Tuesday, January 17, 2017

Moody's Settlement and Its Wider Implications for Finance and Beyond

This blog is provided by guest contributor Marc Joffe.  Marc also studies and writes extensively on debt issues in sovereign and sub-sovereign markets.  His recent commentary on the relative strength of US cities can be found here.  The following views are his own, and do not necessarily reflect those of PF2.


On Friday afternoon, Moody’s settled DOJ and state attorneys general charges that it inflated ratings on toxic securities in the run-up to the financial crisis. Moody’s paid $864 million to resolve certain pending (and potential) civil claims, considerably less than S&P's settlement of $1.35 billion. While the settlement appears to close the book on federal investigations of rating agency malfeasance, the episode deserves consideration because it has something to teach us all about broader institutional failures, and their implications for both the economy and news coverage.

Moody's received better treatment than S&P despite the fact that its malpractice was painstakingly documented in 2010 by the Financial Crisis Inquiry Commission. I suspect that Moody's achieved a better outcome than S&P for some combination of three reasons: (1) employees were more disciplined about what they committed to email, so DOJ lacked some of the smoking guns S&P analysts handed it (including the infamous message sent by one S&p analyst to another "We rate every deal. It could be structured by cows and we would rate it."); (2) senior management and corporate counsel took a less confrontational approach to prosecutors; and (3) Moody's carried the water for Democrats at critical times during the Obama administration. Moody's Analytics economist Mark Zandi was a vocal proponent of the 2009 stimulus bill and other Obama policies. Meanwhile, the rating agency declined to follow S&P in downgrading US debt from AAA in 2011. 

Having worked at Moody’s structured finance in 2006 and 2007 – but not in a ratings role – I recall that most rating analysts didn’t think they were doing anything wrong (although it is also true that some left exasperated). I believe this was the case because the corruption of the rating process occurred gradually. In the 1990s, ratings techniques were primitive, but appear to have been motivated by an intention to objectively assess then novel mortgage backed securities and collateralized debt obligations. After the company went public in 2001, quarterly earnings became a concern for the many Moody’s professionals who were now eligible for equity-based compensation.

As the structured finance market soared during the early part of the last decade, the pressure to dumb down ratings standards increased. As portrayed in The Big Short, analysts at S&P and Moody’s understood that the failure to give investment banks AAA ratings for the junk bonds they were assembling from poorly underwritten mortgages would place their companies at a competitive disadvantage. 

The collapse of rating agency standards is one case of a much larger set of problems that are threatening our economy and social fabric: professionals who we expect to provide objective information prove to be biased. It’s like a baseball umpire calling a strike when a batter lays off a wild pitch. While that type of behavior could ruin a ball game, the loss of integrity by financial umpires has more earth-shaking implications.

Aside from rating agency bias, the financial crisis was also triggered by a spate of dodgy appraisals. Inflated home appraisals, made at the behest of originators trying to qualify new mortgages, also contributed to the 1980s Savings and Loan crisis.

Malpractice by supposedly unbiased professionals also exacerbated the 2001-2002 recession. The values of dot com stocks were inflated when securities analysts issued misleading reports exaggerating the companies’ earnings potential. The analysts’ judgment was clouded by incentives at their investment banks, which profited from underwriting stocks issued by these overrated companies. Meanwhile, Arthur Andersen’s shortcomings in auditing Enron's books magnified the impact of that firm’s spectacular 2001 crash.

So the credit rating agency problem is part of a more generalized issue that encompasses appraisers, auditors and security analysts. It can occur whenever professionals are asked to provide objective evaluations: they can succumb to their own biases or pressure from those who have a vested interest in the outcome of the review. Because the judges usually receive less compensation and have lower social status than those who are judged, they are especially vulnerable to temptation.

And the problem is not limited to finance. Journalistic institutions which have built stellar reputations for objective, fact-based news reporting have let their standards slip, especially during the contentious 2016 election and its aftermath.  For example, the Washington Post recently embarrassed itself by hastily reporting that the Russians had hacked a Vermont power utility. Ultimately, it turned out that a computer virus created in Russia was found on a laptop at the utility’s offices. The laptop was not connected to the power system, and the virus was typical of Eastern European computer worms that proliferate across the internet. Adding insult to injury, the newspaper failed to issue a proper retraction when the story collapsed.

Like those working at Moody’s, I suspect that most WaPo reporters didn’t imagine that they were doing anything wrong. They may have been guided by a belief that the public needed to be more wary of the Russians, especially now that they appear to have influence within the Trump administration.  Some mainstream media reporters may honestly believe that protecting America from the Russians and from Donald Trump is more important than living up to the ideal of objectivity that had been the gold standard of 20th century news coverage. It is also possible that reporters are influenced by pundits, government sources and political power brokers: there have been many cases of journalists cycling in and out of government roles, so a victory by one’s favored party can offer career benefits.

But whether it’s Moody’s and S&P or a major news outlet, we all suffer when systemically important providers of allegedly objective information lose their bearings. Even the most primitive organisms need facts to survive. Prey that deny knowledge of the position and trajectory of predator movements become dinner. Today’s most complex social organism, American society, needs institutions that provide just the facts in a dispassionate manner. The rot destroying the foundations of these organizations should worry all of us regardless of our position in the financial hierarchy or on the political spectrum.