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Friday, September 28, 2007 12:25 AM

Time To Break Up The Credit Rating Cartel

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The Associated Press is reporting Pension Fund Sues Moody's Over Ratings.

In a lawsuit filed in federal court in Manhattan, the Teamsters Local 282 Pension Trust Fund alleged the New York company's ratings of bonds backed by subprime mortgages -- including bonds packaged as collateralized debt obligations -- were materially misleading to investors concerning the quality and relative risk of those investments.

"Moreover, even as a downturn in the housing market caused rising delinquencies of the subprime mortgages underlying such bonds, Moody's maintained its excessively high ratings, rather than downgrade the bonds to reflect the true risk of owning subprime-mortgage-backed debt instruments," the lawsuit says.

The lawsuit is seeking class-action status for all purchasers of Moody's shares from Oct. 25, 2006, to July 10, 2007.
The Executive Shuffle

In response to the lawsuit and SEC investigations Moody's shuffles executives, seeks subprime changes.
Moody's Corp's (MCO) Moody's Investors Service, a ratings agency accused of helping inflate the subprime mortgage bubble, named three new ratings executives on Wednesday and proposed changes in the subprime rating industry.

In a statement, Moody's said that, after talking to industry participants, it was calling for information about non-prime loans that get bundled into bonds to be verified by third parties. Issuers of non-prime mortgage bonds should provide stronger warranties to investors regarding loan information.
The last thing we need is "third parties" verifying non-prime loans. That creates pressure to make more loans prime and it brings into question all sorts of problems with determination of "third parties" and their competence.

SEC Investigation at S&P and Moody's

The SEC is investigating Conflict of interest charges at US credit ratings agencies.
Credit ratings agencies need to separate their rating and advisory functions because of conflicts of interest in their relationship with Wall Street, the newly appointed head of a high-level government advisory panel said on Wednesday.

"I do not think that the market can discipline ratings agencies sufficiently," said Mr Mindich, chief executive of Eton Park Capital and a former colleague of Hank Paulson, the Treasury secretary, at Goldman Sachs, the investment bank.

Christopher Cox, chairman of the Securities and Exchange Commission, told the Senate panel his agency was investigating whether companies such as Standard & Poor's and Moody's were "unduly influenced" by issuers and underwriters that paid for credit ratings.
Agencies Deny Inflating Ratings

The Independent is reporting Credit agencies deny inflating ratings to beat rivals.
At the heart of the controversy is the fact that it is the Wall Street banks that pay the agencies to rate the new products. One after another, Senators accused the agencies of giving artificially high ratings to ensure that the business did not go to their rivals.

Senator Jim Bunning, a Republican from Kentucky, described the process as "like a movie studio paying a critic to review a movie and then using a quote from his review in the commercials". A Democrat, Robert Menendez, said the agencies were "playing both coach and referee".

But Vickie Tillman of Standard & Poor's credit market services said that the agencies took every care to try to ensure accurate ratings, and that no analyst was ever paid according to the amount of business he or she generated, or the types of ratings given. "S&P does not and will not issue higher ratings in order to garner additional business," she said.
Indiscretion or Incompetence?

In Mispricing Risk / Conflict of Interest I talked about the obvious conflict of interest between ratings companies and the companies they rate.

In Moody's In Wonderland I wrote about Moody's stunning display of twisted logic, whereby they actually made it a blessing to have rising default risk.

In The Rating Game Scam I commented on a Bloomberg article accusing the S&P and Moody's of Masking $200 Billion of Subprime Bond Risk.

In Fitch Discloses Its Fatally Flawed Rating Model, I talked about fatal flaws in rating housing related debt.

Obviously there are huge conflicts of interest. So the advisory panel is talking about a need to "separate rating and advisory functions".

Would that stop people within a company from talking to each other? Would it eliminate pressure from management from one group or another to get revenues up? Would it stop rumors or allegations of improprieties? The answer to all three questions is no.

This is just more regulation on top of more regulation. Would physically splitting up each of the functions into two separate companies be the solution. No, that's not it either. The root of the problem lies in government intervention and sponsorship of the ratings agencies in the first place.

The rating agencies were originally research firms. They were paid by those looking to buy bonds or make loans to a company. If a rating company did poorly it lost business. If it did poorly too often it went out of business.

Low and behold the SEC came along in 1975 and ruined a perfectly viable business construct by mandating that debt be rated by a Nationally Recognized Statistical Rating Organization (NRSRO). It originally named seven such rating companies but the number fluctuated between 5 and 7 over the years.

Establishment of the NRSRO did three things (all bad):

1) It made it extremely difficult to become "nationally recognized" as a rating agency when all debt had to be rated by someone who was already nationally recognized.
2) In effect it created a nice monopoly for those in the designated group.
3) It turned upside down the model of who had to pay. Previously debt buyers would go to the ratings companies to know what they were buying. The new model was issuers of debt had to pay to get it rated or they couldn't sell it. Of course this led to shopping around to see who would give the debt the highest rating.

With that I have to sit back and laugh at one of the original opening statements in this article: "I do not think that the market can discipline ratings agencies sufficiently," said Mr Mindich, chief executive of Eton Park Capital and a former colleague of Hank Paulson, the Treasury secretary, at Goldman Sachs, the investment bank.

Clearly Mr. Mindich does not understand the free market. The problems arose because the free market was disrupted by a misguided mandate by the SEC.

Those interested in more information on this topic can read Removing a Regulatory Barrier by Senate Republican Jon Kyl or Creating a Competitive Rating Agency Sector by the American Enterprise Institute. Also note that the number of rating agencies is back up to 7 from 5 as of September 25 2007. See SEC Reanoints Rating Agencies.

The Solution is Amazingly Easy

Government sponsorship of organizations and intervention into free markets always creates these kinds of problems. The cure is not an executive shuffle, third party verification or half-measures and more regulation that mask over the issues by splitting functions within an organization. The SEC created this problem by creating the NRSRO. The problem is easily fixable. It's time to break up the cartel by eliminating the rules that created it. Moody's, Fitch, and the S&P should have to sink or swim by the accuracy of their ratings just like everyone else. Ratings would be a lot better if corporations had to live or die by them. Free market competition, not additional regulation is the cure.

Mike Shedlock / Mish

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