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Thursday, June 3, 2010

Head of Ratings Agency Tells Investors not to Rely on Ratings

Bloomberg / Business Week

Stephen Joynt, of Fitch, left; with Raymond McDaniel, center, of Moody’s; and Deven Sharma, of S.& P., are sworn in at a House Congressional Hearing in October, 2008.

Moody’s Corp. Chief Executive Officer Raymond McDaniel said his company’s ratings of collateralized debt obligations and residential mortgage securities in the past several years have been “deeply disappointing.”

McDaniel said the collapse of the housing market and subsequent economic slump were of a magnitude “many of us would have once thought unimaginable,” according to written testimony submitted to the U.S. Financial Crisis Inquiry Commission for a hearing today in New York on credit ratings. He said he is proud of Moody’s reputation and the firm’s record of 100 years of rating trillions of dollars in debt.

“However, the performance of our credit ratings for U.S. residential mortgage-backed securities and related collateralized debt obligations over the past several years has been deeply disappointing,” he said. “Moody’s is certainly not satisfied with the performance of these ratings.”

Moody’s, Standard & Poor’s and Fitch Ratings face scrutiny by Congress and state insurance regulators after assigning top grades to U.S. subprime-mortgage bonds just before that market collapsed in 2007, sparking the financial crisis. Moody’s said last month it may be sued by the U.S. Securities and Exchange Commission for filing false and misleading descriptions of its credit-ratings policies.

Warren Buffett, the billionaire chairman of Berkshire Hathaway Inc. and Moody Corp.’s largest shareholder, is also scheduled to testify. Buffett declined to provide his written testimony in advance, according to the FCIC. He had to be subpoenaed to be compelled to appear today, said Tucker Warren, a spokesman for the inquiry commission.

‘Not Pretty’

In his opening remarks, Chairman Phil Angelides said, “To be blunt, the picture is not pretty.” He added that “Moody’s did very well. The investors who relied on Moody’s ratings did not do so well.”

Angelides characterized the ratings service as a “triple-A factory,” saying that it assigned the top grade to 42,625 residential mortgage-backed securities from 2000 to 2007.

“In 2006 alone, Moody’s gave 9,029 mortgage-backed securities a triple-A rating,” said Angelides, whose panel was created to investigate the causes of the financial crisis as Congress debates the most sweeping overhaul of banking regulations since the Great Depression. “To put that in perspective, Moody’s currently bestows its triple-A rating on just four American corporations.”

AAA Downgrades

Many high-level ratings had to be lowered. In 2006, 83 percent of triple-A products were downgraded and in 2007, 89 percent of those considered investment grade were reduced to junk, Angelides said.

“This comes as close as you can to the very product being fraudulent or of no use to the marketplace in reality,” he said.

Former employee Eric Kolchinsky testified today that “it was very clear” that his future at the firm and compensation depended on the market share that he brought in. “That was reinforced in many ways, especially with these e-mails that were sent out at least quarterly and occasionally monthly,” he said.

“The problem with the ratings process is if you had a hunch that something was wrong or it was a qualitative feeling things were wrong, you couldn’t really do anything because you couldn’t say no to a deal,” Kolchinsky told the commission.

Kolchinsky has said Moody’s violated securities laws by knowingly providing “incorrect” ratings. The company has denied the claim.

Congressional Bills

The U.S. Senate in May approved a plan to allow regulators, instead of bond issuers, to choose who rates asset-backed securities after investors said the ratings companies inflated assessments of mortgage bonds because they were paid by Wall Street firms selling the debt. A panel, overseen by the SEC, would assign a credit-ratings company to evaluate an offering.

The proposal is part of a larger financial reform package that the Senate passed last month. After being reconciled with the House version of the bill, it must be signed by President Barack Obama to become law.

Moody’s shares gained 36 cents, or 1.9 percent, to $19.66 at 10:35 a.m. in New York Stock Exchange composite trading. They had lost more than 30 percent this year through yesterday.

S&P and Fitch representatives weren’t invited to speak at the hearing today because their testimony wasn’t needed to understand issues with the credit-ratings industry, said Warren, the FCIC spokesman.

The fact that only Moody’s executives will appear today isn’t related to its being notified by the SEC that the company may be sued, Warren said.

Buffett Sells

Buffett sold Moody’s stock in each of the last three quarters, reducing a stake that had remained steady at 48 million shares since 2000. Buffett, who oversees a U.S. equity portfolio with a market value of $50.9 billion at the end of March, invests in firms that he thinks have long-term competitive advantages.

Profits in the ratings industry are under pressure as bond buyers seek alternative sources of research, said Meyer Shields, an equity analyst with Stifel Nicolaus & Co. Some investors are doing more evaluations of debt on their own, while others are bypassing established firms such as Moody’s for newer ratings companies, Shields said.

“Clearly, rating agencies missed this whole crisis,” Shields, who has a “hold” rating on Berkshire shares, said in an interview. “It does, I think, change the perception of the value that the rating agencies bring to the table.”

Moody’s, whose founder John Moody created credit grades a century ago, competes with McGraw-Hill Cos.’s S&P unit and Fitch Ratings for business assigning grades to corporate debt and mortgage bonds.