Are the ratings agencies fit to judge us?

Moody’s has stripped the UK of its AAA credit rating, the first cut since the 1970s. An activist researcher says governments should do more to expose and prosecute misconduct and incompetence by the too-powerful ratings agencies.

Last week Moody’s, the American international credit rating agency, cut Britain’s AAA credit rating, prompting calls for further drastic cuts in our public services. But who are Moody’s to be judging us at all? What is their credibility worth?

Moody’s calls itself “an essential component of the global capital markets” providing "credit ratings, research, and risk analysis." For these services Moody's took $2.7 billion in revenues last year, claiming its "commitment and expertise contributes to transparent and integrated financial markets". Let's keep that phrase in mind.

Earlier this month Reuters reported that the United States Justice Department and multiple states are discussing suing Moody's for allegedly defrauding investors. “Moody's already faces fraud claims filed from private investors," noted Reuters. "Abu Dhabi Commercial Bank, King County in Washington State, and other investors are suing the firm over losses in Cheyne, a structured investment vehicle.”

In 2010 the United States Securities and Exchange Commission published a report of its inquiry into Moody's. In early 2007, according to the SEC report, a Moody’s analyst told the Moody’s European Ratings Committee that due to a “computer coding error” investments for sale in Europe since September 2006 were wrongly given a AAA rating – when they should have been rated up to 3.5 notches lower.

What did Moody's do next? The SEC quoted an internal email of 24 January 2007 sent from a Moody’s rating committee member to the Team Managing Director chairing the Committee:

“In this particular case we seem to face an important reputation risk issue," wrote the Moody's executive. "To be fully honest this latter issue is so important that I would feel inclined at this stage to minimize ratings impact and accept unstressed parameters that are within possible ranges rather than even allow for the possibility of a hint that the model has a bug."

The computer coding error was fixed on 12 February 2007. Instead of following procedure, immediately informing investors and correcting the faulty ratings, the Moody’s Rating Committee held a series of meetings in Europe (including the UK) and eventually decided on 27 April 2007 to tell nobody of the coding error and not to downgrade the affected credit ratings.

The SEC found that the Committee’s reasons for taking no corrective rating action, were totally inappropriate, namely:

  1. downgrading would negatively affect Moody’s reputation;
  2. downgrading would impact on the investors who relied on the original ratings;
  3. downgrading would validate a competitor’s public criticisms of Moody’s ratings of these types of investments.

Were these the only non-credit related factors the Moody’s Committee took into account? Or was there more at stake that would drive a ratings committee to break their own rules which were a condition of their licence?

At the time of the cover-up Moody’s was on the verge of applying to renew its licence to issue credit ratings. Would the SEC issue a licence to a company who had overrated investments sold in Europe up to 3.5 notches higher than they should have been rated?

Oblivious, at this point, to Moody’s conduct, the SEC issued Moody’s Investor Services with their new licence in September 2007.

The 2010 SEC report into the cover-up concluded that the SEC could not pursue a fraud enforcement action against Moody’s because these events happened in the UK and Europe: it was out with their jurisdiction.

Three weeks ago the United States Justice Department launched a civil suit against Moody’s great rival, Standard & Poors, alleging, according to the Wall Street Journal, that S&P “ignored its own standards to rate mortgage bonds that imploded into the financial crisis and cost investors billions.”

S&P denied wrongdoing and according to the Journal, “said the government's allegations stem from S&P's rating of collateralized debt obligations, or CDOs, issued in 2007 that included bundles of subprime mortgages”.

On reading this, I was reminded of the SEC report into Moody's. I immediately wrote to the UK Treasury to ask if our Government would finally start proceedings against Moody’s for violating their ratings licence by not following their own rules on rating investments to be sold to European financial institutions.

Six days ago, on Wednesday 20 February, the Treasury replied in this way:

“I am writing on behalf of Her Majesty’s Government to thank you for your email of 5 February. Ministers are always keen to receive feedback from people up and down the country, so it is very good of you to take the time to write and to let them have your views. Please rest assured that the contents of your letter have been registered by the Treasury. Thank you, once again, for taking the trouble to write to us with your views. Regards, Adeola Otinwa”

So that’s all right then.