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Yesterday, when I heard Warren Buffett’s comments about the role rating agencies played in stoking the flames of our financial failure, I was markedly disappointed. Buffett has been a great inspiration to me personally, both as an investor and human being, and I expected more honest rebuttal on the part of agencies such as Moody’s (MCO), Standard & Poor’s and Fitch. When given the opportunity to bring down the hammer, he simply deflected the blame onto banks that had to be bailed out by taxpayer dollars. One of those banks accepting bailout money (either because they needed it, or were pressured into doing so) was, of course, Goldman Sachs (GS). The same GS that Mr. Buffett helped prop up during the crisis through multi-billion dollar injections of capital. Seems like a mixed message.

A quick history lesson will prove useful when talking about Moody’s and credit rating agencies (CRAs) in general. Credit ratings agencies, mostly Moody’s and S&P, were created to fill a need for an objective rating system for traded firms. The idea was simple; assign a grade to each company depending on their likelihood to repay debt obligations. The system was subscription based at conception, which meant people who needed information on these securities paid for the reports. At this point, the clients of the CRA were primarily investors. The model worked because it was in the best interest of Moody’s and S&P to provide good, honest reporting to the people they were serving. However, soon the business expanded to such a point that the subscription based revenue model was no longer viable.

Enter from stage right one of the stars of our financial show: moral hazard. Believe it or not, there was a decision made that the companies being rated should actually start paying for their own ratings. In a way it makes sense; if companies want to borrow at the lowest cost, they must pay for an auditor to check them out. However, this meant that the companies the CRAs reported on had now also become their clients. Even if these agencies had been government controlled or not for profit entities, most people can agree there was a problem with this model.

However, when Moody’s went public in 2000, the problem became much more serious. Lots of “cozying up” with clients began to take place. Sylvain Raines may have said it best when he said, “people talk about moral hazard at banks, but the moral hazard for rating agencies is extreme.” It is difficult to objectively assess risk and credit worthiness when you are in close personal and business contact with the subjects you are rating. The fact that Buffett does not address this obvious hazard is disconcerting.

The arrival of a third rating agency, Fitch, began to create competition between the three firms. Although Fitch had been a “nationally recognized statistical rating organization” since 1975, they didn’t become relevant until the 1990s. Once Fitch arrived, the duopoly was put under pressure and price competition lowered the intensity of research and increased the rate at which ratings were provided. At the same time, there was other pressure they began to feel; the pressure to produce more favorable ratings than the other CRAs. This created incentive to rate companies more highly than they otherwise may have been rated. One thing to notice is that Moody’s had been notorious for being more severe in their ratings than S&P. This all began to change during the housing bubble.

While the competition between these firms was becoming an issue, MBS/ABS securities were also becoming a more important part of their revenue stream. These two things combined to create an incentive to win as many MBS/ABS contracts for rating as possible. This basically meant giving favorable ratings to companies so that they could win more bids. In fact, since Fitch’s initial MBS ratings were significantly lower than either of the other two agencies, and they were basically excluded from rating these securities altogether.

In regard to Moody’s, they made some severely questionable moves prior to the crisis. First, they eliminated the premium that gave a bonus to a certain package of securities that were diverse. This “diversity score” relied on the financial theory of risk mitigation. When this was abolished in 2000, collateralized debt obligations (CDOs) were just beginning to become a major player in the security market. Eliminating the diversity score coincidentally greatly improved the ratings for these homogenous portfolios overnight.

Another shady move that Moody’s made involves the formula used to rate ABS and MBS. The formula used to rate them had a severe mathematical error. The error was estimated to have increased the CDO ratings by as many as four notches. Instead of correcting the formula, an emergency meeting was apparently held and changes were made to maintain the AAA ratings on MBS/ABS. The SEC is still investigating how accurate these allegations are.

Was this a coincidence? I think not. The combination of these two moves by Moody’s made it almost impossible for the other agencies to compete with the “quality” of their ratings. Fitch refused to rate the MBS market as anything other than slightly above junk. However, S&P felt pressure to stay in business and kept up with the trend of overrating securities. These pressures greatly increased the ratings given to pools of mortgages that should have been rated far below investment grade. The risks were there, but moral hazards prevented the CRAs from doing their jobs.

My major problem with Buffett’s most recent comments is his comparison between Moody’s and the general public. Warren said that the managers at Moody’s “made a mistake that 300 million other Americans made.” This is certainly true, but it is the role of agencies such as this to NOT make those mistakes. If they are held to the same standard as the general public, then why are they paid millions of dollars a year to rate companies and securities? Why do they exist? If what Buffett says is true, we might as well eradicate the ratings agencies altogether.

Should the ratings agencies be held accountable? Absolutely. There is no one person to blame for the housing bubble or subsequent financial collapse. However, these agencies were supposed to be the vanguard of investor protection and they failed miserably. CRAs played a dynamic role in the overconfidence of the market leading up to the housing bubble. Blame must be laid, and there must be creative new ways for investors to research companies. This model is broken, Mr. Buffett, and no amount of public politicking will prove otherwise.

(ref: Sam Jones, “When Junk Was Gold – Part 1/2,” Financial Times, 18 Oct. 2008: 16)

Disclosure: No positions

Source: Why Buffett Is Wrong