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


“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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What's been said:

Discussions found on the web:
  1. Eric Davis commented on Nov 21

    Wait till the insurers go belly up, and that sets off new waves of downgrades, and write downs.
    When people say that these are just “accounting anomalies”, and it has actual value. No sane European or Asian investor will touch them.

    “Down the rabbit hole” this gets scary.

    Just my wacky Crystal ball.

    Then the fed will be forced to cut… Forced.

    On that note…

    Happy Turkey day!!!

  2. the cds trader commented on Nov 21

    Sounds about right. And this rating agency competition has been common knowledge for years. Several years ago when I worked on a CDO structuring desk the common question to ask a client who needed a certain rating was “can you use [Fitch/S&P/Moody’s]” and then just use the one that would give you the highest rating.

    The whole game behind structuring is/was to get as high a rating as possible relative to market-implied ratings from spreads. It was a simple matter of arbitraging the historical ratings transition probabilities that the ratings agencies publish…and hence why you get the biggest cr*p in CDO’s, since if you need to put a BBB credit in, say, you are going to take the one with the highest spread so that you can take the most money out.

  3. Jason C commented on Nov 21

    I think its a question of employee talent, if your bright why work for a ratings agency when you can be on the other side of the wall earning much, much, more.

  4. Philippe commented on Nov 21

    On factual proof one can easily see the wrong timing and strangely more than wrong of the credit / agencies when looking into the above site as published by the Federal reserve of Boston «  FIGURE 14 rating and default rates« . This site provides the best photography of their indigent state
    I suggest that IMF and World Bank be merged together in order to provide a supra national rating agency.

  5. wally commented on Nov 21

    Before the SEC or anybody else gets aggressive about ‘supervising’ rating agencies, they would be well advised to consider if they really want that responsibility. It simply makes them the target the next time some problem arises… and one will.

  6. Marcus Aurelius commented on Nov 21

    In short, if you don’t agree to the scam, they kick you out of the gang.


    I’ve always said that Mortgage Brokers would bring down the industry. Seems I was almost right (it’s the brokers, and the ratings agencies). Someone is going to be left holding the bag, and it’s not going to be the street or the brokers. That leaves us.

    Is there a latin phrase for “Let the seller beware?” I doubt it.

  7. Philippe commented on Nov 21

    There is one which is revolving around the same spirit
    “Margarita pro porcibus”

    read “pearls for pigs”

  8. justin commented on Nov 21

    Gasparino, should be applauded, instead the CNBC gang gives him the cold (cool) shoulder. Or am I just imagining things?

  9. SubprimeGuy commented on Nov 21


    So government regulation via NRSRO designations which restricts competition and BASEL II which bestows practically unlimited power to the rating agencies has helped to create a system where people rely on this clearly flawed business model. So then the answer is more government regulation? It seems to me that this country is on course to regulated itself to death. Does no one believe in Laissez Faire capitalism anymore?

  10. kharris commented on Nov 21

    If we substitute “stock analyst” for “ratings agency” and “rate” for “underwrite” and change the dates by about a decade, this is not a new story.

    With that much money at stake, the issuer is likely to pay more to those who apply lipstick, less to those who apply judgement.

  11. CaptiousNut commented on Nov 21

    A Congresswoman wonders how ratings agencies can be so consistently wrong?

    Even in a credit crunch I’ll take the ratings agencies’ track record over the success ratio of Congress.

    All Gasparino is doing is aiding and abetting a political “fix” that, a la SarBox, will certainly only hurt investors and consumers.

    As a previous poster already alluded to, this “conflict of interest” between agencies has existed forever. Bond buyers are big boys and have known it all along. Every professional relationship is fallible and has conflicts. One might even say that journalists are biased toward demagogery, selling books, and class baiting. Using hindsight to rile up the economically illiterate LCD hardly merits our praise.

  12. Marcus Aurelius commented on Nov 21

    “With that much money at stake, the issuer is likely to pay more to those who apply lipstick, less to those who apply judgement.”

    Posted by: kharris | Nov 21, 2007 9:05:21 AM


    That’s ’cause they need the lipstick (great demand for lipstick nowadays).

    Good judgement?

    Not so much.

    The entire ratings/credit/securities industry, to a person, is already aware that they are involved in a gigantic scam. The scam is large and elaborate, the chances of getting caught are diluted by the sheer number of players and the lack of a clear focal point for accountability.

    They all understand that the real question isn’t, “is this right or wrong.” The real question is, “Are you in, or out?”

  13. Philippe commented on Nov 21

    « Does no one believe in Laissez Faire capitalism anymore? »

    Pascal said ‘Ne pouvant faire que ce qui fut juste fut fort, on fit que ce qui fut fort fut juste’

    « As one may not succeed in turning what is just, strong, he will endeavour to make what is strong, just »

  14. Northern Observer commented on Nov 21

    Look at the apologists. It’s all fun and games until your financial system implodes. One would like to think that in a competitive market an agency that took its fees from the buyers of debt rather than the issuers would have the leg up as being inherently more accurate. But the ratings agencies have been around what 50 years? It would have happened by now.

    I am sorry that this episode is an argument for a socialist idea – a publicly funded rating agency OR private agencies that are regulated and prohibited from taking cash from issuers of debt (conflict of interest duh) I am sorry if this is against your personal ideological beliefs but you know the world is too complexe to fit into one set of ideas about how everything works best. Let’s not sovietize outselves now. Think outside the box

  15. Bob A commented on Nov 21

    Oh but you can trust our government officials because they hold to a higher standard

    “I had unknowingly passed along false information. And five of the highest ranking officials in the administration were involved in my doing so”

    Scott McClellan in his new book.

  16. lemmoth commented on Nov 21

    Couldn’t agree more with CaptiousNut. If the system is so bad why haven’t I seen any proposed solutions, let’s see – maybe because that would require a government agency to provide a default probability and extent analysis.

  17. Marcus Aurelius commented on Nov 21

    Big Government and Big Business have merged.

    I think there’s a name for that.

  18. druce commented on Nov 21

    These comments from David Einhorn are apparently scanned making it harder to read, but pretty awesome:

    Consider municipal bonds. According to S&P’s long-term data the 10 year default rate on an A rated municipal bond is 1%; while a corporate bond’s default rate is 1.8%; and a CDO’s is 2.7%. An A rated muni has the same chance of default as a AA/AA- rated corporate and a AA+ rated CDO. When municipal bonds default the expected recovery rate is 90% compared to 50% on corporates and CDOs.

    In early September, a senior Moody’s executive confirmed this suspicion at a small private dinner sponsored by one of the brokerage firms. He said, “Moody’s would never lower the credit ratings of a financial guarantor, because that would put the guarantors out of business.”

    It is plain that the states and cities and towns in this country are triple A credits without triple A ratings and the financial guarantee companies have triple A ratings without being triple A credits.

    Is it a coincidence that rating agencies charge more to rate bonds in the more lenient categories?

  19. druce commented on Nov 21

    The cratering of second-tier guarantor ACA may foretell what’s in store for ABK and MBI:

    • November 7: ACA reports $1B loss, which wipes out equity and results in a negative net worth.
    • November 9: S&P puts ACA on credit watch, threatening to reduce credit rating from grade A (“the obligor’s capacity to meet its financial commitment on the obligation is still strong” – negative shareholder equity notwithstanding). ACA professes surprise at the rating agency action, since GAAP writedowns were merely ‘unrealized’ losses.
    • November 19; ACA notes in 10-Q, that, if downgraded below A-, collateral would have to be posted, and that ‘Based on current fair values, we would not have the ability to post such collateral.’ Stock craters, market cap under $40m.
    • In the not too-distant future, some insured bonds will default. Then ACA will default on its obligation to make the bondholders whole. Then, post default, ACA will actually get a rating below investment grade – straight to D.
    • or maybe, just maybe, since the market already acknowledges ACA is toast, S&P will end the charade and put them out of their misery.

  20. Peter commented on Nov 21

    Ignore my previous comment :)

  21. Philippe commented on Nov 21

    Our contemporaneous civilisation has the benefit of the insight and the capitalist system is the most efficient of the economic pacts.
    That does not mean that all equilibriums are made for lasting and needs for readjustments do not arise.

  22. Toro commented on Nov 21

    Looks like Charlie has material for a new book.

  23. Doug_S commented on Nov 21

    Typical government. They created the problem by holding that the 1st amendment prevented rating agencies from selling ratings only to brokers and traders. So the rating agencies started charging the issuer. Mow we need a new waive of regulation. Give poison as food and more poison as the remedy.

  24. dblwyo commented on Nov 21

    Excellent & lengthy post – thanks for the survey. Let’s take it as given – that is there is an inherent conflict in the rating agencies business model. Yet at the same time we must have a rating mechanism for the credit markets to work. What’s the alternative ? Do we have a fundamental and irreconciliable paradox at the heart of our market mechanisms ? One that can never be fixed ?
    The breakage is in the institutional design and the counter-productive incentives that bring broad public interests into conflict with the narrow ones of the agencies.
    My suggestion – instead of them rating the instruments per se set up something like a 2ndary insurance and/or bond market where as part of the CDO package the originator is required to purchase appropriate insurance. That would then create a counter-flowing set of incentives were lower rates would follow from better grounded ratings; it’d make the markets work in a market-like fashion.
    If Mankiw can get a bunch of hype going on his blog for Pigou taxes and create all sorts of support for a carbon tax surely BP and its’ readership can start a groundswell to fix this before it’s “fixed” for us by Congress (that 2nd fix is used the same way we use to fix the calves into steers)

  25. The Big Picture commented on Nov 21

    David Einhorn on Credit Agencies

    Apropos of our last post, a dozen of you (1st in: Scott Frew of Rockingham Partners) directed our attention to David Einhorn’s presentation at the Annual Graham Dodd Breakfast. The PDF text of the full presentation is at Naked Shorts . . .

  26. Marcus Aurelius commented on Nov 21

    Our contemporaneous civilisation has the benefit of the insight and the capitalist system is the most efficient of the economic pacts.
    That does not mean that all equilibriums are made for lasting and needs for readjustments do not arise.

    Posted by: Philippe | Nov 21, 2007 9:56:27 AM


    Not that criminality and/or fraud would ever taint the Capitalist ideal of efficiency and/or equilibrium. Readjustments? Ain’t they the same as regulations?

  27. Tom commented on Nov 21

    Sounds like we need something akin to Sarbanes-Oxley for the credit rating agencies and the whole mortgage lending/financial engineering industry.

    Last time around it was the dot.coms, IPO scandals (Quattrone should have gone to prison), Enron, Worldcom, and Arthur Anderson (now defunct). Today its unscrupulous mortgage lenders, subprime loans, financial engineering/CDO’s, and rating agencies.

    Why is it that we can never seem to get rid of financial scandals? Is it due to an incompetent Fed addicted to bubble blowing? Or our incompetent government unable to think or act proactively to properly regulate industry?

    Maybe it all comes down to one thing: AMERICAN GREED? Aka Capitalism…

  28. a guy called john commented on Nov 21

    there are so many middle-men in these deals. parasites skimping their percentages. what happens when you’ve sucked everything you can get and kill the host?

  29. Peter Principle commented on Nov 21

    I’m not by nature a libertarian, but maybe this is one case where the libertarians have it right — maybe the rating agencies are simply obsolete.

    We now have extremely sensitive and somewhat liquid (and getting more liquid all the time, at least up until the recent difficulties) markets for pricing default risk. That being the case, maybe the rating agencies (and the reg systems built on their ratings) only make things worse by encouraging buyers and sellers to ignore market signals — or play arbitrage games to exploit the difference between ratings-implied prices and reality-based prices.

    So why not let the CDS market issue the ratings? The bureaucrats (corporate as well as governmental) no doubt will argue that a market-based system would be too “unstable,” but at this point i think we’ve had about all of their kind of “stability” we can stand — as we discover daily.

  30. jim commented on Nov 21

    Warren Buffett is one of the biggest shareholders of Moody’s. You would have thought he would have paid attention to the problem. Surely he knew it existed.

  31. blam commented on Nov 21

    There is an agency already in-place for deterring those abusive self-regulating bodies that defraud the public. It is called the department of corrections. Now if we can get that piece of shit leg-breaker Dick Cheney out of government, maybe our market system will begin working again.

    Let’s start with the current fraud – the oil futures market.

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