Speaking out

As the financial crisis unfolded, investors, regulators and journalists all took turns to criticise the major credit-rating agencies for issuing inaccurate ratings. The core allegation is that the agencies’ overly optimistic ratings on complex financial instruments encouraged investors to funnel billions into dodgy, sometimes worthless, securities. This is believed to have been a major contributing factor in the credit crisis.

But despite regulatory reviews and lawsuits on both sides of the Atlantic, Eric Kolchinsky, a former senior analyst at Moody’s Investor Services, says that the rating agencies are still issuing inflated ratings and, far from improving, the problems have actually got worse.

“We have not cured the disease,” he says. “In many ways, the incentives for rating agencies have become worse since the credit crisis. There are now more rating agencies and they are all chasing significantly fewer transaction dollars.”

Kolchinsky took these views to a congressional inquiry in the USA. Here, in his first interview with a British journalist since the hearing, he describes what life was like inside Moody’s, the structural problems that led analysts to issue overly rosy outlooks on subprime-backed securities, and what urgently needs to be done to improve standards. Moody’s has said that it reviewed the claims and found them to be groundless.

Kolchinsky claims that he was booted out of Moody’s due to raising his concerns internally and with his supervisors. Throughout most of 2007, he was the managing director in charge of the unit that rated asset-backed collateralised debt obligations (or ABS CDOs). Based on his experience, he believes these subprime-backed instruments are “toxic” and should be binned for good. The rating agencies, however, continue to rate them.

Back in September 2007, Kolchinsky was worried that Moody’s was issuing ratings on securities backed by poor assets with inaccurate ratings. In 2009, he wrote a letter to his bosses warning that analysts were issuing inaccurate ratings. He also raised the issue with the US Securities and Exchange Commission (SEC).

In September 2009, Kolchinsky was suspended. Moody’s insists this was because he refused to co-operate with the independent investigation charged with exploring his allegations. Kolchinsky believes he was given the shove because he refused to rate those CDO deals.

Within days of being dismissed, Kolchinsky agreed to present his evidence to the US House Committee on Oversight and Government Reform, which was investigating the role and influence of rating agencies. He was also interviewed live on CNBC and Bloomberg.

Risky business

The problem, according to Kolchinsky, is structural. “The system does not incentivise the rating agencies to say ‘no’. No one asked us to lower our standards; in fact, if you managed to raise standards and still maintain your market share, everyone would be much happier. But at the end of the day, you could never say ‘no’ to a deal.”

Moody’s refutes this allegation, but it was unable to provide details on the number of ABS CDOs it refused to rate during 2007.

It is an inability to overcome this fundamental conflict of interest – no transaction to rate, no fee – that, many believe, has led to problems throughout the financial system. “Today, there is even less of an incentive to say ‘no’ because there is less money around and there are even more rating agencies,” Kolchinsky says.

Poor incentives exist all the way through the securitisation chain, he claims. Lots of parties receive their fee based on the successful completion of a transaction, which means there is no incentive, other than moral duty, to ensure the product has a long shelf life. Furthermore, he claims, financial firms were too willing to believe everything their models told them. “Models can be twisted to say what you want them to say.” When asked what it was like working for the unit in Moody’s that rated subprime securities, he says: “It was crazy. There were a lot of those deals going on. We were definitely understaffed.”

Within the rating agencies, the balance of power is stacked heavily in favour of the business managers, he claims, adding that analysts are routinely bullied by business line managers, and their decisions are overridden in the name of generating revenue. According to Kolchinsky’s evidence, Moody’s compliance department was understaffed and had little professional compliance experience. “Instead of ensuring that the rating process is free from conflict, the group sits idly by as these transgressions occur,” he says.

“I still think Moody’s is a good company, mostly, and mostly they are good people. Ninety-five per cent of the people are trying to do the right thing. But you need to be able to control business managers, just like in any company, and for that you need an independent compliance department, especially at a rating agency,” he says.

A Moody’s spokesman says: “Moody’s has very strong policies and procedures in place to manage conflicts of interest. We acknowledge that there is a potential for conflict of interest in any business; the key is how well we manage that conflict. We have rigorous safeguards in place to protect the integrity of our ratings from commercial considerations.

“Our ratings aren’t assigned by an individual analyst, they are assigned by a committee of analysts who each have a vote in the committee. In addition, compensation for Moody’s analysts and senior managers is not linked to the financial performance of their business unit. We do not take commercial considerations into account when we develop methodologies or assign our ratings.”

Kolchinsky criticises the rating agencies methodologies used to rate structured finance securities. He says they are “unrealistic” and “haphazard”, and are never validated if that means jeopardising revenues. He believes the ratings are not revisited regularly enough to ensure accuracy and to realistically reflect the underlying credits.

To this assertion, Moody’s responds: “We are fully transparent about the basis for our ratings. Our methodologies are freely available on our website. It would be clear to the market if we did not adhere to our methodologies.”

Long way to go

The most worrying of the allegations against the agencies is that none of these structural problems have actually improved. The emphasis on incentives, conflicts of interest and poor methodologies all persist, Kolchinsky says, and this is storing up problems for the future.

“The problem with the market today is there’s a feeling that we’ve passed the hump. In my view, we’ve stabilised the patient but we’re only treating the symptoms. We’ve still not addressed the core fundamental problems that exist; we’ve not cured the disease.”

Several treatments have been suggested. These range from overhauling the model so that buyers – in other words, the investors – pay for ratings, to replacing the rating agencies with a regulator. The problem with that is regulators don’t want to step in and tinker with the system too much during such a tumultuous period. There are also suggestions that credit insurers could take over the mantle and determine a company’s credit worthiness.

The only potentially effective proposal is a system of self-funded buy-side ratings that are paid for by the investors that use them. But this model isn’t free from conflicts of interest either, Kolchinsky says. In his experience, most asset-backed CDOs are retained on the balance sheets of the banks themselves. “For most of the deals in my product area, the issuer and the investor were the same party. It was practically an ‘investor pays’ model.”

One thing that would help is better regulation, he says. “You have to begin by accepting that rating agencies perform a quasi-regulatory function. If someone is performing a regulatory role, you cannot have them competing completely unfettered.”

Standards exist for the ratings industry, but they are voluntary and consequently not applied that frequently. Only seven out of 21 credit rating agencies surveyed by the International Organisation of Securities Commissions had actually incorporated the Credit Rating Agency Code, which is intended as a standard of good practice. But the ratings industry does appear to be on the brink of a much more stringent regulatory regime, which could try to enforce standards. The US House Financial Services Committee recently agreed to set new rules for the rating agencies.

The bill, which still faces scrutiny from the Senate, would allow the SEC to test the methods employed by ratings agencies and to sanction lax supervisors. In April, the Group of 20 agreed to extend regulatory oversight and registration of credit rating agencies to ensure they meet international standards and prevent unacceptable conflicts of interest. Investors will have a responsibility to conduct more due diligence themselves and not rely on a credit rating to tell them everything. In the future, much less importance is likely to be attached to ratings. This could signal the end of the agencies reign as the dolers of judgment in the financial system.

“If I were a doctor,” Kolchinsky says, “I would diagnose the rating agency patient as very curable. But treatment needs to be urgently applied to avoid further damage.” IT

Nathan Skinner is associate editor of StrategicRISK, a sister title of Insurance Times