The Rating Game: Putting the Company's Profits and Market Share Before Quality Ratings

Here's how broken our current system has become: Not only are the ratings agencies competing as for-profit businesses, but our two largest agencies arecompanies driven solely by profits.
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PowerPoints, emails, and transcripts obtained by Sen. Carl Levin's Permanent Subcommittee on Investigations illustrate the real magnitude of Sen. Al Franken's victory today. Sen. Franken was able to pass an amendment which eliminates the conflict of interest that's created when ratings agencies "compete for business." It passed the Senate in a 64/35 vote - and it was a bipartisan victory, no less, with 10 Republicans joining 54 Dems to support it.

Here's how broken our current system has become: Not only are the ratings agencies competing as for-profit businesses, but our two largest agencies are publicly traded companies. That means they don't just worry about making a profit. They also have to worry about impressing the stock market on a quarterly basis to boost their stock prices and further enrich their executives. And who influences stock prices the most? Traders on Wall Street, who are also the agencies' customer base and the objects of their scrutiny.

Nowhere is this inherent conflict of interest better illustrated than in a PowerPoint presentation which consultants gave to Moody's Investor Service in 2002. Consultants held focus groups and conducted interviews with key Moody's executives and associates in the Structured Finance Group (SFG), which is responsible for rating complex and potentially risky financial products. Here's the money shot:


Got that? The people responsible for rating risky financial instruments thought their business objectives were "increased revenue," "increasing market share," and "fostering good relationships" (with issuers before investors). Seemingly as an afterthought, the Moody's group added that they should develop "high quality ratings and research." An equally critical paragraph appears further down on the same slide:

"When asked about how business objectives were translated into day-to-day work, most agreeg that writing deals was paramount, while writing research and developing new products and services received less emphasis. Most agreed that there was a strong emphasis on relationships with issuers and investment bankers." (emphasis mine)

In other words, getting more business came first - hence the mentions of revenue, market share, and pleasing the issuers and investment bankers who drive those numbers. Research got "less emphasis." And why wouldn't that be the case? Moody's parent corporation (which is listed on the New York Stock Exchange as MCO) has quarterly earnings to meet. So does its principal competitor, Standard & Poor's. S&P is a division of publicly traded McGraw-Hill (NYSE:MHP), with annual revenues of $2.61 billion for 2009 (that's nearly 44% of the parent company's $5.95 billion in revenue).

No wonder the Levin Subcommittee found internal emails like this one from S&P: "I don't think this is enough to satisfy them. What's the next step?" Even more telling is this question from the transcript of the "Managing Director's Town Hall Meeting" at Moody's in September of 2007. Managing Director Raymond McDaniel was asked about "the financial outlook for the rest of the year." The question continued: "... 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 ... It's disheartening ... to see what's going on with the stock price."

In other words, the people entrusted with rating financial products are concerned about the value of the stock they hold in their own company ... which is driven by the actions of the people they're rating! McDaniel responded that critics "are not going to find anything at Moody's in terms of corrupt or bad actions."

To that point, New York Attorney General Andrew Cuomo is investigating eight banks for allegedly having given false information to Moody's and its competitors. The New York Times also reports that sources say Cuomo is "interested in the revolving door of employees of the rating agencies who were hired by bank mortgage desks to help create mortgage deals that got better ratings than they deserved." The Cuomo investigation was sparked by an earlier Times report which said that "Wall Street was given access to the formulas behind those magic ratings -- and hired away some of the very people who had devised them."

Ratings agencies were then shocked -- shocked -- to learn that banks might have manipulated their models - models which they freely gave to them as their "customers." Yves Smith considers it very plausible that the ratings agencies were "duped, rather than dumb" - or worse, complicit. But these possibilities are not mutually exclusive. At the very least, Levin Subcommittee exhibits like the Powerpoint slide, internal emails, and Moody's Town Hall transcript show that it was in the agencies' financial interest not to know the truth.

The Franken Amendment fixes this problem by directing the SEC to create a board that will assign one rating agency to rate each new issue-backed security. The majority of seats on the board would go to investors. (More detail here.) As Sen. Franken explained during today's debate, the system would provide incentives for accuracy (rather than for ratings that please issuers), and the board is self-governing. Issuers would be free to seek other ratings once the board-approved agency had made its conclusion.

While the amendment passed today, it does have opponents. In an uncharacteristically inarticulate floor speech today, Sen. Chris Dodd opposed the bill for reasons he couldn't quite specify, saying that it made him "uneasy" and he "wasn't sure it was sound." Since the reasons for his opposition were unclear, it's equally unclear whether any deals might be underway to weaken the amendment with other provisions during the negotiation process.

Hopefully that can't or won't happen, but the mentality and the power base that create our current ratings agency problem is alive and well. Sen. Franken has won an important victory today, and it needs to be defended at all costs.

(Note to my fellow observers and scribes: Now that he's helped transform the financial world, can we please write about Sen. Franken without making "playful" references to his entertainment career? He's earned that. I'm not naming any names, but you know who you are.)


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 ""

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