The Problem at Moody’s

Kevin Hall of McClatchy has an article  about Moody’s that goes beyond the usual — giving AAA ratings to products “structured by cows” and taking money from the cows (actually, the “cows” comment was from S&P). He documents how Moody’s forced out executives who questioned the lax rating policies, replaced them with executives from the structured finance division, and filled its compliance division with people from that same division.

In this week’s column at The Hearing, we discuss this as an example of a common tension within businesses — between the revenue-generating side of the business and the people responsible for product quality. The problem is that in the short term, you can maximize revenues by cutting corners on quality, but in the long term, cutting those corners can come back to hurt you. Or it can hurt your customers. Or the whole economy, as it turns out. Unfortunately, however, there is no particular reason to believe that companies will resolve this tension in a way that is good for them in the long term, let alone the economy.

By James Kwak

42 responses to “The Problem at Moody’s

  1. “Hence a certain tension between religion and society marks the higher stages of every civilization. Religion begins by offering magical aid to harassed and bewildered men; it culminates by giving to a people that unity of morals and belief which seems so favorable to statesmanship and art; it ends by fighting suicidally in the lost cause of the past. For as knowledge grows or alters continually, it clashes with mythology and theology, which change with geological leisureliness. Priestly control of arts and letters is then felt as a galling shackle or hateful barrier, and intellectual history takes on the character of a “conflict between science and religion.” Institutions which were at first in the hands of the clergy, like law and punishment, education and morals, marriage and divorce, tend to escape from ecclesiastical control, and become secular, perhaps profane. The intellectual classes abandon the ancient theology and-after some hesitation- the moral code allied with it; literature and philosophy become anticlerical. The movement of liberation rises to an exuberant worship of reason, and falls to a paralyzing disillusionment with every dogma and every idea. Conduct, deprived of its religious supports, deteriorates into epicurean chaos; and life itself, shorn of consoling faith, becomes a burden alike to conscious poverty and to weary wealth. In the end a society and its religion tend to fall together, like body and soul, in a harmonious death. Meanwhile among the oppressed another myth arises, gives new form to human hope, new courage to human effort, and after centuries of chaos builds another civilization”

    http://en.wikipedia.org/wiki/Will_Durant

  2. Where is Cotton Mather when we need him?

  3. A fopllw up from Kevin Hall is also out looking at the regulation that may come, but making clear it’s insufficient

  4. some guy in a cube

    “Unfortunately, however, there is no particular reason to believe that companies will resolve this tension in a way that is good for them in the long term, let alone the economy.”

    About as close to a universal as possible. In fact, you will never starve taking this trade.

    If it’s not nailed down, most people will take it. Cash on the table doesn’t stay there for long.

  5. The only relevant question here is how we could have ended up in the hands of financial regulators that were so stupidly naïve and gullible so as not to know that by assigning, through the capitals requirements for banks, so much importance to the ratings, the credit rating agencies, besides of course being humanly fallible, were bound, sooner or later, to be captured.

    With friends like these regulators… who really needs enemies?

  6. These comments were added to the end of the superseded Move Along thread. In order that the thoughts don’t get lost, I re-post them here.

    Dear Mr. Kwak and Mr. Johnson,

    It is simply not true that those of who understand the true nature of the issues that gave rise to the Baseline Scenario are doomed to being helpless victims shouting in the wilderness. As your own research has clearly shown, small groups of dedicated people are able to affect massive change, through means dictated by circumstances. That is called leadership, and *all* social change, positive and negative, is the result of leadership.

    In that light, I call upon us all to ACT in order to reform not only the U.S. financial sector, but by doing so lay the foundation for the more just society we all seek.

    I challenge you, dear sirs, to exercise LEADERSHIP by committing yourselves to acting on your convictions. It is only through acting on your convictions that you will provide the best possibility for seeing them realized.

    In fact, you are already intellectual leaders of a gathering movement, even if you have yet to realize it. You have it within your power, yes power, to provide necessary sustenance to this movement. In the immediate term this can be done via the following:

    Post information about the Showdown in Chicago (http://www.showdowninchicago.org/index.html), a protest against the same policies that you also oppose. You need not endorse the action, merely help publicize that people who hold views very similar to your own (i.e., Dean Baker) are brave enough to act.

    When you find yourself on major media outlets, like Bill Moyers, mention that there are grassroots organizations fighting this battle. Again, not an endorsement, just assist us in letting people know such organizations do exist and they can decide for themselves whether joining such an organization is good use of their time.

    Provide free speaking engagements to organizations like A New Way Forward (I am a volunteer member of a local ANWF organizing committee), who would absolutely be honored to hear from you.

    This is just a start, but it might have more impact than you realize.

    At the very least, please do not help perpetuate the notion that, unless we happen to be a member of the oligarchy or in a position of extreme political power, we must be resigned to our fate on the short end of the stick.

    Sincerely,

    W.E.B Crawford
    Volunteer Organizer ANWF-Bay Area

    Thank you Mr/Ms Crawford for pointing this out to James/Simon. A dialogue about this dialogue is overdue.

    They are stuck in a cycle of digging up a particularly heinous sample of fraud, corruption, ignorance, stupidity, spin or greed. The commentators then respond with suitable exclamations of shock and horror, or by offering their own competing instances of skullduggery. After 50 to 150 remarks, all goes quiet again until the bloggers post their next outrageous tidbit and the pattern repeats.

    Whatever is going on here is hardly commensurate with the scale of the catastrophe that awaits us.

    There are plenty of sites that do couple thought and action like yours and http://www.Avaaz.org

    By the way, here is your link again – URLs in brackets do not work here.

    http://www.showdowninchicago.org/index.html

    So, is the dearth of action:
    – Utter disillusionment and loss of faith in macroeconomics?
    – Academic abhorrence of anything practical?
    – Fear of power brokers and becoming branded political troublemakers (surely a bit late to worry about that)?
    – MIT timidity (hasn’t Baseline Scenario played down that link enough already)?
    – Or what?

    I do not believe it is a lack of understanding of where to start or what to do to make their case more compelling. This is the age of Wikinomics, Groundswell, We-Think, Here Comes Everybody. MIT has a Centre for Collective Intelligence. Obama, himself, is an object lesson in surfing the social media.

    My gut feel is that it is simply that – like anorexics trapped in a dysfunctional frame of reference – Simon and James just can’t see their way out of their rut.

    So, come on people. It is not good enough for Susan Hockfield to bemoan the need to downsize, If ever the world needed thought leadership it is now.

  7. IMHO the credibility of these rating agencies are on par with Michael Miliken the junk bond king. Who can trust them after they facilitated a collapse of the world financial system that was backstopped by trillions of tax dollars. Why are these rating agencies still even operating?

  8. In the Middle Ages the Church had everything practical locked up in the Guilds and Crafts. Intellectuals wanting to organize had to promise that what they were doing was of no practical use at all. Hence, they founded their universities on the notion of “knowledge for enlightenment”.

    The outcome has been the baleful “academic” tradition in education.

    When I was a young engineer, there were superb three or four year “sandwich” courses called Diplomas in Technology that consisted of six months in industry and six months in college. Sadly, they were not as prestigious as University Degrees so the technical colleges became Universities and all the practical content was deprecated. Soon engineers were graduated who couldn’t weld, use a lathe or milling machine, and couldn’t read engineering drawings (hadn’t been taught the difference between first and third-angle projection).

    Later the UK Royal Society for the Arts sponsored a heretical initiative called “education for capability”. However, by then there was virtually no manufacturing left in the UK.

  9. There’s that word, “foundation” that has been cropping up more and more lately.

    I think part of the problem is that much more of the burning building has to come down, before it can be cleared away and a new foundation poured. We’re only about the 4th inning here, as long as its still legal to mix metaphors in mixed company.

    My gut feel is that Simon, Peter (where the heck is Peter?) and James (again, not in the apostolic sense) are working for wolves in sheep’s clothing.

    In related news, the Catholic Church has been embracing disenfranchised Anglicans lately.

  10. Worse… why are these regulators still regulating?

  11. We haven’t thrown them out yet.

  12. Or more broadly, why hasn’t a single damn thing changed?

  13. Modern corporations consist of mismanagement layered on top of more mismanagement in a synergistic symphony of mismanagement.
    However, what you are describing is not mere mismanagement. It’s the total breakdown of corporate law in the service of organized crime.

  14. Anyone who says “capitalism is the worst system except for all the others” is probably up to no good.

  15. Even if anyone who says “capitalism is the worst system except for all the others” is up to no good that would unfortunately not have to mean they are wrong.

    We have to learn to do the best with what little we have.

  16. I don’t see any difference between this corporate governance issue, financial regulation, or the health care debate.

    Society as a whole is not willing to entertain long term solutions. Politicians get elected by saying that they will immediately fix everything, CEOs get promoted by making dangerous bets that could blow up later, and the Average Joe bought houses thinking that they just found a money tree. In the long run we are all dead. There is no magical switch that will fix a couple of decades of unsustainable living. Maybe the government should admit that they don’t have one.

    I am not sure how to sell a lower standard of living as the long term solution to this crisis. But the more quick fixes the country tries, the more the fat cats will make sure they have horded enough for the winter.

  17. But we have so much. I just don’t think we realize how much.

    Aside, then I’ll go away again for a while:

    There have been some excellent comments lately, touching on project planning, concensus building, and specific line items we need in an action plan. Just a suggestion, but could we tag new ones in a way that makes them easily searchable? Perhaps put the word “Calamari” in body of the comment, or something like that? Then we can easily do a weekly inventory of suggestions.

  18. To me that phrase is a pejorative way of saying “capitalism is the best, and if you don’t like it, suck it up because there’s no alternative and so stop looking for one”

  19. In fact, what bothers me most is that the current system is not capitalism, but consistently misidentified with capitalism so that you can substitute “the status quo” for capitalism in that phrase.

  20. This is an excellent post by Mr. Kwak. Kevin Hall showed there are still people out there who believe in true journalism. I guess if Mr. Hall was working for WSJ they would ask him to take a tape recorder and ask Rush Limbaugh who will win football’s NFC West division this year. Lucky for Kevin Hall and lucky for us, he works at McClatchy.

    A quote from Kevin Hall’s story:
    “The story at Moody’s doesn’t start in 2007; it starts in 2000,” said Mark Froeba, a Harvard-educated lawyer and senior vice president who joined Moody’s structured finance group in 1997.

    Froeba says the story starts in 2000. Interesting to note that was just one year after Gramm-Leach-Bliley was passed and one year after Glass-Steagall was repealed.

  21. oh, god, how many times have I fought that battle…. and the truly stupid part is that producing quality ends up being way less expensive…

  22. (re “Thank You” post which was deleted quickly after posting. Maybe it will turn out that James’ wife got a hold of his laptop and wanted to post a little something herself. Curious in any case)

  23. It’s sweet. Whatever, it’s his business.

  24. I do. At least you can persecute, prosecute, and execute your enemies.

  25. If this engenders less and less trust in ratings agencies (why S & P is complaining, no doubt), then it will mean less desire to follow ratings issuance, or an outcry for more aggressive regulation of the agencies. The agencies are just another tool of the out-of-control oligarchs/plutocracy, another tool destined to create economic chaos once again. Let’s face it, this seems to fly in the face of “no honor among thieves” since the thieves seem to be honoring only the other theives and no one else. But maybe, since it is obviously just one big happy cabal, there is not real honor, just aggressive cooperation.

    What happened to ethics, anyway? Am I so wrong to hope that we can do something to put the train back on the tracks? It is a sad, sad day in which the evill choir is singing in such perfect harmony. What did Nostradamus have to say about this?

  26. Brooksley Born was a person responsible for product quality. She is being sold to us as “the one true fighter on the inside.” But this creates in me a tension, between what they’re saying, and what I’m reading.

    Very smart person. Very aggressive, very tenacious, top of her class. (Not always a good thing).

    Her mom was a teacher, and her dad ran the welfare system in San Francisco. Very responsible job. Lots of money in welfare.

    After law school, she settled at Arnold and Porter, where she and Switzerland and vague industries became the best of friends. She also taught at the Catholic University of America.

    This rang a few bells. Who else worked at Arnold and Porter? Joseph Califano. What did he do in government? Among other things, he was secretary of health education and welfare. He was a graduate of the College of the Holy Cross.

    According to legend, Born went to work at Arnold & Porter because one of the few top women lawyers worked there, and Born sought a mentor. Did the two hit it off? Was she there at the same time as Califano? Did he bring her on?

    In any case, she’s being marketed heavily. Caveat Emptor.

  27. Here’s the limited hangout and simulspin:

    “She ends up at Arnold & Porter, a prestigious law firm, and she begins representing futures exchanges, including the London Futures Exchange, which is an important one.

    She starts becoming an expert in an area of the law that very few people are experts in. And she gets involved in the ’80s in this really important headline-grabbing case of the manipulation of the silver market by these wealthy brothers, the Hunt brothers.

    Wealthy Texas brothers, right?

    Yes. And she was representing the clients of a Swiss bank who were being accused of being complicit in all of this. But through that process she begins to understand how these markets work. And she gets to bore into a subject, and gets sort of an insider’s look at it, because she’s representing these people who had millions of dollars at stake that other lawyers who might just have a casual interaction with that world might never have gotten to glimpse.”

    http://www.pbs.org/wgbh/pages/frontline/warning/themes/born.html

  28. In truth this president has never ran anything. So we have this big mess:

    http://americaspeaksink.com/2009/10/wall-street-the-president-and-the-rest-of-us/

  29. The pharma industry (rather the fDA) recognized long ago the conflict between production (those that get paid to ship product out the back door) and Quality Assurance. Therefore the QA managers in the manufacturing plants report to division, not the local plant managers. The conflict between the Moody’s employees are the same type of thing.

    It is difficult to be objective when you are paid on how much product you get out the back door. That is why an “indpendent” group (QA) for pharma make decisions on quality matters.

  30. I commend in all ways and forms what Brooksley Born tried to do. But, to honor that same spirit, we have to be clear on that the current crisis did not originate from derivatives but from investments in securities backed with subprime mortgages and wrongly rated AAA.

    In fact had the regulators not regulated to the extent of creating that arbitrary difference between a “AAA rated low risk” requiring only 1.6 percent in bank equity while forcing a normal “high risk unrated entrepreneur to cover for the cost of an 8 percent capital requirement, we might well have been on our way to another crisis, but we would have avoided the current one.

  31. Meanwhile among the oppressed another myth arises,

    actually I am weary about something arising out of the oppressed:

    Arnold Toynbee claims it is the elites coming up with something new using the image of mountain climbers as an analogy, i.e. one climbs ahead until he/she reaches a ledge and then pulls the others after him

    George Orwell claims that it is only gentlemen who are capable of starting revolutions because they have an image of what’s their due i.e. if they are on the dole they expect it to be sent to them instead of standing in line hat in hand and this is the difference in self-perception that fuels them

  32. much more of the burning building has to come down

    that of course is what everybody with a heart earnestly wishes but it is also extremely dangerous and I mean life-threatening dangerous

    the much less glamourous way would be to stream-line procedures within them starting from really small and insignificant things. But as this will never make headlines it is not going to happen. On the other hand if you do not eliminate the forcing of moral corruption of the cubicle paper pushers and allow them to work according to time honoured standards again everything else is only too likely to end up as window-dressing.

    as the apparent revival of the Orthodox Church in Russia suggests institutions are unkillable – imagine even 70 years of a regime stamping on them including lots of priest-killing couldn’t do it

    as to foundations I am extremely weary of them ever since I heard how far reaching the involvement of our Bertelsmann Stiftung (foundation) in the shaping of public opinion is. Bertelsmann is the media company owning Random House so they’ll be somewhere somehow in the US also.

  33. n the service of organized crime

    ?? in competition with organized crime?

  34. anti_fascist_freedom_fighter

    Why is Moodys still in business? Why not pull their corporate charter, prosecute and put the criminal bastards in prison and put the rest of the employees on the unemployment line, and severely regulate this segment of the industry. Make an example out of Moodys and every other member of this huge fake investment scheme.

  35. So we’re to look at Moody’s as a common business from a simple engineers vs. salesmen standpoint, as if it’s like a company that sold hot dogs with it’s head honchos in recent years cutting corners by buying wild boar for .10 cents on the dollar then steam rolling the honest hard working staff to use cheaper meat and hire more kids outside stadium to work on game nights off the books.

    As they say in Chicago– “Yeah, .. no”.

    Maybe we should just go ahead and wake up to the idea that Moody’s always operated more like a quasi government agency, with a function on par with national security, health and safety, giving them a very high duty to get it right, and anything else was pure negligence in in motion. Actually, I’d say Moody’s was more like a blasting company that should just face strict liability and even criminal charges for getting it wrong, no matter how nicely its leaders, bankers, advisers dress.

    One could easily trace that negligence back to the investment bankers, the GAAP accountants and lawyers who decided Moody’s would make a great public company, driven by quarterly profits and conflicted consulting fees to generate turnkey profits for Warren’s big contribution to Bill’s charity that brings Windows to schools on every corner of the earth and for others looking for toll booth profits on the entire economy at the expense of… the entire economy.

    As it was, Moody’s was a small billion dollar private company that made its employees and owners wealthy for doing a good job guarding the shareholder and net asset values of every business, agency, or municipality worth rating.

    It wasn’t like there was nobody to sound the alarms or that it was impossible for another company to compete, if the buyside did their fiduciary duties.

    It’s good to see Moody’s in the headlines for sure, because it’s an obvious spot where the whole thing went down the shitter. But society has a right to retribution too, much more than 2000:1 charming psychopaths have a right to fly away to private islands and gated communities in tropical places out of earshot unmolested for every Bernie. And it sure would be nice to hear someone name names in the appropriate tone.

  36. Absolutely we must name names and that is why I name the regulators, the regulators and the regulators in that specific order.

    The credit rating agency issue, is an irrelevant issue, because what are we as a society to gain from having the credit rating agencies point out the directions with 100 percent accuracy if we have nothing to gain from going where those directions will lead us?

    What’s in it for humanity to help those in AAA rated land? I would have to answer, nothing!

    The real AAAs are already more than strong enough, and so who we really need to support are those living in double B or below land in order for them to have the chance of becoming the AAAs of tomorrow

    And, just in case, this is said by someone who in January 2003 published in the Financial Times a letter that said “Everyone knows that, sooner or later, the ratings issued by the credit agencies are just a new breed of systemic error to be propagated at modern speeds”

  37. I must say that in some strange way I find this all too amusing. I was one of those rating analyst told to find new employment when there was a management change at Moody’s. Though I cannot say that I agreed with all of Mark Adelson’s decisions when he ran the group, I can say that the methodology was consistent and tractable. The team that replaced my team had very little knowledge of mortgages. More importantly, Clarkson ran the place like a dictator on steroids. Creativity was replaced with brown-nosing and kissing up to the right people…this was a recipe for disaster.

  38. Solving the problem with the credit rating agencies is a non-issue that we should not lose time on.

    I have drafted my recommendations here http://bit.ly/1Xby8A and I sincerely appreciate any suggestions or editing help as well as passing on the ideas to as many as possible so that we get these reforms going in the right direction.

  39. CREPerspective

    Naive? Hardly! The revolving door between Wall Street, the Fed and Treasury gave Wall Street carte blanche. Even if you concede that the people at the Fed and Treasury weren’t evil, they were so warped in their perspective that they couldn’t see the obvious.