Buffet Defends Rating Agencies

Speaking at Berkshire Hathaway Inc.’s annual meeting, Chairman and CEO Warren Buffett defended the company’s maintenance of its stake in Moody’s Corporation.

Mr. Buffett said rating agencies “made the same mistake” that everyone else did in overvaluing the health of the housing market. However, he countered, Moody’s — as well as McGraw-Hill, Standard & Poor’s and Fimalac SA’s Fitch Ratings — possess strong pricing power and require little in capital needs.

“There is obviously a backlash against rating agencies,” he said. “If they are not forced to change the whole structure around them … in some dramatic way, [they are still] a pretty darn good business.”

Mr. Buffett also pointed out that Berkshire has “never paid any attention” to credit ratings for bonds. “We don’t think we should farm out — outsource — investment judgment,” he said.

Rating Agencies Point Out Catch-22

The investigations on Capitol Hill have turned to how the rating agencies publicly shared the computer models they used to devise ratings. Ostensibly, the practice ensures that banks and other issuing bonds aren’t surprised by a weak rating that can adversely affect their ability to sell. What the Senate Panel took issue with is how it opened the door for bankers to work backwards: tinkering with complex mortgage deals until the model delivered the desired rating.

David Weinfurter, a spokesman for Fitch Inc., defended his company by saying it had made its models public in response to demand for increased transparency. He also pointed out that a committee, not the models, ultimately assigned ratings.

“There’s a bit of a Catch-22 here, to be fair to the ratings agencies,” said Dan Rosen, a member of Fitch’s academic advisory board and the chief of R2 Financial Technologies in Toronto. “They have to explain how they do things, but that sometimes allowed people to game it.”

EU Revises Rules on Rating Agencies

The European Commission has suggested a list of revisions to EU rules on credit rating agencies that would increase transparency and centralize European supervision. Should the proposals be enacted, the European Securities and Markets Authority (ESMA) would take over the supervision of rating agencies in Europe from national authorities. The ESMA is a new entity whose legislation is still being negotiated by member states and the European Parliament.

Commission President Jose Manuel Barroso has stated that a European credit rating agency is another possibility. “We are looking at the idea,” he said. “Is it normal to have only three relevant actors on such a sensitive issue where there is a great possibility of conflict of interest? Is it normal that all of them come from the same country?”

Any proposals along these lines are not expected before September.

Bad idea. Leave credit evaluation to the market participants. Eliminate NRSRO designations. Ban governmental endorsements of rating agencies. Delete the use and reference to ratings.

Buffett Testifies Before FCIC

Warren Buffett recently testified before the Financial Crisis Inquiry Commission (FCIC) alongside Raymond McDaniel, the CEO of Moody’s Corporation.

Apropos of the report that 91% of AAA-rated, residential mortgage-backed securities issued in 2007 and 96% of similar securities issued in 2006 have now been downgraded below investment grade to junk status, the Commission asked Buffett what he thought of the provision in the bank reform bill that would regulate rating agencies.

Buffett responded that while he “hated” the current system, he wouldn’t go so far as to outright support the measure. “I don’t know the answer to that,” he said. “The wisdom of somebody picking out raters, is that going to be perfect? I don’t know.”

He added that, “When rating agencies come to Berkshire, they have me by the throat. I have no leverage whatsoever. If there were 10 agencies and I took the cheapest one, people would say ‘You took the cheapest, but they didn’t do the work,’ so it’s not an easy answer.”

Buffet’s testimony can be seen at: http://www.cspan.org/Watch/Media/2010/06/02/HP/A/33689/Financial+Crisis+Inquiry+Commission.aspx

Senate Subcommittee focuses on Moody’s and Standard & Poor’s

The Senate’s Permanent Subcommittee on Investigations has uncovered Moody’s and Standard & Poor’s employee emails that call into question the legitimacy of their AAA ratings that were given to hundreds of billions of dollars’ worth of subprime mortgage-backed securities that have now been downgraded to junk status.

Paul Krugman, writing in The New York Times, believes that those emails reveal a deeply corrupt system.

In one email, a Standard & Poor’s employee explains that they needed to “discuss adjusting criteria” used to evaluate housing-backed securities “because of the ongoing threat of losing deals.”  Another regrets needing “to massage the sub-prime and alt-A numbers to preserve market share.”

The emails leave little doubt that the inherent conflict of interest in the rating agencies’ business model impacted risk assessments. Consequently, the financial system unknowingly took on more risk than it could responsibly handle.

No legislation is currently being considered to regulate this activity.

Moody’s Cooperates with Financial Crisis Panel Subpoena

Moody’s Corporation began handing over documents one day after the Financial Crisis Inquiry Commission issued the company a subpoena for failing to comply with requests for documents. Moody’s missed a March 23 deadline to release documents that the panel requested months earlier.

The panel’s chairman, former California state treasurer Phil Angelides wouldn’t specify what the documents were, stating only that they were “essential documents and emails relevant to our investigation.”

The commission had cause to worry about how quickly documents were supplied: They only have until December 15 to complete their investigation and report on the causes of the financial crisis.

Moody’s said in a statement that it “continues to devote substantial resources to producing documents and making our people available” to the committee.

Cuomo Suspects That Banks Lied to Ratings Agencies

On May 12, New York Attorney General Andrew Cuomo subpoenaed eight banks in an effort to discover whether they had intentionally misled rating agencies to inflate the grades of certain mortgage securities.

The banks involved are Goldman Sachs Group Inc., Morgan Stanley, UBS AG, Credit Suisse, Deutsche Bank AG, Citigroup Inc., Credit Agricole SA and Merrill Lynch & Co (recently acquired by Bank of America Corp.). The major ratings agencies, Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, were also subpoenaed.

Since 2008, New York State and federal regulators have been looking into why the agencies gave top grades to subprime-mortgage backed securities and collateralized debt obligations that later fell dramatically in value.

Reportedly, Mr. Cuomo is also interested in learning why bank mortgage desks hired former rating agency analysts. He is examining whether the analysts’ experience and relationships at the rating agencies contribute to inflated ratings for these mortgage deals.

Data that banks provide to the ratings agencies to evaluate their securities is generally verified through third-party due diligence. It is not known whether these third parties will also be subpoenaed.

Goldman Sachs Hit With Civil Fraud Charge

The Securities and Exchange Commission (SEC) has announced a lawsuit against Goldman Sachs for creating and selling a mortgage investment that was secretly intended to fail. Goldman repudiated the charges, calling them “completely unfounded in law and fact,” and that it would “vigorously contest them and defend the firm and its reputation.” Furthermore, Goldman pointed out that it lost money on the transactions in question.

Central to the SEC’s case against Goldman and numerous others is how credit-rating firms downgraded 99% of the underlying mortgage securities by January 2008.

Though the SEC had informed Goldman as far back as the middle of last year of a possible suit, the fact that it was a civil fraud lawsuit came as a surprise. Goldman was not given the normal opportunity to discuss a settlement or prepare for the announcement.

Politicizing the SEC isn’t good for anyone. The market demands a level playing field. That the SEC terms some actors as worse than others is not good public policy. Everyone should get the same treatment, neither better nor worse.

Standard & Poor’s Striving to Change Bill

McGraw-Hill, which owns Standard & Poor’s, wants to change language in a Senate financial overhaul bill. It believes the current language would put credit-rating companies at a disadvantage in court.

McGraw-Hill Executive Vice President Ted Smyth issued a statement Wednesday that said the bill “creates a discriminatory pleading standard for credit rating agencies, with many unintended consequences for the market.”

Smyth was referring specifically to the portion of the bill that would enable investors to take legal action against rating firms that “knowingly or recklessly” fail to conduct a reasonable investigation of a company when developing ratings.

Instead McGraw-Hill argues that a credit rating agency could be sued for failing to predict a bankruptcy, for example, which occurred without fraud while auditors, lawyers, bankers and equity analysts would have no liability. The firm wants the provision altered to remove this discriminatory language and instead retain the agencies’ current liability standard that requires that fraud be present.

If we are trying to create a Full Employment Act for class action securities lawyers, this will do it. Can’t we just use a simple, elegant age-old solution? Fully disclose any conflicts of interest and then its caveat emptor.

Senator Reed Blasts Credit Rating Agencies

Bloomberg News obtained an email by a McGraw-Hill lobbyist urging Senators Bob Corker (R-TN) and Judd Gregg (R-NH) to come out against financial regulatory reform.

In response, Senate Banking Committee member Jack Reed (D-RI) said, “This cynical attempt by Wall Street lobbyists to kill Wall Street reform before it has a chance to see the light of day must be resoundingly rejected. Credit rating reform addresses one of the systemic failures that caused the financial crisis.”

High standards regarding negligence have until now protected rating agencies from lawsuits. But under Mr. Reed’s proposed “narrowly tailored” legislation, investors would be able to sue ratings agencies if they could prove they had “knowingly or recklessly failed to review key information in developing ratings.”

Current “reform” measures for rating agencies will make the ratings worthless, as the rating opinion will be about the creditworthiness of the asset, and eluding legal liability. Ratings will all be warm, generic vanilla pudding.

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