Been in a Bad Moody’s Recently?

One of the arenas that seems to be slipping out of regulators’ radar is the rather low level of viability that appears to attach to credit ratings given by companies like Moody’s and Standard and Poor’s. For example, as a precursor to the mega-economic collapse, creative players on Wall Street took advantage of the misnamed “free and competitive marketplace” by pitting rating agencies against each other – each vying for the lucrative contract from the issuing institution on Wall Street to rate any form of new debt including the derivatives (like subprime mortgage bundles) – by, “wink wink,” being gentle (e.g., giving a rating way above what made common sense) to the new debt.

The June 10, 2010 DailyFinance.com provides the absurd results of this standard practice: “Recent studies of rating agencies have been quite damning -- showing that they assigned top ratings to scads of securities that either defaulted or performed poorly, and such ratings played a large role in the financial crisis. One recent congressional investigation by Senator Carl Levin (D-Mich.) found 91% of AAA-rated, residential mortgage-backed securities issued in 2007 and 96% of similar securities issued in 2006 have since been downgraded below investment grade to so-called junk status…‘The miss was huge,’ said Phil Angelides, chairman of the Financial Crisis Inquiry Commission at a rece nt hearing. ‘Ninety percent downgrade. Even the dumbest kid gets 10% on the exam.’”

Corporations often borrow money in non-banking lending structures such as corporate IOU’s called commercial paper that are floated in the open marketplace to the general public. Financial institutions typically bought up aggregations of debt – picking up thousands of mortgages and bundling them into one package – selling fractions of those bundles (derivatives) into the market as well. But for stock brokers and fund managers looking at new debt instruments to buy for their own account or sell to customers, they really need to be able to assess the risk to determine both pricing as well as whether or not they really want to buy or recommend such instruments to clients. It would be close to impossible for such a potential buyer or trader of such instruments to do the massive examination of all the underlying loans in the bundle, particularly if they are involved in many such bundles, so instead they rely on the relevant rating agency that is supposed to be neutral and accurate in their assessment.

Unfortunately, under current practices, the company or institution that creates the debt and puts it out into the market gets to pick the credit rating agency. And the credit rating agency makes money by charging such companies/institutions for the service. But let me ask you a question… if you can place debt only if you get the right rating, would you pick an agency that is generally known to overrate debt or one that is known as strict? A little conflict of interest. There are several clear solutions to this problem, but effective lobbies at every level have managed to keep this aspect of financial reform out of pending legislation. One obvious solution is to take the right to choose the rating agency away from the issuing company. A better solution would be to have a federal agency certify the rating agencies to new standards and require issuers to enter a blind pool of potential rating agencies and get stuck with a random choice over which they have no control. It makes absolutely no sense to let the entity placing the debt have the right to shop around for the most lenient rating agency.

But the flaws in the credit rating schema in this country run deeper than what is illustrated above. Clearly, the financial markets no longer believe the ratings themselves. After all, if two companies are rating exactly the same, logic would suggest that their commercial paper would therefore carry the same interest yield. An “A” should have the same meaning for both, but that clearly is not how the market operates – at least when the issuing company is well-known and well-covered by analysts at the big financial institutions… which may not be the case for bundles of massive micro-debt. In these situations, trading banks and big institutional buyers do not rely on the credit rating agencies and assess the risk based on their own analysis.

DailyFinance.com provides a clear example: “Indeed, as investors found out during the financial crisis, they might buy debt from two companies with the same rating and yet be exposed to two completely different risk profiles. It's an expensive imbalance. To wit: McDonald's debt currently yields 2.43%, while [Bank of America]'s debt yields 4.97%-- more than double that of the hamburger company's. On a $1 billion loan, that translates to about $25 million more in annual interest payments for BofA… ‘These spreads are indicative of the fact that the ratings are wrong and that the markets are further ahead of the curve than the rating agencies,’ says James Camp, managing director of fixed income at Eagle Asset Management in St. Petersburg, Fla., with $17 billion in assets under management. ‘While I don't rely on ratings, you can't ignore the fact that the market trades off those ratings, which it shouldn't because the ratings methodologies are proven to be flawed.’”

One of the biggest issues in our recovery is confidence, which includes trust in the accuracy and fairness of the system. “According to the new NBC News/Wall Street Journal poll, just 35 percent now believe that ‘the stock market is a fair and open way to invest one’s money’ compared to 58 percent who do not believe the stock market is now fair and open due to ‘corporate corruption and broker practices.’” AmericanProgress.org (May 17^th) On May 13^th, in my Wall Street’s No Hitter blog, I noted: “‘Despite the running unease in world markets, fo ur giants of American finance managed to make money from trading every single day during the first three months of the year." Their remarkable 61-day streak is one for the record books. Perfect trading quarters on Wall Street are about as rare as perfect games in Major League Baseball. [On May 9^th], Dallas Braden of the Oakland Athletics pitched what was only the 19th perfect game in baseball history… But Bank of America, Citigroup, Goldman Sachs and JPMorgan Chase & Company produced the equivalent of four perfect games during the first quarter. Each one finished the period without losing money for even one day.’ [NY Times, May 11^th] Morgan Stanley missed the cut; it had four net loss days during the same period.”

There’s a good chance that the rating agencies most identified with the subprime debt won’t survive the spate of litigation directed at them; Moody’s and S&P might disappear, but the underlying problem still needs to be addressed now. Congress and the administrative agencies in the Executive Branch have a duty to the American people to try and level the playing field and right the obvious wrongs in our financial system. Lobbyists and special interest groups – ultra-powerful in a world of cash-starved election campaigns – press for their advantage in the near term. They believe that that can do what they have for decades… run this country to their maximum advantage regardless of the consequences for everybody else. But history teaches us invaluable lesson: there comes a point where such special interests are crushed – sometimes violently – and the system that supports them replaced. Nothing is forever, and Wall Street may be hastening an alternative ending which I doubt they really understand. Remember what happened to Marie Antoinette – a member of the imperious French monarchy who responded to the people’s cry for bread, “Let them eat cake”? Yeah, that one.

I’m Peter Dekom, and I guess history is not a prerequisite to getting an MBA.