Pigs at the Trough: Rating Agencies as Corrupt as Ever

Pigs at the Trough

The big rating agencies are as corrupt as ever. But don’t blame them. That would be like blaming pigs for feeding at the trough.

Please consider the New York Times article Ratings Agencies Still Coming Up Short, Years After Crisis by Gretchen Morgenson.

The mistakes that led to the 2008 mortgage crisis can’t happen again, right?

Not so fast, particularly if you’re talking about credit ratings agencies like Moody’s Investors Service and Standard & Poor’s. Eight years after these companies were found to have put profits ahead of principle when they assigned high grades to low-quality debt securities, some of the same dubious practices continue to infect their operations. That’s the message in the most recent regulatory report on the companies from the Securities and Exchange Commission.

The credit ratings agencies played an enormous role in generating billions of dollars in losses during the debacle. Internal emails that emerged in congressional investigations were especially revealing of the problems at these companies. “We rate every deal,” one Standard & Poor’s employee famously wrote. “It could be structured by cows and we would rate it.”

There’s an entertaining — and illuminating — scene in the movie “The Big Short” that perfectly captures the pathology. As a Standard & Poor’s employee played by Melissa Leo replies when asked why the ratings agency didn’t insist on higher standards: “They’ll just go to Moody’s.”

Pigs Will Be Pigs

Morgenson explains the new SEC findings in detail.

However, Morgenson failed to mention it was the SEC who created the pigs when it mandated all debt must be rated by a recognized rating agency.

I have written about this problem on many occasions, including a post in 2007 before the financial crisis hit.

Time To Break Up The Credit Rating Cartel

Please consider a few excerpts from my post Time To Break Up The Credit Rating Cartel, written September 28, 2007.

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.

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.

Current Model Less Than Useless

Any rating agency that gets paid on volume rather than accuracy is less than useless.

Those who want a true rating on an issue go to someone like Egan Jones. They do have to pay for the analysis.

Chicago Pigs

I discussed rating agency fraud as pertains to Chicago on May 20, 2015 in
CNBC’s Santelli and Mish Discuss Municipal Bonds; Egan-Jones on Chicago; S&P Blames Moody’s; Message to Bondholders.

On Monday, I gave Sean Egan of the rating agency Egan-Jones a ring. I asked him how he would rate Chicago General Obligation bonds. Egan replied “deep in junk territory”.

Here is a table I put together that shows how various agencies rate Chicago debt.

Rating Agency Date Rating Level Outlook
S&P 5/14/2015 A- 3 Levels Above Junk Negative
Kroll 5/11/2015 A- 3 Levels Above Junk Stable
Fitch 5/15/2015 BBB+ 3 Levels Above Junk Negative
Moody’s 5/12/2015 Ba1 Junk Negative
Egan-Jones 5/18/2015 “Deep Into Junk” Negative

Eliminate the Pigs

When Moody’s rated Chicago debt Junk, the city shopped around and went to Kroll instead.

For a detailed explanation as to how Kroll came into existence, please see Rate Shopping Whores and Chicago’s Bond Rating.

The solution is clear: Get rid of pigs and take away the trough.

Mike “Mish” Shedlock