How Can Moody's Survive as an Independent Credit Rating Agency?

The Securities & Exchange Commission now says it will probe into the operations of the three top US credit rating agencies, in the wake of their questionable top-notch ratings of poor subprime mortgage bonds and a report about computer errors leading to erroneous triple-A ratings of European debt securities at Moody's Investors Service.

But this story is bigger than the subprime bond ratings controversy and the computer error. The credit rating agencies have been a problem I have warned you about since last fall ("Market Regulators, Read This Now," "What Congress Must Ask the Federal Clean-up Crew," "How Congress Can Fix the Crisis" and "Cleaning up Wall Street's Housing Mess").

The questions the SEC, the exchanges and investors should ask are these:

How does Moody's, the second largest credit rating company, keep its government and stock market status as a nationally recognized statistical rating organization when its last quarterly report shows it has a negative book value of $903m and when it is in awash in short-term debt that it's using for a planned $4b worth of stock buybacks, a debt position S&P now threatens to downgrade?

How does a rating agency so submerged in debt and with declining earnings, a company that has one of the most important stock market functions in the world, think it can publish investment ratings of Wall Street firms and their debt securities when its own financials are in such disarray?

How can market regulators think that Moody's, now thoroughly dependent on the banking sector for its survival, can still issue ratings independent of the very banking sector it depends on to stay alive?

Isn't the following worthy of inquiry too? Moody's hired the law firm Sullivan & Cromwell to conduct a "thorough" external review of its process rating European constant-proportion debt obligations or CPDOs, due to the computer error.

However, last year Moody's hired Sullivan & Cromwell to represent it in civil lawsuits relating to subprime lending. Isn't this a conflict of interest?

Back to the computer error problem at Moody's. Senior staff at New York-based Moody's were allegedly aware in early 2007 that these European securities, backed by borrowed money to place bets on credit-default swaps, should have been ranked as much as four levels lower than triple-A, the Financial Times reported, citing internal company documents. A computer error triggered the inaccurate rankings, the FT said.

The SEC's sudden change of heart is striking. It was only just recently that SEC chairman Christopher Cox said that, because the ratings for these European securities were handed out by Moody's in Europe, the SEC may lack jurisdiction over the probe.

This, despite that fact that at least one CPDO deal I have documents on from the European firm ABN Amro was in fact offered in the US in October 2006, an offering ABN Amro notes up high in its marketing materials as one that carried a triple "AAA rating by Standard & Poor's and Moody's on both the timely payment of interest and the ultimate payment of principal."

The SEC's turnaround comes after US Senator Charles Schumer (D-NY) had urged U.S. regulators to investigate whether the credit-rating unit of Moody's erroneously ranked European securities higher than the debt deserved and to fine Moody's if it delayed disclosing mistakes.

The ``revelations'' are ``indicative of a culture of shirking responsibility that must end,'' Schumer, a New York Democrat, said in a letter to Cox. ``I urge you to fully investigate this matter and impose appropriate sanctions on Moody's for their failure to disclose their ratings errors.''

The SEC now says it will propose new rules in June to limit conflicts of interest at the credit rating companies and boost disclosure about assets packaged into securities.

Again, the credit rating agencies have been a problem I have warned you about since last fall. Lawmakers and market watchdogs had already heavily criticized Moody's and Standard & Poor's for handing out triple-A ratings to subprime mortgage securities like Kleenex, and then keeping those ratings well into the fall despite rising defaults on the loans backing them.

It was only last fall when the ratings agencies finally moved in any significant way to slash ratings on hundreds of subprime backed securities, down from the top notch grade to junk status. A conflict of interest has been that the credit rating agencies get paid by the issuers to rate their debt securities, so the fear is they may be more inclined to give higher grades to their clients' securities.

Whether the SEC will back a quarterly report from the ratings agencies showing their performance, somewhat like a quarterly report card, remains to be seen. 

Again, the following is worth noting. As I've told you, Moody's hired the law firm Sullivan & Cromwell to conduct a "thorough" external review of its "European CPDO ratings process."

However, last year Moody's hired Sullivan & Cromwell to represent it in civil lawsuits relating to subprime lending, notably, "putative class actions brought by Moody's stockholders claiming that Moody's and several of its executives violated federal securities law by failing to disclose that the agency's subprime ratings were allegedly inflated," according to Sullivan & Cromwell's letter to clients dated May 12, 2008.

And again it bears repeating that S&P now may downgrade Moody's A-1 rating on its commercial paper, (debt maturing in nine months or less), due to "recent press reports regarding potential problems with analytical models and methodologies used in Moody's process for rating European constant-proportion debt obligations (CPDOs)," said S&P in a statement. S&P has put Moody's commercial paper on credit watch and also noted the reports about the problems come at a time when expected declines in revenue and cash flow at Moody's are likely to reduce its "flexibility in its leverage profile."  

What S&P overlooks is the perilous condition of Moody's balance sheet. Moody's is a company awash in debt, it levered up its balance sheet at a time when it is conducting huge stock buybacks, $4b of which it has approved since 2006. All at a time when Moody's earnings actually declined from 2006 to 2007.

I have to ask this again, according to Moody's recent balance sheet, it has negative shareholders equity of $903m. How does a credit rating agency get to operate with a negative book value? Even small broker dealers must have at least $10,000 in net capital to trade.

Again the question for market regulators is this: How can a company so submerged in debt, with declining earnings, think it can hand out ratings of banks, investment banks and their debt securities when its own financials are in such disarray?

Again I ask you, how can market regulators think a credit rating agency so dependent on the banking sector for its commercial paper, can issue ratings independent of the very banking sector it depends on to to do its stock buybacks?

Warren Buffett, your company, Berkshire Hathaway, owns a 19.6% stake in Moody's.

Are you listening?