Nearly two years after the start of the recession and 11 months after the Securities and Exchange Commission took action to correct the practices that produced the downfall, Eric Kolchinsky, a former managing director at the credit rating agency Moody's, warned that the trade in dubious securities continues.
Those deals, in turn, are facilitated and legitimized by the same credit rating agencies whose questionable judgment and internal conflicts of interest ushered in the worst financial collapse since the Great Depression.
"In many ways the incentives for rating agencies have become worse since the credit crisis," Kolchinsky told a House Financial Services Subcommittee. "There are now more rating agencies and they're all chasing significantly fewer transaction dollars."
Moody's and other prominent credit rating agencies are private companies whose revenue stream derives from fees paid by the issuer of the debt securities they rate, a business model known as issuer-pays. In this business, more ratings means more money. And until recently, business had been booming.
Much of this can be traced to the explosion in new debt securities--bundles of mortgages and other types of consumer debt sold to investors--each of which was rated by the credit rating agencies. Moody's earned $165 million from fees in 1999; just six years later this sector had grown to $883 million or more than two times what they earned from more traditional instruments like corporate debt.
Many of these complex securities, which were rated investment grade, permitting banks, money market funds, and other financial institutions to invest in them, subsequently blew up when real estate values dropped in 2007.
Despite that history, credit rating agencies, desperate for business and competing for market share, are still rating these securities, according to Kolchinsky.
"This toxic product needs to be consigned to the dustbin of bad ideas, but unfortunately there are no incentives for rating agencies to say 'No' to a product no matter how poorly thought through," Kolchinsky said.
Congress is now weighing regulatory legislation that would force historic changes in this largely unregulated industry. The House bill, which was approved by the House Financial Services committee and is set to be introduced to the House in the next few weeks, calls for enhanced SEC oversight, mandatory disclosures of both fees and conflicts of interest, and would impose liability for the first time on the credit rating agencies.
Meanwhile, Moody's has spent $820,000 lobbying Congress on this pending legislation. Neither Moody's nor their lobbying firm, Akin Gump Strauss Hauer & Feld LLP, responded to requests for comment.
However, critics contend these are meager reforms that will not rein in egregious practices such as preliminary ratings, in which the agencies are paid a fee to consult issuers and pre-rate their securities, ratings shopping, in which issuers can use the competition between the agencies to get the most favorable rating, or the rating of troubled debt securities that Kolchinsky warned against. Instead, the legislation may end up erecting higher barriers to entry that will fortify the dominance of issuer-pays giants like Moody's.
From Manual to Monopoly
The recent arrival of Moody's as a major Wall Street player was hardly assured. The company began in 1909 when founder John Moody published Moody's Analyses of Railroad Investments. Unlike previous publications that compiled statistics and information about companies, this one offered something completely new: rigorous and methodical analysis. By analyzing the railroad companies, Moody arrived at letter grades for their corporate bonds. The scale went from Aaa for bonds with the highest probability of repayment down to C for the most dubious. In so doing, Moody became the first to issue ratings of public market securities, according to the company.
Moody's ratings manual was a hit. Within five years, Moody's was rating industrial companies and municipalities and by 1924, was covering nearly the entire U.S. debt market.
Improbably, Moody's, along with rival ratings publishers, which began a spectators to the market, were brought to its very core in the aftermath of the Great Depression. To insure the financial stability of the nation's banks, the Securities and Exchange Commission, created in 1934, forbid banks from holding bonds below investment grade, in which the risk of default judged to be higher. Having established this, the SEC left the determination of which individual bonds were investment grade to Moody's and the three other ratings manuals. They had been deputized.
State by state, regulators followed suit, mandating that insurance companies and other financial institutions maintain capital levels based on the credit ratings of their bond holdings. By 1975, even Wall Street's portfolios heeded the credit ratings. All this, of course, meant big business for the companies. Their imprimatur was essential to the thousands of corporations, cities, and even sovereigns issuing debt.
Sensing its newfound importance, Moody's shifted to a new business model in the mid-1970s. Where, previously, Moody's had made money by selling their bond rating manual to investors, they now began to charge the companies issuing bonds a fee for the service.
"The rationale for this change was, and is, that issuers should pay for the substantial value objective ratings provide in terms of market access," according to the company's website. "In addition, it was recognized that the increasing scope and complexity of the capital markets demanded staffing at higher levels of compensation than could be received from publication subscriptions alone."
Revenue shot up. By tapping the thousands of companies issuing debt for each of their bonds issued, Moody's rose from a small-time operation at the margins of finance to a significant player, with the money and prestige to match. Their ratings became free to the public.
In 1975, the SEC issued another fateful regulation for the credit raters. The commission, concerned by the possibility that phony credit raters could defraud the market, established that only ratings by "nationally recognized statistical rating organizations (NRSRO)," mattered in determining capital requirements. The three raters--Moody's, Standard & Poor's, and Fitch Ratings--were inducted into this new category. And with the SEC controlling who could be an NRSRO, few new companies entered the sector and those who did were soon swallowed up by three reigning companies. Over the next quarter century, the business became a triumvirate.
This ascendance was not solely the result of regulation, according to New York University economics professor, Lawrence J. White, who has written extensively on the credit rating industry.
"The market for bond information is one where economies of scale, the advantages of experience, and brand name reputation are important features," White wrote in statement to the SEC. "The credit rating industry was never going to be a commodity business of thousands (or even hundreds) of small-scale producers, akin to wheat farming or textiles."
Moody's rates all segments of debt, from corporations to financial institutions, public works projects, governments, and structured securities and charges them for the service. Moody's Investor Service, the credit rating company, charges bond issuers from $1,500 to $2.4 million, the amount depending on factors like the principal amount on the bond issue, the complexity of analysis required, and the type of security. Near the height of the housing bubble, in 2006, Moody's Investor Service made $1.6 billion on these fees from issuers--86 percent of its revenue that year. The remaining revenue comes from institutional investors and issuers who pay for analysis and consulting.
Moody's rates debt securities from over 13,000 companies and 110 sovereigns. Some have argued that with so many clients, the raters are less likely to be biased in favor of one, if in so doing they would harm their reputation for accuracy. Moody's maintains that the rating process itself is also a check on undue influence by issuers.
Ratings decisions are made by a committee of analysts, the size and composition of which is determined by the type of security being scrutinized. Their task is to gauge how likely the issuer is to repay the debt.
"Moody's measures the ability of an issuer to generate cash in the future," according the company's website. "This determination is built on a careful analysis of the individual issuer and of its strengths and weaknesses compared to those of its peers worldwide."
Ratings are decided by vote. Analysts who sit on the committee are prohibited from holding securities in or having any relationship with the company whose debt security is being rated. Nor are they involved in negotiating fees with this company or compensated based upon the rating conferred. By maintaining objectivity at the analyst level, Moody's contends that its ratings are safeguarded from the influence of clients.
However, critics say that these checks hardly make Moody's impartial. Analysts, as employees, have an implicit incentive to see the company's revenue and market share grow. In the case of compensation with company shares, it is explicit.
The company is torn between the goal to be as accurate as possible--to be seen as legitimate and accurate by the marketplace--and the imperative to get as much business, namely ratings, as possible. Recent trends have exacerbated this precarious balance.
The Race to the Bottom
The explosion of the structured finance market upset Moody's existing model. When investment banks transformed household debt into a commodity, they needed ratings to sell them to institutional investors. That's where Moody's, and other credit rating agencies, came in.
For large fees, Moody's rated complex new financial instruments and even began to consult on these securities and issue pre-ratings. One new type of product was the mortgage-backed security, which is essentially debt pooled from mortgages. The arranger, perhaps with the undisclosed assistance of a credit rating agency, divided the mortgages into sections, known as tranches, based on the likelihood of repayment; the junior tranches--the riskiest--were increasingly loaded with subprime mortgages after 2001.
These securities, which were unique and often exceedingly complex, were different in kind from Moody's previous ratings. Instead of examining the ability of one company to repay, these instruments were composed of hundreds, perhaps thousands, of borrowers. Moody's had to evaluate the criteria by which the issuer had divvied them into tranches.
Only a few issued these securities: private mortgage lenders, banks, and government-sponsored entities like the Government National Mortgage Association. In turn, these companies hired arrangers, typically investment banks, to structure the securities. For the issuers, the deal's profitability came down to maximizing the size of the highest rated tranche or the number of tranches that were investment grade. Since these securities have a higher rating--meaning a better chance of being repaid--the issuer pays a lower interest rate to the investor.
Handling high volumes of complex products from the same investment banks diminished the independence of the credit rating agencies, according to White.
"An investment bank that was displeased with an agency's rating on any specific agency's rating on any specific security had a more powerful threat--to move all of its securitization business to a different rating agency--than would any individual corporate or government issuer," White said.
With each company competing for this structured finance business, critics contend a culture developed in which issuers shopped for favorable ratings in return for continued business. In this hyper-competitive marketplace, credit rating agencies competed for market share by curtailing scrutiny of the products they rated.
For this market, the credit rating agencies developed a new offering: the preliminary rating. For a fee, Moody's analysts could help an issuer structure a mortgage-backed security and then provide a preliminary rating. This became a way for investment banks to lock in the most favorable ratings of their securities. And while it grew into a substantial source of revenue for the credit rating companies, it cast away their perceived objectivity. After all, they were now rating securities they helped design.
New Rules for an Unregulated Industry
Some of these conflicts of interest will be addressed by the Credit Rating Agencies Reform bill, which is expected to be brought to the House floor for a vote during the next few weeks. If enacted, it would extend regulatory oversight to a corner of the market that has been virtually unregulated since the days of John Moody a century ago.
While SEC oversight began in 2006, for the most part the commission has been limited to running the NRSRO designation process. This bill would expand their authority, establishing an NRSRO office at the commission which would supervise the companies, and issue rules for the management and disclosure of their conflicts of interest.
Under the new rules, Moody's would have to disclose the fees it was paid with each rating, as well as its rationale for the rating, the completeness of the information that went into it, and the risks of default. They would also have to disclose fees for preliminary ratings, if provided.
In addition, the bill mandates that a third or more of the credit rating agency's board of directors must be independent. Paid a fixed salary and serving a fixed term, these directors will be tasked with overseeing rating protocol and management of conflicts of interest.
Reform advocates, like the Consumer Federation of America, see additional oversight and a more independent board as a means to protect the interests of those who rely on credit ratings. They have spent $100,000 this year lobbying for this bill and other financial reforms.
"In this key governance role, overseeing the development of methodologies, overseeing the handling of conflicts of interest, you increase the chance that the credit rating agencies will be operated in the interest of investors," said Barbara Roper, the group's director of investor protection.
Even these steps are paltry, however, in comparison to the imposition of liability. Moody's and the other credit agencies, with roots in publishing, have effectively defended themselves from lawsuits for a century on free speech grounds; they consider their ratings opinions. That is now imperiled on three fronts: legislation, proposed rule changes by the SEC and pending court cases. In one recent case, in which Abu Dhabi Commercial Bank is alleging fraud by the credit rating agencies, the federal judge threw out the companies' defense, saying that deliberate misrepresentation, if committed, is not protected by the first amendment.
While the credit rating agencies have always been subject to liability for fraud, they have attained their own legal status within the marketplace. By law, financial statements and disclosures must be factually accurate and complete. However, credit ratings have been exempt from this legal standard since 1981 by the SEC. Revoking it is now under review.
The House bill does not address the credit rating agencies first amendment arguments, but it establishes civil liability for "knowingly or recklessly" violating the securities laws, including the disclosures required by the act. Other sections of the bill stipulate that the companies must factor all information known about the company into the rating.
The Financial Services Committee approved the bill handily, with a vote of 49 to 14. Credit rating reform is less complex than other efforts, like regulating derivatives, and more politically palatable given the ire at ratings agencies, according to Roper, who says it was the only legislation actually strengthened in committee. With Wall Street distracted by other, larger bills, Roper believes the credit rating agency reform legislation stands a good chance of passage.
"The credit rating agencies don't have the same muscle to get the legislation changed," said Roper. "And the financial services industry, which might serve as an ally under other circumstances, is distracted by other issues."
Reforms May Miss the Mark, Say Critics
When the SEC directed that banks must hew to credit ratings in 1936, the intent was to protect the nation's banks, and thus their depositors, from risky securities. A stable banking system remains the principle goal of reformers.
To accomplish this, reforms of the credit rating industry might take two directions. One would remove regulatory references to ratings, strip the companies of their special status with the SEC, and deregulate the industry. Credit ratings would no longer dictate what securities money market funds, mutual funds, pension funds, and banks may hold or set capital requirements for other institutions. In this system, portfolio management might fall on banks and bank regulators--not the credit rating agencies. Ratings would be pure opinion.
Reformers, as this bill makes evident, are taking the other direction: enhancing regulation of the credit rating agencies and formalizing their status within the economy.
"As gatekeepers to the markets, credit rating agencies must be held to higher standards," Congressman Paul E. Kanjorski, who introduced the bill, said in a press release. "We need to incentivize them to do their jobs correctly and effectively, and there must be repercussions if they fall short."
Imposing liability is the most radical change proposed. It would strip them of their legal immunity and open the companies to claims from both issuers and investors. Moody's argues this would jeopardize their objectivity because issuers, for instance, might use the threat of a lawsuit to coerce a better rating.
Many industry experts, however, feel that this scenario is unlikely since the plaintiff would have to prove high standards of malfeasance on the part of the rating agency.
Instead, former Moody's employees like Scott McCleskey, a vice president who was responsible for compliance and internal policies, say the company's overriding fear of litigation detracts from their capacity to manage conflicts of interest.
"Their biggest worry is civil liability," said McCleskey. This comes from "having a general counsel's office that has been all about keeping away from lawsuits. And that's sometimes at odds with good compliance. You know, you want to document things, you want to write things down. If you're worried about liability, that's exactly what you don't want to do."
The bill would make the credit rating agencies more transparent by exposing the fee structure, and thus potential conflicts of interest, behind each rating, according to many industry experts. However, they say that the bill will not eliminate ratings shopping.
That's because ratings shopping is a byproduct of the issuer-pays business model, according to Jerome Fons, the former managing director of credit policy at Moody's.
Better ratings mean higher profits for issuers. So they seek the best ratings amongst the accredited rating agencies, whom they pay for the service. As long as these ratings are required and there is competition amongst the rating agencies to get this business, this practice will continue.
Even if the bill banned preliminary ratings--which it falls short of doing--issuers would find ways to shop credit raters, according to White. For example, suppose that a certain ratings firm acquires a reputation among issuers for complaisance, but for some reason investors don't realize this. Issuers will tend to migrate to this firm. They won't even need to pay them for a preliminary rating.
Regulators have fostered more competition by registering seven more rating agencies since 2002, bringing the total number to 10. This also was believed to reduce reliance on the big three--Moody's, S&P, and Fitch Ratings.
However, when taken together, the bill's changes may actually reinforce the position of these three companies. Since the bond rating business is based on trust, these established firms already have an advantage over the newcomers. Added to this, the costs of liability, increased regulation and disclosure may discourage entry further, according to White.
White illustrated his point with Jules Kroll, the founder of a risk consulting firm who recently announced he wanted to get into the credit rating business.
"But would he want to become an NRSRO if it means he means he has to jump through all kinds of hoops and have all this extra administrative cost?" White asked. "Moody's, which is a multi-billion company, can easily afford it. Can Mr. Kroll?"
"Moody's, Standard & Poor's, and Fitch's--three companies that everybody loves to hate," White added. "But, irony of ironies, when the smoke clears, they will even more important because there will be even fewer potential entrants."