Rating Agencies: still the same conflicted judges

The rating agencies guys wore blue suits from J.C. Penney, with ties that matched too well, and shirts that were starched just a bit too stiffly. They weren't players and they didn't know the people who were either. Michael Lewis, The Big Short

The movie The Big Short ends with the ominous warning that the monster that created the 2008 financial crisis isn't dead. A spore of collateralized debt obligation was released in 2015.

But far scarier than the reappearance of arcane securities is the report the SEC released December 28 when nobody was looking that suggests the "Big Three" rating agencies--Standard and Poor's, Moody's and Fitch--are still Wall Street's bumbling wingmen.

In the run up to the subprime meltdown, agencies were rating subprime debt triple A, perpetuating the myth that subprime mortgage bonds were low risk and enabling Wall Street firms to attract billions of dollars in revenue.

Subprime comes from the Latin sub meaning to fall short of + prime meaning of the greatest commercial value. English rated subprime debt as middling but the rating agencies overruled common sense with uninformed opinions based on optimistic models and insufficient information, opinions that refused to budge even as towers of debt began to crumble.

That was eight years ago. Standard and Poor's paid $1.4 billion in fines for its role in tanking the economy, and Dodd-Frank set up the Office of Credit Ratings to oversee credit rating agencies. Surely things have changed. To find out if the rating agencies have been rehabilitated, I read the 2015 Summary Report of Commission Staff's Examinations of Each Nationally Recognized Statistical Rating Organization so that you wouldn't have to.

Imagine having three mischievous children and the babysitter won't tell you which one dipped the kittens in flour and shut them in your closet for the evening. That's kinda like the report from the SEC. It doesn't name names and it won't tell you how to clean up the mess or prevent it from happening again, but it will tell you to enrol the children in medieval French classes. 

"One larger NRSRO did not code the quantitative model used for an initial rating of a structured finance transaction in a manner that reflected the actual terms of the transaction…resulting in a substantial downgrade."

Apparently, either Standard & Poor's, Moody's or Fitch pulled a Steve Harvey. 

Standard & Poor's, Moody's or Fitch also failed to apply the proper assumptions to numerous ratings, and mistakenly applied methodologies. It assigned ratings that differed from what their models suggested without documenting the rationale, and senior personnel unilaterally changed recommended ratings, just like they used to do in the bad old subprime days.

The Staff recommends that NRSROs enhance their internal controls, properly train supervisors regarding the code of conduct, and adhere to applicable record retention requirements.

The Staff? Is the SEC a watchdog or a collection of kind-hearted nurses in a rogue geriatric ward?

The report goes on to chronicle how some organizations changed their ratings methodologies willy-nilly and others didn't bother to review their models at all. The Staff recommend that these NRSROs ensure they adhere to policies and procedures regarding methodologies and models, and take their meds. 

Ratings publications contain errors, errors are discovered in a "substantial number" of third-party models and rating files are missing crucial documents. The Staff, that at this point must be exasperated at the number of wet beds, missing dentures and pills stuffed inside pillowcases, simply says...

The Staff recommended that this larger NRSRO ensure that all analytical personnel be made aware of and adhere to its error correction policies.

In assessing conflict of interest, the report notes the necessity of ensuring that the person who negotiates the fee for a rating should not be the same person who determines the rating or its methodology. The rules ignore the inherent conflict of interest of a company that is paid to rate its customers' products.

Some companies don't have adequate conflict of interest policies in place, others have policies but ignore them. A few analysts own securities of the companies they rated. The Staff tries to keep marketers from crawling into bed with analysts, but it's hopeless. The Staff posts more recommendations.

Some rating agencies provide unsolicited ratings to try to lure business away from competitors. It's so naughty to come on to the competition's beloved, telling them that they're better looking than the assessment they get at home. The Staff recommend that agencies establish policies that ensure commercial considerations do not influence employees' behaviour, enhance internal controls concerning recusals, and tell Mr McDaniel in 3C to put his pants back on. 

The SEC offers a list of recommendations, but Fortune says that the solution is heftier fines. Standard and Poor's should have paid $2.4 billion+ rather than the $1.4 billion they paid for their role in the subprime debacle. But the problem isn't the size of the fines. The problem is a conflict of interest, the rot in the core of the rating agencies' business model. Paying more fines is like increasing the parking ticket for a truck full of time bombs.

The problem is threefold:

1. Rating agencies aren't independent;
2. Given the power they wield, rating agencies should be more golden than Sachs, but they're considered to be the post offices of the finance industry and don't attract elite talent; 
3. As a result of #2, rating agencies aren't as clever as the organizations they're rating.

Back in 2007 analysts at Standard & Poor's wrote about a deal they were being asked to examine:

“Btw — that deal is ridiculous,” one wrote. “We should not be rating it.”

“We rate every deal,” came the response. “It could be structured by cows and we would rate it.”

There is still no reason for the rating agencies to care about what farm animal has created the instruments they rate. Their only allegiance is to their customers on Wall Street, not to the truth or to the lives behind the debt. 

In that same year, 2007, another S&P employee wrote mock lyrics to the tune of Talking Heads' Burning Down the House entitled, Bringing Down the House.

Watch out / Housing market went softer / Cooling down / Strong market is now much weaker / Subprime is boi-ling o-ver / Bringing down the house.

Are we going to let rating agencies bring the house down again? It sure looks like it.

About the Author: Lynne Everatt gives both the book and the movie The Big Short triple A ratings. 

How would you fix the rating agencies? Share your thoughts in the comment section below.