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

Category: Credit, Derivatives, Real Estate, Really, really bad calls

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

30 Responses to “Ratings agencies: ‘Kool-Aid drinking’ lapdogs”

  1. leftback says:

    Rep Elijah Cummings was licking his chops on TV a few days ago, and whio can blame him? I think he is anxious to bring out the big stick for some of our heroic rating agency executives. The show trials of 2009-2010 are going to be awesome, but of course the lawyers are the only people who will benefit in the end….

  2. jdmckay says:

    I watched these hearings.

    The rating Agency reps were utterly… pathetic. Literally, pathetic. They did not even try to defend themselves. Statements from each, that they were “working hard” to “restore confidence”…

    I was waiting for the FBI to walk in, throw ‘em all in a dumpster, and hoist ‘em out.

    Obviously, I knew they were a big part of the catalyst for this thing. I had been anticipating these inevitable hearings to try and better understand mechanisms that led them to AAA CDO ratings.

    What I heard was utterly… utterly unbelievable defenseless pass-through-bots, entirely unrepentant. Unbelievable.

  3. leftback says:

    Posted by: jdmckay | Oct 23, 2008 7:20:19 AM

    “I had been anticipating these inevitable hearings to try and better understand mechanisms that led them to AAA CDO ratings.”

    I think they slipped ‘em a few Benjamins under the table, jd, and that was the mechanism that led to the AAA ratings. This seems like an industry we just don’t need, a bit like the bond insurers. I agree that the entire performance was pathetic.

  4. Marcus Aurelius says:

    They don’t call it “crony capitalism” for nothing. The Ratings Agencies’ testimony was nothing short of an admission of criminal conspiracy to commit theft by deception/fraud. Time to dust off the RICO laws.

  5. Mark says:

    So regulation failed. And we need more right? Better smarter regulation this time.

    Regulation made money managers, who have fiduciary responsibilities to their investors, lazy and provided them a CYA protection. Lets make professional accountable again.

  6. tom says:

    What do you expect when the rating agencies are PAID by the very clients their rating?!
    i mean, DUH!! And these are supposed to be among the “smartest men in the room?” What kind of stupidity/larceny/corruption is Wall Street made up of anyway? Why would anybody now trust ANYTHING either Washington or Wall Street does or says?

    Thanks for fuckin’ up the whole world, scum.

  7. Bill says:

    And was was our government (headed up by GWB) while this was happening ? Hear no evil , speak no evil .

  8. Stevey G says:

    Clearly the agencies are guilty, but surely something bigger was at play, surely the overall system was at fault.

    Right now it looks obvious. – But at the time, how long would the CEO of one of the agencies remained in charge if he had refused to play the game. – The rival agencies would have snapped up all the business, eventually making huge profits.
    - Would the owners have stayed with the CEO if that had happened? I doubt it. Almost certainly he would have been sacked, furthermore key staff probably would have also already walked.– The system itself got worn down and eventually broke somewhere along the line.

    I’m not absolving/or excusing the agencies at all. But it helps to look back at the climate at the time, and the bigger picture. — If a new and better model is going to emerge from this, it is important to understand the context, behind the decisions that ultimately led to disaster, rather than just look for scapegoats.

  9. Kid Dynamite says:

    didn’t the ratings agencies, like everyone else, blaming an impossible to have foreseen sustained decline in home prices for the trouble?

    i cannot comprehend how falling home prices cause the problem – can someone enlighten me? I’m sick of talking heads using it as an excuse.

    a mortgage is based on the value of your home at a specific time – the time when you originate it – it is completely unrelated to the current price of your home. when your home price falls, it has ZERO impact on the affordability of your mortgage.

    this is a fact, not an opinion – unless there is a new product i don’t know about where the monthly payments are based on the current home value – but i don’t think we’ve gone that far, even among all the new innovative mortgage types.

  10. Tony says:

    How much due diligence should be doen by purchasers of such debt?

    Or is it standard practice to just accept the ratings agencies’ evaluation?

    Were Fannie and Freddie culpable for not looking out for their shareholders?

  11. grumpyoldvet says:

    Er, Mark…..we probably don’t need more regulation but ENFORCEMENT. Lack of enforcement has been going on for at least 2 decades. Kinda like the speed regs on highways that everybody, including the police, seem to ignore….at least until there is a wreck and then they act.

  12. CNBC Sucks says:

    Did you guys and gals catch Dennis Kneale and the CNBC Lose Your Power Lunch gang decrying the failure of someone at S&P to delete certain incriminating text messages (such as on rating “deals structured by cows”) yesterday, as opposed to the actual malfeasance that took place?

    I am amazed by how ethically challenged CNBC is allowed to get on the air.

  13. grumpyoldvet says:

    Has Jack Welch’s wife thorwn him out of the house. Lately making an awful lot of appearances on CNBS. His visage is enough to scare anyone and the BS that spews from his mouth is just that BS.

  14. dead hobo says:

    Yes, it’s bad alright. But, as we all know, these are show hearings. Nothing will get done. Nothing will change. Incompetence and disinterest will continue as a matter of practice. A few clerks might have to live in fear of making mistakes now, but this will also be for show. Those in control will do still whatever they please, only have better excuses for doing it.

    AS5, a child of SarbOX and the PCAOB, was supposed to buff up internal controls and make it the responsibility of auditors to ensure these controls were operating correctly and the responsibility of management to sign off on the assertions that they actually worked, under penalty of law. I believe the failures here were so blatant that a felony might be hiding here somewhere. So, where’s the cops? Where’s the tort bar? I know, the Big 4 are too big to fail, now that there are only 4. This one is going to be swept under the rug.

    Nothing is going to change, and anyone who really believes otherwise is really simple minded.

  15. dead hobo says:

    Or, to put it bluntly, Kudlow was actually right. SarbOx is a waste of effort. His railings and rantings against it years ago were spot on. It is basically a show piece law with no substantial effect on wrongdoing. It is a full employment act for accountants in disguise. Bury it. This is one regulation that belongs down the crapper. Let’s lower the cost of doing business. It’s a proven failure.

    Good idea though. On a superficial level, it seems like it might have kept the world honest. Ha Ha to that. What wasn’t ignored was worked around. Congress will probably exempt the rest of the failures as an expedient to the bailout package.

  16. Right now it looks obvious. – But at the time, how long would the CEO of one of the agencies remained in charge if he had refused to play the game. – The rival agencies would have snapped up all the business, eventually making huge profits.
    - Would the owners have stayed with the CEO if that had happened? I doubt it. Almost certainly he would have been sacked, furthermore key staff probably would have also already walked.– The system itself got worn down and eventually broke somewhere along the line.

    I’m not absolving/or excusing the agencies at all.
    Posted by: Stevey G | Oct 23, 2008 7:59:39 AM

    O, Stevey, Guess What? You Are, attempting, to ‘absolve/ or excuse’ their actions. towit: “b-b-but if He/They didn’t do it, He/They would have lost their jobs/ somebody would have done it.”

    Ya Know, maybe there was a different course that He/They could have taken(?). Maybe a simple phone call to Crudele @ the Post, are, simpler, an e-mail dump to the i-net and the DOJ?, or, ….., or, ……, etc.

    Actually, it’s pathetic rationalizations, like yours, that let this Cancer metastasize..

    Thanks anyways, though, past that, RICO is what is up…and, yes, I don’t mean Puerto..

  17. Bruce in Tennessee says:

    Morning all:

    There is something I’d like to try this morning. Every time I see a broker on CNBC touting stock picks, there is something I wonder about. “What is the economy going to be like next quarter?” At least that is what I’ve been wondering lately.

    What will we see in 3 months? I have a few ideas…

    Initial claims trended back up this morning, almost to the level of the hurricane layoffs….I think the trend continues.

    Fewer job openings will be available. Washington Post has a good article about that this morning. August had 214k fewer job openings, up from the average 74k for the year..and this should continue.

    http://www.washingtonpost.com/wp-dyn/content/article/2008/10/22/AR2008102203709.html

    Nissan has told Chrysler they are not interested in a deal, especially if it involves money. GM is preparing for involuntary layoffs. GM’s debt is staggering. I think bankruptcy is ahead for F or GM or both by next quarter. The VOLT also may not be wonderful, I read.

    Assuming a democratic victory, I see companies pulling in their CFO’s and battening down the hatches for increased corporate taxes.

    If China does poorly, I see them coming to the US to try to persuade residual manufacturers to relocate. Much like say, Birmingham AL might go after a Toyota plant. I think this will happen, on an aggressive basis, if the way to grow over the next year or two is to take from “them that has”…could lead to calls for protection..

    I see the USD being stong for the next 3 months. Poor for exports, good for oil.

    In sum, I don’t see a good environment for equities, and this is the sort of thing I do when considering how to invest.

  18. tom brakke says:

    @Mark: You are exactly right that investment professionals got lazy. As I pointed out in this piece on Monday (http://researchpuzzle.com/blog/2008/10/20/agents-of-record/), the real problem is that the ratings are used throughout the markets by participants who don’t have the ability to do their own work, because they believe that if you are a “Nationally Recognized Statistical Ratings Organization,” it means something.

  19. Brian says:

    The US government is BROKEN. SEC, FDA, CIA–you name the acronym and I’ll guarantee it’s broken and/or corrupt.

    Now, most of you sheeple probably already know this but what you don’t realize is that it’s not going to be fixed by Obama Christ or McSame.

    As a matter of fact, it’s going to take a massive movement to get anything to really “change” but don’t hold your breath because Fatty America is too busy watching TV to care….

  20. Stevey G says:

    Mark.

    ‘Actually, it’s pathetic rationalizations, like yours, that let this Cancer metastasize..’

    Thanks for that. I think you miss my point…

    What you term a ‘pathetic rationalisation’, is simply how it was. The rationalisation was n’t pathetic, the fact that that could happen at all was pathetic.

    Everyone was chasing the elusive ‘Pot of gold’ that led to ‘Pathetic’ leadership, and decision making, and consequently RICOs — Fully agreed.

  21. Posted by: Stevey G | Oct 23, 2008 9:33:48 AM

    Stevey,

    I apologize for missing your point, text has its limits, and I should have asked you for additional clarity.

    Though, with this: “how long would the CEO of one of the agencies remained in charge if he had refused to play the game. – The rival agencies would have snapped up all the business, eventually making huge profits.
    - Would the owners have stayed with the CEO if that had happened? I doubt it. Almost certainly he would have been sacked, furthermore key staff probably would have also already walked.” I still think that the ‘Playerz’ in the game could have called ‘offsides’, or, at the minimum, refused to play..

    Past that, I’m glad to see that you think RICO, aptly, applies, in this case..

  22. Dr. Kenneth Noisewater says:

    BTW, if federal legislation overrides state right-to-work laws, get ready for even more offshoring… Ever wonder why foreign manufacturers building in the US site their plants where they do? Look at this map and you’ll see an indication of why…

    (and this hits my state pretty hard, as the plant which assembles Chrysler Durangos and Aspens (Newark, DE) is due to shutter earlier than anyone thought (31 Dec).. Right-to-work is probably why any possible feelers to Toyota, Honda, et al. came to nought.)

  23. dave says:

    Weren’t the ratings agencies given government granted monoploies in the 70s? Wasn’t thier compensation scheme also set up by the government?

    Mish has a psot on this once. The ratings agencies are one of the biggest failures of government monopolies in history.

  24. Brian says:

    yeah it’s a good old fashioned Greenspan rally!!!

    Yippee!

  25. Nick says:

    The ratings agencies had oligopoly status bestowed on them by Congress back in the 1970′s. Funny how nobody cares about or mentions that. I would argue that that is the ultimate root of almost all that has happened. As we all know, government “minimum standards” very quickly turn into “maximum standards”.

  26. fresno dan says:

    Seriously, why would anybody listen to a rating agency versus a stockbroker??? Didn’t the agencies rate government bonds lower than private sector bonds with an equivalent chance of default – apparently done to maintain pricing power for their service? Asking S & P about bonds is like asking a realtor if now is a good time to buy a house.

  27. Dave D. says:

    I was going to address the “Nationally Recognized Statistical Ratings Organization” status of these agencies, but it looks like several commenters have already hit on it.

    The criticisms that the ratings agencies were incompetent, corrupt, or both may be true, but they are irrelevant. The incentives were awful. They have government protection and were paid by the issuers. Why would investors trust anyone in that situation? They didn’t have to. And do we really think government officials could’ve understood the risks any better even if they had been watching more closely? AIG had money on the line, and they couldn’t even judge the risk correctly.

    Perhaps it’s time to take away the protection of the ratings agencies and let investors do their own homework. That may reduce liquidity a bit, but look where the extra liquidity got us this time…

  28. Dave says:

    Let’s all remember why the ratings agencies where given thier monopoly: “To protect the average investor”. Why did the average investor need protection.

    Once the government decided to live beyonds its means it needed someones real savings to steal. Printing had its limits as the end of the 1970s showed.

    If they couldn’t print unlimited amounts of money they would get the private sector to print unlimited amounts of debts. It would call the asset inflation that occured growth and confisate it as either income or capital gains. Whenever the private market tried to correct it would ride to the rescue, lower rates, do a little printing. Ever expanding government debt helped give it all a base. Fancy mainstream economists refered to this as the “democritization of credit”. I call it institutionalized debt slavery.

    So how to get the masses into the bond market. Why shouldn’t they just get bank CDs like they did during those crazy gold standard days.

    Well since the masses don’t understand anything but want to feel safe you needed some official organization to issue “ratings” which would embody risk. Prudent bond fund managers would only buy investment grade debt for thier pension funds or mutual funds or what have you. They would produce pretty looking tables that showed your “value at risk” for a given average “rating”.

    Naturally since the rating agencies need to be official they could only choose a few. Once chosen they couldn’t change based on competition because fund managers would be required to use thier ratings by law. A monopoly was born. Since you can’t require fund managers to pay rating agencies for ratings they are required to use by law, you decided to have the issuers pay them.

    Now we can get the suckers (aka masses) into the bond market and let the debt bubble grow eating up all the available real savings until there is nothing left.

  29. Mike in NOLa says:

    The DOJ should go after them like they went after Arthur Anderson. Didn’t matter that AA was eventually found not guilry. I provides a good object lesson.

  30. Pat G. says:

    Fire these assholes and let’s move on. Let’s stop the blame game. We must work together to fix our nation now. There was much complicity throughout the Federal Government that helped create this mess mostly as the result of greed.