Risky Business

In 2006, Raymond W. McDaniel, Jr., chairman and CEO of Moody’s Corporation, proclaimed, “I firmly believe that Moody’s business stands on the ‘right side of history’ in terms of the alignment of our role and function with advancements in global capital markets.” Editorialists, pundits, and lawmakers alike have scrutinized this sentiment over the past year, debating the role that credit-rating agencies played in the subprime crisis. Instead of the blame game it used to be, this debate has recently become a more fruitful discussion between the public and private sectors—policymakers and rating agencies—about how to better design the process of rating securities and minimize conflicts of interest. “The status quo isn’t good enough,” said SEC Chairwoman Mary Schapiro at a roundtable discussion on the subject last week. While some problems with rating agencies are indeed structural, there are more basic issues of risk-taking behavior at stake that cannot be changed simply through regulation, cooperation, or incentives.

Moody’s, like rival firms Standard & Poor’s (S&P) and Fitch, Inc., follows a “corporation-paid” model, in which the corporation issuing a security pays for Moody’s to rate that security. This creates a conflict of interest. Since rating agencies want to keep a steady flow of business, they have good reason to overrate securities and make their customers—the issuers—happy. Indeed, rating agencies in the past have given collaborative feedback to issuers to such an extent, some argue, that their ratings were no longer objective.

While proposed solutions help fix conflicts of interest, more inevitably arise. A simple alternative would be to return to the “investor-paid” model that rating agencies followed pre-1968, when S&P began charging issuers for ratings, in addition to the subscription fee they had always collected from investors who used the ratings. Yet, as many firms argue—both in 1968 and in recent months, when the model has again been proposed as a viable solution—relying solely on a subscription service does not bring in enough revenue to allow rating agencies to innovate and keep up with increasingly complex financial products. Other officials have focused on fixing the mechanics of this structure. New York Attorney General Andrew Cuomo, for example, announced an agreement with rating agencies in June in which issuers simply pay for rating agencies to review the securities with no requirement to produce a rating. Relieving this pressure to produce could foster objectivity and minimize conflicts of interest. In that case, though, the problem of being paid to judge your boss’s daughter, so to speak, still remains. The Cuomo plan does not change the “corporation-paid” model and its attendant conflicts of interest.

How, then, can regulators and businessmen alike mitigate this conflict? The most logical initial step is to place renewed emphasis on the investor’s responsibility to rely on a constellation of datapoints, rather than one datapoint, when she makes an investment.

John Moody anticipated this problem when he published the first Moody’s Analyses of Railroad Investments in 1909. Moody prefaced the book with a note about its scope, cautioning that it was “in no sense a ‘manual’” and instead a tool to enable investors to “analyze the conditions back of all security values.” Like his future competitors, Moody specifically intended his credit ratings to enable analysis rather than be ends in themselves. Nonetheless, by 1970, when the firm switched to a “corporation-paid” model, Moody’s ratings had become decisive factors for investors. In fact, by 1970, ratings from Moody’s, S&P, and Fitch had become such an important part of bringing securities to market that Moody’s felt it necessary to capitalize on the “market access” their ratings provided by charging issuers. The SEC’s decision to classify Moody’s, S&P, and Fitch as “nationally recognized statistical rating organizations” in 1975 didn’t help matters, as this imposed a rubber stamp that reinforced ratings as standalone measures of risk.

The problem here involves both agencies like Moody’s, with its horde of analysts, and the investors they inform—and so does the solution. It evidences a broader issue that technology and innovation bring to all facets of life: carelessness. If you can find the answer by searching Google or glancing over a Wikipedia article, why read a book? If you can rely on a credible rating for a complex financial security, why do further research? In a narrow sense, the lack of context attendant in these bursts of data leads to small errors, and, on a broader scale, this limited scope contributes to major market failures.

Many of these credit-rating agencies are beginning to argue that their ratings are informed opinions, not answers, just as Moody described in 1909. Thus, some claim, they should be exempt from rebuke. According to The Wall Street Journal, many credit-rating agencies intend to use the constitutional right to free speech as a defense against upcoming litigation cases. While this may be juridical truth, and a clever defense, conflicts of interest and careless behavior will remain even under the old, investor-paid model. All the regulators can do is continue to effectively cooperate with rating agencies, working to create a better—albeit imperfect—system.

As for the rest of us, we can do no more than take a moment to think. It’s worth it.


Noah M. Silver ’10, a former Crimson associate editorial editor, is a history concentrator in Quincy House. His column appears on alternate Wednesdays.