Ratings agencies: ‘Kool-Aid drinking’ lapdogs

Conflicts of interest, payola, lax SEC oversight, and just plain old incompetence were responsible for credit rating agencies’ "disastrous performance" in assessing risks of mortgage-backed securities. That was the testimony of two former high-ranking officials at Moody’s and Standard & Poor’s in Congressional testimony.

Not only were the methods used to rate structured securities flawed,
the profit motive totally skewed the ratings agencies business model. We discussed some of the more outrageous comments yesterday (S&P: We Knew Nothing! Nothing!)

Here’s a brief excerpt:

"The three major agencies — Moody’s, Standard & Poor’s and Fitch — were caught in a race to bottom, forced to lower their standards in an attempt to maintain their market share, said Raymond McDaniel, chief executive officer of Moody’s, who testified on Capitol Hill on Wednesday.

"We drank the ‘Kool-Aid,’" McDaniel wrote in an internal memo released Wednesday.

That race to the bottom was very lucrative in the short-run for the companies, but disastrous for the global economy in the long haul, said Rep. Henry Waxman, D-Calif., chairman of the House Oversight and Government Reform Committee. Waxman said revenues at the three ratings agencies doubled between 2002 and 2007 to $6 billion, while Moody’s had the highest profit margin of any company in the S&P 500 for five years running.

The three agencies rate financial securities on the risk that they won’t be paid off.

Between 2002 and 2007, the agencies rated a flood of mortgage-related securities issued by Wall Street firms, giving many of the securities a coveted AAA rating at the time, only to downgrade most of them as house prices tanked and defaults spiked. The subsequent collapse in the value of those securities has taken the global financial system to the "brink of the abyss," in the words of the head of the IMF."

Here’s another regulatory failure: SEC supervision of the 3 big ratings
agencies failed utterly, letting them engage in a form of officially sanctioned
payola — selling their AAA ratings to the highest bidding underwriters. In doing
so, the agencies "put the global financial system at risk because they had to be lapdogs, not watchdogs, to survive."

Up next: SEC Chairman Chris Cox gets grilled on his agency’s oversight of the credit rating agencies at  Oversight and Government Reform Committee hearing.

(With this post, we add the category "Regulation")

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Sources:
Ratings agencies ‘put system at risk,’ CEO says
Testimony shows watchdogs were ‘Kool-Aid drinking’ lapdogs
Rex Nutting
MarketWatch 5:19 p.m. EDT Oct. 22, 2008
http://tinyurl.com/5fjkpp

Credit Rating Agency Heads Grilled by Lawmakers   
GRETCHEN MORGENSON
NYT, October 22, 2008   
http://www.nytimes.com/2008/10/23/business/economy/23rating.html