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Confessions of rating agency staff

Last week the Financial Crisis Inquiry Commission called employees and affiliates of Moody’s Rating Agency before them in New York to give evidence to explain their part in the US sub-prime mortgage crash and ensuing global recession.

While current Moody’s executives and even shareholder Warren Buffett defended the ratings agency as merely a provider of information who was as in the dark as everyone else, it was Mark Froeba, a former senior vice president of Moody’s, who offered up the most interesting insight into how the ratings agency played its part in the meltdown.

Froeba left the firm in 2007 but in his testimony to the Commission he outlined a culture within the agency that he believed led to inaccurate ratings on securities to benefit the banks and keep Moody’s market share higher.

“The Moody’s of [pre-2000] had the stature and maybe even the power to stop something like the sub-prime bubble had it arisen then. Unfortunately, by the time the bubble arrived, Moody’s had deliberately abandoned its stature and surrendered this power,” he said.

This was illustrated by former Moody’s managing director Eric Kolchinsky, who also left in 2007. His testimony said: “The focus on market share inevitably lead to an inability to say “no” to transactions. It was well
understood that if one rating agency said no, then the banker could easily take their business to another.

“Market share issues had totally corrupted the way Moody’s analysts and managers conducted rating analysis.”

Mark Froeba

“For senior management, concern about credit quality took a back seat to market share. During my tenure at the head of US asset backed securities, I was able to say no to just one particularly questionable deal. That did not stop the transaction – the banker enlisted another rating agency and received the two AAA ratings he was looking for.”

Froeba told the Commission how Moody’s became hell-bent on taking market share from its rivals by initiating a “campaign of intimidation” against employees who would rate an asset against the wishes of the provider.

Froeba said the firm would threaten “poor performance evaluations, no promotions, no raises, effective pay cuts, smaller bonuses and restricted stock options” if analysts made investment bankers unhappy.

He said: “By bullying Moody’s analysts into docility and by encouraging bankers into bold defiance, Moody’s ratings were made to be no better than its competitors’ worst ratings.”

He told of analysts who were replaced and fired after banks “aggressive complaints” against less than satisfactory ratings only for the replacement to find that the initial assessment was precise while the bank’s model “was wrong, or at least very imprecise.”

“You began to hear of analysts, even whole groups of analysts, at Moody’s who had lost their jobs because they were doing their jobs, identifying risks and describing them accurately,” Froeba said.

Kolchinsky told the Committee he was once criticised by a manager for “spending too much time reading research.”

Froeba’s testimony also details an occasion where Moody’s Europe changed its scoring system so as to offer better ratings on European pooled securitisations and gain market share. Froeba said this allowed some securities to gain scores one or two notches above their real risk rating.

Froeba said: “Market share issues had totally corrupted the way Moody’s analysts and managers conducted rating analysis…malfeasance may be buried under so many layers and layers of complexity that only a small number of experts would ever notice and understand it.”

Moody’s chief operating officer Raymond W. McDaniel said the performance of many of Moody’s mortgage security ratings were “deeply disappointing”. He said the firm was “raising the bar” on its rating actions and was welcome to more transparency in the sector.

But McDaniel stressed that his firm were just as surprised as anyone when securities were found to be significantly more risky than Moody’s had assessed.

“The rating agencies faced the age old and pedestrian conflict between long-term product quality and short term profits. They chose the latter.”

Eric Kolchinsky

Kolchinsky said: “The rating agencies could generate billions in revenue by rating instruments which few people understood. The lack of guidance from the private and public users of ratings ensured that there was little concern that anyone would question the methods used to rate the products. The rating agencies faced the age old and pedestrian conflict between long-term product quality and short term profits. They chose the latter.”


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There are 9 comments at the moment, we would love to hear your opinion too.

  1. Sounds just like how the UK banks operated to me. Sacking people who understood risk and replacing them with people who didn’t.
    So, as with the UK banks, what’s now important is are they genuinely going to reverse this and get rid of their current staff and re-recruit those who knew what they were doing?

  2. Hossein Ameli 8th June 2010 at 9:47 am

    “The rating agencies faced the age old and pedestrian conflict between long-term product quality and short term profits. They chose the latter.”
    Unless somethig fundamental is done to address this root cause, we will get back here sometime in this decade or the next.

  3. We all know that the FSA have chosen to view commission paid by a provider as a potential source of bias – thus RDR.

    Sheila Nicoll concentrates on how IFAs need to adapt in her piece on MM here:

    An extract from my comment on her piece read:

    Quote: “Can we take it that the FSA will not allow any product to be marketed which carries with it any immediate, or more importantly any latent risk?

    Risks which may not be transparent and visible within the product itself but lie in the complex world beyond it, a world which included Repo 105s, and and still lives with uncoordinated global accounting methods?

    With that wider perspective in mind – and given the FSA’s thoughts on the calumny of commission/payment bias, what time scale should we envisage before the FSA address the question of Rating Agencies and radically alter how they are paid?”

    What this evidence from the Financial Crisis Inquiry Commission reveals is one of the latent risks to which I alluded.

    If the FSA truly see a “risk” in a one man IFA being biased by a payment from a provider – how much bigger is that “risk” when the issuer of a security is paying the rating agency for the rating which is to be attached.

    The evidence is all around us – the requisite action from the FSA is not.

  4. you get exactly the same situation in certain network/national research depts. Management don’t want the best products on the recommended list, they want the products from the provders that have given them money.

  5. Julian Stevens 8th June 2010 at 12:18 pm

    We desperately need a Financial Crisis Inquiry Commission here in the UK to investigate and if necessary rip apart the FSA.

  6. These guys are effectively the Gate Keepers and should be the first point of call to the regulators with full whistle blowing proceedures encouraged

    its not the Analysts to blame here its the management and they need to be stripped down and have less influence on external analysis as this portrays a culture of bullying and harrasment with deadly consequences for us all. Back in tnhe 90 s i worked for a well known player in the market and saw a similiae culture exist with a £1 million fine to boot.Not the fault of the good guys at all but of gredy management often at the middle end and not on the board

  7. This is what happens when ‘sales’ takes over the senior management. Pursuit of short term gain (thats where the bonus is guys) over long term stability. Ask the banks, fund managers and life offices that have all suffered after chasing increased market share by getting in ‘sales’ people at the top.

    Shareholders are partly to blame as the require stella performance from the companies they invest in when what you really want from banks etc is staid performance. If you want high returns you have to take a risk – simple investment advice I believe.

    As usual the authorities who were also employed to spot these issues were asleep on the job.

    Can someone please explain what they do again?

  8. And we needed the Financial Crisis Inquiry Commission to ‘uncover’ the bleedin’ obvious?

    Who said all this was a ‘collective intellectual failure’?

    That’s the problem with regulators, too many intellectuals who can’t see the wood for the trees..

    Come on George, slice and dice.

  9. I liked Mike Horsemans idea. Why not reward whistleblowers in companies/providers by rewarding them financially, say 1% of the fine imposed, it sounds drastic but it would force companies to clean up their act when you have a financial motivation for disgruntled low-level staff to prevent shady hidden practices from going unnoticed until its all it hit the fan.

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