This morning's Wall Street Journal [subscription required] describes the critical role that ratings agencies such as Moody's Corp. (NYSE: MCO) and McGraw Hill Companies' (NYSE: MHP) Standard & Poor's played in spurring the growth of the of mortgage backed securities (MBS) that are currently slashing confidence in the global financial system.
At the heart of the problem is a fundamental conflict of interest within the ratings agencies. They are supposed to provide objective analysis so investors can decide whether to invest in specific securities. But they are paid by the people who issue the securities they are supposed to rate.
In fact, the ratings agencies' fees are about twice as high when they rate a security backed by a pool of home loans than corporate bonds -- Moody's took in $3 billion for such structured finance ratings between 2002 through 2006 accounting for 44% of its 2006 revenue -- up from 37% in 2002.
But wait -- it gets worse. Ratings agencies relied on data from underwriters to do their analysis -- so there's no way to know whether the data was accurate or tilted to encourage a higher rating. And the underwriters shopped the ratings business to the various firms -- picking the one that gave it the highest rating.
And since the securities, backed by pools of as many as 14,500 mortgages, were so complex, institutional investors relied on the investment grade rating to make their purchase. Unfortunately, the ratings agencies models did not accurately predict how bad things would get with subprime -- by 2006, for example, they found that many subprime borrowers were not even making their first payments after signing their contracts.
The result is that the firms decided to give up on the lucrative ratings game and tried to salvage their reputations (and hopefully minimize their legal exposure). On July 10, Moody's cut ratings on more than 400 securities that were based on subprime loans. S&P put 612 on review, and downgraded most two days later.
The full extent of the damage remains a mystery. But MBS investors relied to their detriment on the gold wrapper these ratings agencies were paid to produce by the very issuers whose toxic waste they were supposed to analyze on behalf of investors.
When all the damage is known, it may be worth thinking about whether this is the best way to run a financial system.
Peter Cohan is President of Peter S. Cohan & Associates, a management consulting and venture capital firm. He also teaches management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned