock trading, harassment of a whistle blower, and intentional deception of the public for its own financial gain. It got everything wrong when it came to rating debt, despite reports it should have known all along.

How is Moody's handling the public shame caused by its ignominious failures? By lecturing the government on how to handle the disaster its own ratings helped to create.

The Moody's File

The SEC declined to file fraud charges against Moody's last month, not because they thought the "agency" was innocent -- the evidence showed otherwise -- but because it said there was a jurisdictional problem. As the SEC's report made clear, Moody's knew a number of credit ratings had been incorrectly rated too favorably. But rather than face the public embarrassment of admitting its mistake, Moody's let the public believe the ratings were accurate. Moody's looked the other way as investors were placed at risk, twiddling its thumbs and whistling to itself like a crooked cop ignoring a robbery.

To conceal its mistake, Moody's s-l-o-w-l-y let the numbers climb back to where they should have been all along. As the SEC makes clear in its report, there is substantial evidence that fraudulent behavior occurred and that investors were misled as a result. The report also presents evidence which shows that Moody's misled the SEC itself, which is a violation of law.

In the latest scandal, a firm that analyzes home mortgages just testified that it told banks that the mortgages they were bundling were a mess, with more than one in four failing to meet even basic underwriting standards -- and they kept on doing it anyway.

They told the rating franchises, too. But, as the head of the analysis firm observed, "if any one of them would have adopted it, they would have lost market share."

He can't help it if he's lucky

As if Moody's reputation wasn't battered enough, there's the matter of questionably timed stock sales by Moody's CEO Raymond McDaniel. One trade that sent out shock waves was McDaniel's sale of 100,000 shares of stock the same day the SEC told Moody's it was investigating the company. That looked very much like trading on insider information of a highly material nature, since the SEC notice threatened a "cease and desist" that would essentially strip Moody's of its "badge and gun" as an agency.

McDaniel says in his own defense that the 100,000-share transaction was part of an "automatic sale" that he didn't directly initiate. But the "automatic sale" was only arranged a month earlier, after Moody's would have been well aware of any SEC investigation. And there's a pattern: A Harvard professor was quoted by Kevin Hall of McClatchy Newspapers as follows: "If you look at his major sales in 2007, 2009, 2010, they are all around price peaks and followed by large declines. The likelihood that this is just 'lucky' is very low -- it appears he is using inside information to time his trades."

Hall and McClatchy had been on the Moody's story like white on rice, as the saying goes. The headline McClatchy gave to Hall's October 2009 story, "How Moody's Sold Its Ratings -- And Sold Out Investors," shows how strongly his editors backed his work.

Senate panels and the Financial Crisis Inquiry Commission both began investigating Moody's shortly thereafter, and the FCIC found it tough sledding. Both the FCIC and California Attorney General Jerry Brown found that Moody's was dragging its feet on providing requested documents. The FCIC was forced to issue a subpoena, and Brown had to go to court to force compliance with a subpoena he had already issued.

Revenue over research

Moody's drive to "always be selling" severely compromised its judgment, according to reports. As Hall reported last June, Moody's executives described its former CEO as "getting in their face whenever they raised obstacles to rating a complex deal, often boasting that they weren't the ones responsible for Moody's surge in revenues."

"Agencies" like Moody's don't make money by generating accurate ratings. They make it by generating ratings that make the customer -- the banks, funds, and insurance companies issuing these debts -- look good. No wonder analysts were discouraged from raising red flags about risky deals. A review of emails and other documents generated by the Senate Permanent Subcommittee on Investigations provided more evidence of this pattern. As an internal PowerPoint showed, consultants who spoke with members of the group that rated the riskiest financial instruments found that they saw their roles as follows:

  • Generating increased revenue.
  • Increasing Market Share and/or Coverage
  • Fostering good relationships with issuers and investors
  • Delivering high quality ratings and research

Just in case that didn't make priorities clear enough, the consultants added: "When asked about how business objectives were translated into day-to-day work, most agreed that writing deals was paramount, while writing research and developing new products and services received less emphasis."

A "franchise," not an agency

That's why the word "agency" is such a misnomer. It's a word with multiple meanings, but in this case it suggests a quasi-government function. The FBI is an "agency." The Environmental Protection Agency is an "agency." Moody's isn't that kind of agency. You'd have to look to another definition, like "the capacity, condition or state of exerting power" or "an establishment engaged in doing business for another." The analysts who placed "writing deals" above research aren't "agents," except for the high-stakes gamblers who pay their fees.

Follow the money. McDaniel held a "town hall meeting" with employees as the economy was crashing around them, thanks in large part to the great ratings they and their colleagues had given to fraudulent products. He said "... my thinking is there's a much greater concern about the franchise. Everyone in this room is a long-term investor (ed: presumably in Moody's stock), for sure."

The raters all own stock in Moody's and want "the franchise" to succeed. That's not an agency. It's a "franchise." That's why the company reportedly "purg(ed) analysts and executives" who warned that there was trouble coming. It's why Moody's and its competitors don't want to be held liable for "recklessly" issuing bad information. It's why they withheld their services at a crucial time because they didn't want to responsible.

Now an ex-employee is alleging they defamed him after he raised issues of fraud and inflated ratings internally, and then to investigators. Agencies don't do that. Franchises do.

Ending the rigged game

Despite all the evidence, Moody's is still treated as a credible player ... and one that's powerful enough to send a warning shot across the bow of the United States government. It threatened to downgrade the US government's debt last March if more wasn't done to reduce the government's debt.

That's the kind of rigged game we're facing: One of the biggest sources of the government's debt is the economic collapse. That collapse was enabled in large measure by the bad ratings issuing by rating franchises like Moody's. Now Moody's wants to hamstring the government's ability to repair the damage it helped create. And it might. They're that powerful, and the system is that rigged.

Imagine: Moody's still holds enormous power because it can deny the government a AAA rating -- the same rating it once freely gave to mortgage securities underwritten so badly that 28% of them were virtually worthless. It's a classic film noir ending: The double agents, the cops on the take, they're the ones who wind up having connections, the ones who seem to come out on top in the end.

The Franken Amendment would slow down the profit-driven salesmanship of the ratings franchises. Good idea, but why stop there? Where are the prosecutions? And it's time to consider shutting these groups down. You've seen this movie, too: everybody knows you can't trust a double agent.

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Richard (RJ) Eskow, a consultant and writer (and former insurance/finance executive), is a Senior Fellow with the Campaign for America's Future. This post was produced as part of the Curbing Wall Street project. Richard also blogs at A Night Light.

He can be reached at "rjeskow@ourfuture.org."

Website: Eskow and Associates