Conflicts of Interest at the Ratings Agencies

Jesse Eisinger looks at ratings agencies in the September issue of Portfolio, and spends a lot of time making the distinction between active and passive involvement on their part. Active involvement, it seems, is "one of the dirtiest open secrets in the mortgage-ratings world," and constitutes a conflict of interest on the part of the ratings agencies which sullies their precious purity.

I don't want to come across as being overly sarcastic here. If you're a ratings agency, your reputation for bestowing ratings without fear or favor is the most valuable thing you have. Even the impression of impropriety in such matters can be very damaging indeed.

And while ratings agencies exist for the benefit of investors, they're paid by issuers. That is most definitely a conflict of interest – although it's one that's not confined to the world of structured credit.

I just wonder whether investors would really prefer the ratings agencies to be less actively involved in bestowing ratings. Active involvement does, after all, inevitably bestow a deeper and more sophisticated understanding of a deal's structure than simply being shown the structure and asked to provide a rating.

The key issue, I think, is not that active involvement is bad – in many cases, it can be a good thing. (Although it's certainly weird that the ratings agencies seem to be so keen to deny that they have any active involvement in deals.) The problem comes when a ratings agency, after having worked closely with an issuer for a long time, gets lazy about asking tough questions, or assumes that the answers to those questions a few years ago are the same as the answers to those questions today.

In April, Moody’s said it would start doing what it should have done long ago: more aggressively scrutinizing new mortgage loans. The company acknowledged that its models, created in 2002, were out-of-date. “Since then, the mortgage market has evolved considerably, with the introduction of many new products and an expansion of risks associated with them,” a Moody’s report said. In hindsight, it seems astounding that the most influential rater of mortgage bonds wouldn’t be upgrading its models regularly to account for the growth in exotic mortgages.

Did the constant stream of money flowing from mortgage-backed issuers to Moody's bottom line encourage the company to forget to reconfigure its models? It's possible. But I reckon that the same thing would have happened if Moody's had been purely passive in its ratings, and got the money with even less work. Perhaps then people would be complaining that the ratings agencies hadn't been active enough when bestowing their much-coveted triple-As.