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Ratings Agencies in Hot Seat

Ratings Agencies in Hot SeatMoody’s, Fitch S&P execs testify at U.S. House hearings

October 23, 2008


Confidence in the rating agencies has disappeared because the agencies responded to the demands of security issuers for high ratings and ignored the demands of analysts for more mortgage data and additional staff, according to testimony from former and present rating agency officials at a House committee hearing in Washington.

“There has been a loss of confidence in our industry,” admitted Moody’s Investors Service Chairman and Chief Executive Officer Raymond McDaniel at Wednesday’s hearing by the House Committee on Oversight and Government Reform.

“It’s going to be a while to build that up,” Jerome Fons, managing director of credit policy at Moody’s until 2007, said of this current lack of confidence.

Calling for “substantive changes,” he said, “It’s a difficult problem and we don’t see an easy answer. There’s been an erosion of standards.”

He was responding to a comment by Rep. Christopher Shays (R-Conn.): “I think the rating agencies are useless now.”

The lack of ratings standards was highlighted in some of the examples of past agency behavior raised by Rep. Henry A. Waxman (D-Calif.), committee chairman, and others. A Moody’s executive was quoted as saying that sometimes “we drink the Kool-Aid” and a Standard and Poor’s Ratings Services structured product employee was quoted as admitting, “We rate every deal. It could be structured by cows and we would rate it.”

An official at a privately held rating agency that is paid by investors for its ratings made clear what he sees as distinctions between Triple A ratings of securities and Triple A ratings of corporate debt. It is understood that those corporations “will pay no matter what,” explained Sean Egan, president and founder, Wynnewood, Penn.-based Egan-Jones Rating Co.

But Fitch Ratings CEO Stephen Joynt maintained that his firm’s top rating of securities was based on “full repayment of these securities.”

Ratings agency behavior started to change in the 1970s when agencies began to focus on income from issuers, according to Jerome Fons, managing director of credit policy at Moody’s until 2007. “They wanted to serve many masters but you can’t do that,” he said.

Moody’s missed early indications of the subprime disaster because their “standards were so low,” he said. “In 2006, things were slipping” but the rating agencies “allowed this to go on.”

Egan, discussing the reliance on issuers for earnings, set up an analogy to meat inspection in which inspectors are paid only for the cattle they find untainted, leaving exposed consumers at risk.

“Investors,” he noted, “can’t tell the difference between good meat and tainted meat.”

Now, Egan added, “People are not coming in to the market because they do not trust it.”

However, top executives at Fitch, S&P and Moody’s, in their testimony, denied that there was any conflict of interest that led to distorted ratings. S&P President Deven Sharma, while assuring committee members, “We have measures to protect against conflicts,” maintained that conflicts can occur whether ratings are paid for by issuers or investors.

Moody’s McDaniel and Fitch’s Joynt blamed some of their firms’ high ratings of securities on, respectively, “a loosening of underwriting standards” and “shoddy underwriting.”

“There’s a lot of blame to go around,” said S&P’s Frank L. Raiter, referring to investors as well as issuers and the rating agencies.

“The problem,” Egan pointed out, “is there’s no downside to being wrong. Everyone,” he said, referring to all those from loan-originating mortgage brokers to the rating agencies, “has an incentive for letting things go by.”

Analysts were the only figures not criticized in testimony at the hearing on Credit Rating Agencies and Financial Markets.

“Analysts are hard working people and were sending messages to managers,” said S&P’s Raiter, but those messages were ignored, as were requests for more staff. “The money [from issuers] became so great that the managers lost focus,” he added. “Profits were running the show.”

For a March 2001 deal, he said, he asked for collateral tapes to obtain information on 85 data points, including loan-to-value, FICO scores and property locations but was denied the information.

Raiter said he believed his firm had the necessary data but did not provide it to analysts, resulting in “a breakdown in the analytics.”

S&P and the other two rating agencies not only withheld information from their analysts, said Egan, but “got rid of the people that did understand it [the securities]. They were pushed out the door.”

The current heads of Fitch, Moody’s and S&P all said that practices at their firms were changing.

Future ratings, vowed Fitch’s Joynt, will be “more insightful and forward looking.”

But others were doubtful.

Waxman described their testimonies as simply repeats of what they had long been promising.

And Egan said they will never change.

“You have to accept them for what they are,” he said. “They do what they have an incentive to do. We need to provide a pathway for other voices. The current rating system is designed for failure and that is what we have.”

Jerry DeMuth is an award winning journalist who has been reporting for four decades.

e-mail Jerry at

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