Sunday, December 07, 2008

Did the corporate debt rating agencies have a conflict of interest during the collapse? A look at Moody's

The New York Times has an article about credit rating agencies, particularly Moody’s, “The Reckoning: Debt Watchdogs: Tamed or Caught Napping? In the Housing Boom, Credit-Rating Firms Led Investors Astray,” by Gretchen Morgensen, on p A1, today, Sunday Dec. 7, 2008. The link is here. The stock symbol, MCO, shows that the stock has tanked toward the end of the year, just like everyone else.

The article explains the process of securitization of mortgage loans, and how that hid the individual borrower risk from lenders. Batches called “tranches” were placed in separate rating categories.

The integrity of the rating process seems to be undermined by the pressure on analysts to generate revenue. Moody’s reportedly revised ratings of Countrywide when pressured, and later seemed to back off on fully assessing the risks of the mortgage securities in order to bring in large profits in the short term.

Investors would have a reason to believe that there is an inherent conflict of interest in the corporate ratings process.

The mortgage crisis began to unravel in early 2007, but ratings agencies (including Best and Fitch) probably did not get stricter right away. But in 2008 they had become aggressive; the threat downgrades to AIG was one of the elements that propelled the crisis in mid September 2008, including the Lehman Brothers bankruptcy.

There does not seem to be a comparable problem with individual credit reporting agencies. Accuracy of reports depend on accuracy of information on consumers, and this is a big problem but not related to the underlying integrity of the process. Credit scores, however, seem to depend on arbitrary “risk predictor” rules that constantly need to be reviewed. Underwriting is a sensitive job, and those who do it must avoid personal conflicts of interest. This issue came up in my own career in an oblique way in the 1990s.

In the kind of world we live in, there will always be a private business model to predict risk. Insurance companies have to do this all the time with actuarial tables and prevention of anti-selection. It also gets harder to predict risk in a global world with so much asymmetry. .

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