Rubber Stamp Agencies

Ratings agencies are supposed to solve market failures, not create them. The market failure arises because in most cases it's prohibitively costly for individual investors to collect and analyze the information they need to make informed judgments about the quality of the financial assets they are considering purchasing. Without some means of overcoming this risk assessment problem, these markets are unlikely to flourish. Ratings agencies are supposed to become experts at this task, and hence be more efficient at risk assessment than individuals, and they can spread high fixed costs over many transactions. Thus, they become a low cost source of reliable information on the quality of financial assets. But when agency relationships are broken, i.e. when the profit motive of the ratings agencies provides incentives that are not fully compatible with the best interests of investors who purchase the securities, and when the interests of the ratings agencies instead become aligned with the firms issuing issuing the securities they are rating, problems are bound to develop:

Debt Watchdogs: Tamed or Caught Napping?, by Gretchen Morgenson, NY Times: “These errors make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both.” — A Moody’s managing director responding anonymously to an internal management survey, September 2007.

The housing mania was in full swing in 2005... Moody’s, which judges the quality of debt that corporations and banks issue to raise money, had just graded a pool of securities underwritten by Countrywide Financial, the nation’s largest mortgage lender. But Countrywide complained that the assessment was too tough.

The next day, Moody’s changed its rating, even though no new and significant information had come to light... That was not the only time Moody’s softened its stance on Countrywide securities. ...

Since the subprime mortgage troubles exploded into a full-blown financial crisis last year, the three top credit-rating agencies — Moody’s, Standard & Poor’s and Fitch Ratings — have faced a firestorm of criticism...

The agencies are supposed to help investors evaluate the risk of what they are buying. But some former employees and many investors say the agencies, which were paid far more to rate complicated mortgage-related securities than to assess more traditional debt, either underestimated the risk of mortgage debt or simply overlooked its danger so they could rake in large profits during the housing boom. ...

Moody’s current woes, former executives say, were set in motion a decade or so ago when top management started pushing the company to be more profit-oriented and friendly to issuers of debt. Along the way, the firm, whose objectivity once derived from the fact that its revenue came from investors who bought Moody’s research and analysis, ended up working closely with the companies it rated... [...continue...]