The Abysmal Track Records of Moody's, Fitch and S&P

| About: Moody's Corporation (MCO)

“How could the credit-rating agencies be so wrong consistently? [They were] wrong on Mexico, wrong on Asia, wrong on Enron, wrong on subprime. . . . ”
-Congresswoman Carolyn Maloney (D–New York)

“Most people don’t really know how the bond raters compete in the structured-finance area. “[At my agency], we tried to do our best, but we also understood the conflicts. We all assumed that if we pounded the table too much we’d be left out of the deal.”
-A former employee at a Big Three rating agency

Freddie Mac's (FRE) troubles are front page news today (WSJ: Mortgage Giant Fuels Worries With Steep Loss). Treasury Secretary Hank Paulson has figured out that the Housing slow down isn't bottoming anytime soon, and that 2008 will be worse than 2007.

But the most interesting read of this morbid tale comes from the lesser known publication Trader Monthly (website: Well known muckraker (and CNBC on air editor) Charlie Gasparino (his most recent book, “King of the Club", covers the rise and fall of Dick Grasso) gives the full monty to the Big 3.

Hidden behind a free registration firewall, Berating the Raters pulls no punches. Gasparino calls the rating agencies track record "ABYSMAL." He explains what he describes as their "hopelessly conflicted business model." He challenges readers to consider the track record of "what they get paid to do — weighing the risks for investors and traders who buy bonds."

Most of all, he notes simply: The rating agencies significantly contributed to the subprime crisis that caused the credit crunch this past summer and that may sink the economy into recession.

(How's that for a well crafted and powerful sentence?)

Here's a potent excerpt:

"The bond raters make money through one of the most flawed and conflicted business models in corporate America. The bond raters are supposed to be working for investors (hence the name Moody’s Investors Service, for example) by assigning letter grades to a bond’s ability to make principal and interest payments. The reality is much different. In rating-world lexicon, AAA means that barring nuclear war, the bonds are good. D means they’re either nearing or in default.

This conflict has posed huge problems. Municipalities have canceled contracts with rating agencies that took a negative view, and hired those who were easier graders. All that saber-rattling had an impact. I can remember how former New Jersey Governor Christine Todd Whitman attacked a particularly tough rater at Standard & Poor’s, who subsequently withdrew from the team that gave the green light to some suspect financing by the state.

Such conflicts were at the heart of the rating agencies that missed Enron and a passel of other financial catastrophes. Kenneth Lay, after all, was a valuable client.

With a strong economy and a booming housing market, no one seemed to think twice about the fact that the rating agencies were beginning to make big bucks in the subprime loan market, where their conflicted business model posed a broader problem to the housing market and the entire economy. Over the past decade, packaging subprime loans into sellable securities has been a huge business for Wall Street. Raters who were the easiest graders of the pools of subprime loans — those that demanded the least equity to back up all those CDOs being sold in recent years — got the business. Those who didn’t got left out.

It’s hard to believe a bunch of geeks in New York working at places like S&P, Moody’s and Fitch have so much power, but they do. It’s the dirty little secret of Wall Street . . ."

I cannot steal excerpt the entire piece, but the rest of the article details why the agencies should be getting nervous about now:

There's a new sheriff in town.

Gasparino details the discovery of these issues by the most recently appointed SEC Chair -- former Congressman Cox from default scarred Orange County, California. He is now aggressively pursuing supervising the 3 agencies, with new regulatory powers recently enacted by Congress. (Although its questionable if legislation was even necessary to allow the SEC to regulate rating agencies).

Regardless, its a ripping good read -- well worth the headache of free registration.


Berating the Raters
Charles Gasparino
Trader Daily, December 2007

Mortgage Giant Fuels Worries With Steep Loss
WSJ, November 21, 2007; Page A1

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