Drop Moody’s Into the Volcano

Remember Arthur Andersen? The giant accounting firm ceased operation in 2002 after authorities learned that its auditors had shredded documents related to Enron's fraudulent schemes and were probably complicit in those practices. Even though the firm's felony conviction was later vacated by the Supreme Court, Arthur Andersen's name was so tarnished, and it faced so many outstanding lawsuits, that no one wanted to do business with it any longer. End of story. That's life in the capitalist system, folks.

One of the most distressing things about the current financial scandal is that there has been no similar reckoning against the firms that were supposed to be watching the system for the investment public. Why haven't the rating agencies that were complicit in the subprime-mortgage securities scandal suffered the fate of Arthur Andersen? Despite some moves in Congress to change their behavior, U.S. authorities are still treating the agencies with extreme gentleness. Moody's and Standard & Poor's, the two giants of the industry, are still around despite causing the loss of hundreds of billions of dollars by badly rating subprime-mortgage-backed securities. Not only that, they are basically doing business the same way, taking fat fees from the investment banks whose securities they rate. In testimony before the House Committee on Oversight and Government Reform on Wednesday, a former Moody's managing director, Eric Kolchinsky, alleged that the firm was criminally deceiving investors by purportedly inflating ratings on securities even into the current year, long after the subprime scam had been exposed and the market crash had occurred. Richard Cantor, the firm's chief risk officer, dismissed the allegation as "without merit" at the hearing, but allowed that Moody's did "not give a high grade" to its own performance.

It's important to understand why Moody's and company live on, and why they haven't been forced to endure the rough justice administered to Arthur Andersen. The government is simply too afraid to let that happen. Like many of the big banks, the ratings agencies have been deemed too big or important to the system to fail. Indeed, their prominence in the financial landscape is an ironic result of the government's efforts to fix the system after the Wall Street mania of the '20s led to the Great Depression. "Back in 1936, the bank regulators told banks if you are going to buy bonds, and have them in your portfolios, those bonds cannot be speculative. They must be investment grade. Who is the arbiter of what is speculative and investment grade? These handful of rating agencies," says Lawrence White, a financial expert at New York University. "In essence, the bank regulators were outsourcing this safety decision. The rating agencies' judgments secured the force of law."

Today the main ratings agencies continue to be anointed by the government as "Nationally Recognized Statistical Rating Organizations," in other words as arbiters of what banks, pension funds, and others restricted to "safe" investing can legally buy. Until recently they have even been given First Amendment protections afforded to journalists to protect them against liability for erroneous assessments. It was no accident that among those scheduled to to testify today was Floyd Abrams, the great First Amendment lawyer famed for his defense of The New York Times and other newspapers. His client this time was Standard & Poor's.

But here's the rub. The assessments of accountants like Arthur Andersen can be tested. If an accountant doesn't follow GAAP, or Generally Accepted Accounting Principles, his negligence can be checked, and he can be cast out of the profession—or prosecuted. By contrast, ratings agencies, despite carrying the government's imprimatur, each have their own unique methods of rating. There is no standardized approach as there is in the accounting industry. "They are masters of their own methodologies. You have to prove their own methodologies are wrong," says Kolchinsky. So there is very little accountability or transparency. Under the current system, the agencies almost can't be caught out, even while they enjoy the government's protection. And absolute power, as we know, corrupts absolutely.

The sad thing is that in the days before the subprime securities scandal, Moody's was considered the class act of the ratings agencies, just as Arthur Andersen was once a globally respected firm. Its ratings systems, like Andersen's accounting practices, worked very well in the pre-derivatives days of ordinary corporate or municipal bonds. Back then, the agencies' ratings assessments were publicly available and could be checked. But as the era of "structured finance"—private derivatives or securitized-asset deals between companies—took off, the ratings systems started getting more slippery. As debt began to get packaged and repackaged in ever-more complex bundles of securities, it was impossible to double-check the ratings within those bundles. The fact that every ratings company had its own methodology only made things more complicated. There was no longer any public accountability—the embarrassment of getting a rating badly wrong—to weigh against the temptation of fees from big deals from the issuers. At first subtly, then profoundly, that began to corrupt the culture of once-respectable rating agencies like Moody's. They had become vassals of the Wall Street firms they were rating, and neither the Fed nor the SEC was closely watching the change.