Moody's Agency Doesn't Go Far Enough to Fix the Mortgage Crisis

Moody’s Investors Services announced Monday that it was considering changes in its rating system, including how it appraises mortgage-related securities.

The move, which is a response to both public authorities and the market itself to improve the way they rate debt, is the first such sign from any of the major raters.

Here is a quick look at what is being considered and what it means.

The primary change being proposed is to use a rating scale for structured products that is different from the way they rate corporate and government debt. This step is long overdue. If the move truly makes the process more transparent, then it is a positive sign. No word at this point on the details.

Moody’s said it was also considering adding a warning label to these products, which has about as much value as the warning label on cigarettes. Since they already provide 300-page disclaimers that essentially serve to shield them from liability, what good is a warning label? This step does nothing to address the lack of transparency.

Moody’s followed up by announcing today that it is going to ask for more detailed information from the issuers, which borders on comical. Since they are paid to pass judgment on how well bonds are going to perform relative to their quality, why were they not asking for more detailed information from the outset?

For now, it appears that rivals Standard and Poor’s and Fitch are staying quiet on the proposed changed.

While a more transparent rating process would be advantageous, I still contend that the system is fundamentally flawed. The agencies cannot be truly independent unless Congress (or rather the SEC) rethinks the compensation structure. Unless we revert to the system of old and implement a subscription service, the answer lies with changing their motivation.

How does this happen? Like a child who tantrums and is threatened with having his Christmas toys returned if he does not shape up, nothing motivates like the almighty dollar. Well, maybe other currencies do, but that is beside the point.

The answer is to restructure the compensation system so that the agencies are paid relative to the accuracy of their ratings. In other words, if a security has 90% rated as AAA, the agencies should make money relative to the performance of the bonds. The better it performs, the more they make. The worst it performs, the less they make. Do you think they would have been more accurate in their approach if they had some skin in the game? Absolutely.

I have outlined this proposal in greater depth in Greed, Fraud Ignorance, as it requires a more detailed explanation. Suffice it to say that without significant reform, the proposed changes are window dressing designed to satisfy the SEC.

If the flawed nature of the relationship is not addressed, it leaves the door open for additional malfeasance. Did somebody say SIVs?