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Junked Out: How the Big Three Rating Agencies Lost Their Mojo

NEW YORK (The Street) - The batch of F-rated securities "could have been structured by cows," one handler wrote.

Another admitted, "We sold our soul to the devil."

The job was a total "scam," a third wrote.

These emails did not come from artists pushing pump and dump penny stocks, but respected analysts at the Big Three ratings houses -- Moody's (MCO), Fitch (a unit of Fimalac, FIM: EM Paris) and Standard & Poor's (a unit of McGraw-Hill, (MHFI). The communications, part of a trove of emails, were entered in a 141-page complaint filed Monday by liquidators of two Bear Stearns hedge funds, the collapse of which resulted in investor losses of more than a billion dollars.

"It is time," said James McCarroll, a lawyer representing the liquidators," for these organizations to be accountable for their misdeeds."

Not that the ratings houses hadn't been tagged before by prosecutors. Last year the Justice Department filed a fraud action against S&P, the first time a ratings agency had been targeted by the feds. After which a welter of states in which employee pension funds suffered by inflated ratings filed against S&P.

To be sure, managers of the Bear Stearns funds misrepresented the quality of the bonds they sold. But the high ratings of the junk, some labeled as triple-A, allowed the managers to perpetrate a massive fraud, one that became emblematic of deep economic crisis of 2008-2009.

"The three credit rating agencies were key enablers of the financial meltdown," wrote congressional investigators. "The mortgage-related securities at the heart of crisis could not have been market3e and sold without their seal of approval. Investor relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the ratings agencies."

Not to defend the ratings services, but they were hamstrung by a confusion of cross-pressures and conflicts, the largest being that they received their fees from the very firms whose products they were judging. Low ratings meant lower fees, or worse, the loss of business altogether. The giant Wall Street clients of the agencies were not shy in putting on the squeeze. Consider this email from a furious client to a beaten-down S&P analyst:

"Heard your ratings could be 5 notches back of [Moody's] equivalent. [We're] gonna kill your [residential mortgage-backed securities] biz. May force us to do [Moody, Fitch] only."

Such threats would have been unthinkable had the agencies kept to their original model in which the buyer, not the seller, paid the bills.

The underpinnings of John Moody's 1909 railroad bond ratings - as well as those at Poor's Publishing, Standard's Statistics, and Fitch--were that they would sell their assessments to bond investors in thick, expensive manuals. It would have seemed absurd to these founding houses to have the sellers of stocks and bonds-some notoriously shady-determine their fees.

But that's precisely what happened in 1936 when banks were prohibited from investing in "speculative investment securities" as determined by "recognized rating manuals," namely the Big Three. "Speculative" securities were those determined by the agencies to be below "investment grade." The tables had turned. Regulators had blessed the ratings houses with the power to make safety judgments on securities sold by the banks. The banks had every incentive to pressure the agencies and the agencies every reason to keep the banks happy.

It didn't help that the Securities and Exchange Commission 40 years later wiped out much of the competition-there once were hundreds of ratings services in the United States--leaving the field open to Fitch, S&P and Moody's as exclusive "Nationally Recognized Statistical Rating Organizations" or NRSROs for the vast majority of American financial institutions.

Business boomed for the three, but there were tradeoffs. Analysts worked long hours and were paid a fraction of what their client counterparts made. The best and brightest jumped ship, trading on their inside knowledge of ratings to land big jobs. The ratings houses were viewed as secondary destinations. "Guys who can't get a job on Wall Street," a Goldman Sachs (GS) fund manager told author Michael Lewis, "get a job at Moody's."

And there the hours were brutal. "The analysts in structured finance were working 12 to 15 hours a day," wrote journalists Bethany McLean and Joe Nocera in the book All The Devils Are Here. "They made a fraction of the pay of even a junior investment banker."

"There were far more deals in the pipeline than they could possibly handle," they wrote. "They were overwhelmed. Moody's top brass...wouldn't add staff because they didn't want to be stuck with the cost of employees if the revenues slowed down."

So what's the fix? Simple. Undo the changes of the past few decades and allow the free market to perform its magic:

  • Open up the field to competition; bring in more regional and boutique players; encourage innovation;
  • Return the ratings model to its origins: make the investors pay, not the seller;
  • Spend money on hiring quality people and keeping them;
  • Adhere to fiduciary standards and best practices;
  • Reduce margins: Moody's operating margins at the time of the financial crisis were 50% higher than those at Exxon Mobil (XOM) and Microsoft (MSFT);
  • Protect the analysts from undue outside influence so they can make judgments without fear of job loss.

The cost of these measures is far less painful than a sharp downgrade in reputation.

Written by William Inman

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