The obligations of a debt rating agency

To whom are the ratings agencies legally accountable?

So McClatchy Newspapers has discovered that in late 2007 some analysts at Moody’s Investors Service were “downsized” for expressing concerns about the accuracy of the ratings being applied to some of the CDOs (collateralised debt obligations), especially those comprising MBSes (mortgage backed securities).

The news group alleges that Moody’s shuffled its internal employees, sidelining and/or firing those that were raising red flags and replacing them by structured finance specialists, in order to continue to provide the high ratings needed by the Investment Banks that were assembling the CDOs (see this story). The allegations are supported by quotes attributable to several former employees.

If true, the allegations reveal a deep weakness in the debt valuation process.

The story ends with the comment:

The ratings agencies were under no legal obligation since technically their job is only to give an opinion, protected as free speech, in the form of ratings.

Experts such as Columbia University’s [finance expert, John] Coffee think that Congress must impose some legal liability on credit rating agencies. Otherwise, they’ll remain “just one more conflicted gatekeeper,” and the process of pooling loans — essential to the flow of credit — will remain paralyzed and economic recovery restrained,” Coffee said.

As somebody involved in the equity valuation process, I find this absence of responsibility quite shocking.

In the equity valuation process, an analogous process to debt ratings would be VDD, or vendor due diligence. VDDs are employed to reduce disruption to a Seller’s business. For example, if a Parent company wishes to sell one of its business units (the “Target”), then every potential Buyer would wish to dispatch its own team of analysts to perform (buy-side) due diligence on the Target’s finances, including interviewing management representatives from the Parent and Target.

The VDD approach means that only one team of due diligence analysts is encamped at the Target, preparing a due diligence report. The Parent company contracts the due diligence provider, and pays for the work, and often attempts to suppress any negative commentary about Target business. However, when the transaction is completed, the vendor due diligence report is assigned to the successful Buyer, and the due diligence service provider assumes a duty of care to the Buyer.

This approach focuses the due diligence service provider’s mind on preparing an objective and factual report when confronted by the Parent company management’s intimidation.

This is very different to the “under no legal obligation since technically their job is only to give an opinion” scenario in which the debt rating agencies work.

Isn’t it time that the users of debt ratings demanded that the ratings agencies become more accountable for their “opinions?”

2 comments

  1. Hey, I found your blog while searching on Google your post looks very interesting for me. I will add a backlink and bookmark your site. Keep up the good work!

    (Note, links edited to remove possibility that this is spam instead of a genuine comment)

  2. A sorry story indeed. This reminds me of the problems in the dot.com boom when analysts were saying one thing in public and another in private. Maybe this story is illuminating – it suggests that these hedge fund managers knew the real value of the MBSes.

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