Rating agencies and conflict of interest

According to a Bloomberg news that came out yesterday, Moody’s fired the head of its structured finance unit and said employees violated internal rules in assigning ratings to some of last year's worst performing securities.

Moody's is currently reeling from a credibility crisis after it had been established that it awarded Aaa ratings to at least $4 billion of sub-prime mortgages, before these securities lost as much as 90 % of their value.

"Some of the investors getting involved with (these complex structured assets) that relied on the agencies may not trust them again,'' said Steven Behr, global head of principal strategies at Royal Bank of Scotland Group Plc in London, Britain's second-biggest bank. ``They have a serious credibility issue in admitting to flaws.''

Moody's said that employees, not the company's practices, were to blame. Hence, the firing of the structured finance head, and the possible sacking of many others involved in said practices.

Credibility problem solved? I don’t think so. The article goes on to say that investors think the company is just looking for a scapegoat.

How could something like this have gone on for so long, and for so much, without senior management having known of such practices? Were the employees so good at hiding their practices, or senior management just bad at monitoring how their staff did their job?

When a new security is being contemplated by an issuer, who are there in the negotiating table right from the very beginning, together with his banker and lawyer? That’s right. The independent accountant and the rating agency.

Their purpose there is to jumpstart the due diligence process, so that by the time the issue is offered to the investor, all the kinks and wrinkles have already been identified, and a suitable opinion or rating produced for the benefit of the buyer.

What happens then if enough wrinkles are identified so as to kill the transaction?

Very often, the rating agency is paid a percentage based on the amount of financing. Without an actual financing, therefore, no fee for the rater. Sure, a minimum fee might be negotiated to pay for the rater’s cost and time expenses. But these are minuscule, and does not provide outstanding returns for the rating agency’s own shareholders.

Is it any surprise then that many of the large corporate implosions of recent memory included these supposed guardians of the investing public in the cast of characters?

Arthur Andersen was there every step of the way when Enron was structuring and executing many of its off-balance sheet transactions. Andersen was also there when Worldcom was misreporting its earnings. Both companies garnered good health reviews from the auditing firm. As a result of the blowups from these episodes, Andersen is no longer with us.

Now, with the implosion of the sub-prime market, we see a similar situation happening, with the rating agencies as major players.

These rating agencies were supposed to be the eyes and ears of the investors. They were supposed to sound the alarm bells at the first hint of mismanagement. Are these guardians confronted with conflicts of interest right from the start? After all, who pays for their services? Who shoulders their fees year after year? Who gives them repeat business year after year?

It’s not the investors, for sure, the ones whom they’re supposed to protect. The auditors and rating agencies are paid for by the very same companies and issuers they are supposedly guarding with a hawk’s eye. Where else will you see this kind of conflicted arrangement?

Do you see policemen’s salaries paid for by the criminals they’re supposed to go after? Or for that matter, are our nation’s soldiers paid for by the country’s foreign adversaries? No, and never will be.

Their services can and will only be paid for by those who require their services, the ones who commissioned them for protection. We all know what happens when these protectors start getting payoffs from those they are supposed to go after.

More from the same article:
Moody's said on May 21 that it had begun a review of its CPDO ratings after a report by the Financial Times said some senior staff were aware in early 2007 of a computer error. The glitch gave the top Aaa rating to CPDOs that should have been ranked as much as four levels lower, the FT said. Moody's altered some assumptions to avoid having to assign lower grades after fixing the error, the FT said.

The rating agency changed its assumptions to avoid assigning a lower grade to a transaction? Should a doctor change his diagnosis to avoid telling you that you’re sick?

Under company guidelines, a committee may only ``consider credit factors relevant to the credit assessment and may not consider the potential impact on Moody's, or on an issuer, an investor or market participant,'' Moody's said.

Should a doctor's decision to diagnose illness be determined by the chance to prescribe expensive medicine or major surgery to the patient?

It’s obvious a change in business model is in order for the rating agencies. The change should involve aligning their interest and compensation more with good service to the investor. Also, it is clear that compensation should not significantly change, depending on the outcome of their rating evaluation.

Advising investors is a public service. Perhaps significant income spikes for these “public servants” should be a major concern in the future.