Quality of credit ratings challenged in Congress

A former Moody’s analyst is testifying before Congress today about what he claims are deceptive practices on the part of the credit ratings firm. Moody’s evaluates the credit worthiness of firms and of the debt securities that they issue. In turn these credit ratings are used as the basis for establishing the interest rates that are required to be paid by the issuer to investors. The higher the rating, the lower the interest rate paid. This is very similar to consumer credit ratings. But if the ratings are inflated, not only are the rates paid too low, but the investor understanding of risk is also distorted. This distortion leads to investors mispricing risk and ultimately getting surprised when the debt security they purchased is either downgraded or worse, defaults. Ouch!

Without going into too many of the technical details, the Moody’s analyst is saying that, despite internal changes at the firm and regulatory mandates, inflated ratings are still be issued. Specifically he is saying that Moody’s issued a high rating to a debt security despite the fact that it was planning to downgrade the tranches of securities that backed up the main security. Ugh!

In defense of Moody’s, and the other ratings agencies, evaluating a business or a security for creditworthiness is as much an art as it is a science. However, in the examples brought forth by the former Moody’s analyst, it seems as if there was foreknowledge on the part of Moody’s of an imminent downgrade. Yet they still issued strong ratings.

If true, this is distressing and highlights why incentives and corporate culture are important to evaluate as an investor. If a prospective investment has a toxic culture (think Enron or AIG) then it means that employees are inculcated, and often rewarded, to cut corners or to do just about anything that results in company financial goals being met. Typically this kind of toxicity is brought about by poorly imagined and executed financial compensation packages. These reward risk-taking, and even law-bending/breaking. Double ouch!

So who pays the bills at Moody’s and the other ratings agencies? Mostly the issuers of debt pay for their own securities to be evaluated. Wow! It would be as if teachers awarded grades to the students who paid the teachers’ salaries. Tell me that isn’t ripe for a conflict of interest.

What can Congress do? One thing they could do is require ratings agencies to track their success in evaluating the creditworthiness of issuers. Ideally the ratings agencies ratings are prospective rather than retroactive. In other words, the ratings should predict the ultimate health of the debt security. Again ideally, credit ratings downgrades should not occur after the security and its issuers have imploded financially. Just the sheer act of having to report their successes to prospective investors would shift the behavior of the agencies. Critics say that this would make them overly conservative. I say: good! Why?

There are three options for the ratings agencies: to be overly optimistic, overly pessimistic, or just right. In a perfect world the ratings would be just right. Take it from me as a former very successful analyst, this extraordinarily hard. Why? Even with access to full documentation and corporate management analysts are still many steps removed from the front lines. Everything an analyst deals with is an abstraction. Random data, and lots of it, has to be sorted and understood. Additionally, analysts are trying to predict the future. How do football analysts do in predicting the teams that will play in the Super Bowl and the beginning of each season? And here we are only talking about 30 teams over the short football season of 5 months. So the “just right” scenario is just about impossible. So which side would you prefer the ratings agencies err on: more optimistic, or more pessimistic? Stated another way, would you prefer the ratings agencies to be more aggressive, or more conservative. It’s your money. Thought so.

Be well!

Jason