Moody’s blues

Steven Miller

As you probably know, Nevada's legislative kingpins recently picked a Wall Street firm to write a study justifying heavier state taxes on you.

What you may not realize, however, is that the very firm they hired — Moody's Corporation — played a key role in precipitating the worldwide credit crisis and thus the ensuing economic devastation that today stresses hundreds of thousands of Nevada homeowners and unemployed.

Most news reports have simply referred to the group hired by the legislature's Interim Finance Committee as "Moody's Analytics" — implicitly suggesting that this is a "different" entity from the firm that not only labors today under a large and growing ethical cloud worldwide but is also a prospective defendant in Securities and Exchange Commission fraud proceedings.

In reality, however, the Analytics division of Moody's Corporation was hip-deep in the behavior that brought infamy to a once-respected firm. Indeed, statements on the website repeatedly explain that the division is itself "…a leading provider of research, data, analytic tools and related services to debt capital markets and credit risk management professionals worldwide." (Emphasis added.)

"The company's products and services provide the means to assess and manage the credit risk of individual exposures," continues the statement, "as well as portfolios; price and value holdings of debt instruments; analyze macroeconomic trends; and enhance customers' risk management skills and practices."

How did the credit-risk ratings provided by Moody's — and its competitors Standard & Poor's and Fitch Ratings — became so corrupted that boatloads of toxic-waste mortgages were given triple-A ratings?

One important clue is blandly stated on Moody's website. Recounting the history of the firm, it notes that in the 1970s the "major rating agencies including Moody's began the practice of charging issuers as well as investors for rating services…"

Although this institutionalized moral hazard and a direct conflict of interest, the notice blandly continues, "… in recognition of the staffing requirements demanded by the capital markets' increasing scope and complexity."

Another critical factor is, of course, the fact that Moody's also has protected cartel status, awarded by none other than the U.S. government. "It's hard to believe after Enron and the housing bubble," wrote the Wall Street Journal, "but Securities and Exchange Commission rules still require money-market funds and stock brokerages to hold securities rated highly by Moody's, Standard & Poor's, Fitch and other ‘Nationally Recognized Statistical Ratings Organizations.' The SEC decides which firms to anoint as members of this NRSRO cartel, and that policy has been replicated at the Federal Reserve and in state pension laws and regulations that also demand ratings from a cartel member."

But to get a detailed sense of what Moody's has become, there is no substitute for the testimony former Moody's employees have given before the Financial Crisis Inquiry Commission.

Former Moody's Senior Vice President Mark Froeba, in his written testimony, suggests that America and the world might well have avoided the current financial catastrophe, if the firm had kept its integrity. 

"The Moody's of [pre-2000] had the stature and maybe even the power to stop something like the sub-prime bubble had it arisen then," he testified. "Unfortunately, by the time the bubble arrived, Moody's had deliberately abandoned its stature and surrendered this power."

The problem, he said, was that the leaders of Moody's had become so obsessed with keeping investment bankers ringing the cash register, driving the firm's share-price ever higher, that they began seeing analysts who would rate securities at values lower than desired by investment bankers as internal enemies, against whom, subsequently, they launched a "campaign of intimidation."

Froeba — who left the firm in 2007 — said that analysts who failed to please investment bankers would be threatened by senior Moody's executives with "poor performance evaluations, no promotions, no raises, effective pay cuts, smaller bonuses and restricted stock options."

After banks made "aggressive complaints" over less-than-satisfactory ratings, he said, offending analysts would also be fired and replaced. Later, new analysts would find that the initial assessments had been precise, while the contrary model pushed by the investment bank "was wrong, or at least very imprecise."

"You began to hear of analysts, even whole groups of analysts, at Moody's who had lost their jobs because they were doing their jobs, identifying risks and describing them accurately," wrote Froeba.

"By bullying Moody's analysts into docility and by encouraging bankers into bold defiance," testified Froeba, "Moody's ratings were made to be no better than its competitors' worst ratings."

He detailed an occasion when Moody's Europe changed its scoring system to rate European pooled securitizations higher than other rating agencies would rate them, allowing Moody's to get those investment banks as clients and gain market share. The result was that some securities were rated one or two notches above their real risk level, said Froeba.

"Market share issues had totally corrupted the way Moody's analysts and managers conducted rating analysis," producing credit-risk analyses where "malfeasance may be buried under so many layers and layers of complexity that only a small number of experts would ever notice and understand it," he writes.

Also leaving Moody's in 2007 was former Managing Director Eric Kolchinsky. He had run a unit rating subprime collateralized debt obligations. However, when he warned firm compliance officials of what he believed were securities-laws violations, he was demoted and his compensation was reduced.

"For senior management, concern about credit quality took a back seat to market share," said Kolchinsky in his written testimony. "During my tenure at the head of US asset-backed securities, I was able to say no to just one particularly questionable deal. That did not stop the transaction — the banker enlisted another rating agency and received the two AAA ratings he was looking for."

Agencies like Moody's, Standard & Poor's and Fitch were able to "generate billions in revenue by rating instruments which few people understood," he said. Because of that lack of public understanding, "there was little concern that anyone would question the methods used to rate the products.

"The focus on market share inevitably led to an inability to say ‘no' to transactions. It was well understood that if one rating agency said no, then the banker could easily take their business to another.

"The rating agencies faced the age old and pedestrian conflict between long-term product quality and short term profits. They chose the latter."

Former Moody's managing director Gary Witt recounted an instance when Goldman Sachs used its muscle as a major client to remove a lawyer who scrutinized securitized debt more thoroughly than Goldman liked.

In his testimony, Witt described how one of his staff lawyers, a Rick Michalek, was removed from rating Goldman Sachs Group CDOs at the investment bank's request.

"To the best of my recollection," testified Witt, "in late 2004 or early 2005, I received a request from a CDO structurer at Goldman Sachs that Rick not be assigned to further Goldman Sachs CDOs for the next year. I was told that failure to comply with their request would result in a phone call to one of my superiors."

Although Witt saw Michalek as an exceptionally thorough and expert legal analyst — with skills critically important for reviewing the highly complex "or deliberately misleading deal documentation" that Witt's section dealt with — he was concerned that the Goldman threat "could possibly result in Rick's dismissal." And indeed, as Witt subsequently learned, the head of structured finance for Moody's did personally reprimand Michalek, warning him that "further complaints from the ‘customers' would very likely … abruptly end [his] career at Moody's."

The Financial Crisis Inquiry Commission testimony regarding Moody's reveals a firm that, over the years, developed a seriously corrupt culture where employees were expected to tell customers whatever they wanted to hear and employees were punished for integrity.

That this is the firm selected by Nevada's tax-obsessed politicians to tell them what they want to hear can only be bad news for Nevada taxpayers.

Steven Miller is vice president for policy at the Nevada Policy Research Institute. For more visit

Steven Miller

Senior Vice President, Nevada Journal Managing Editor

Steven Miller is Nevada Journal Managing Editor, Emeritus, and has been with the Institute since 1997.

Steven graduated cum laude with a B.A. in Philosophy from Claremont Men’s College (now Claremont McKenna). Before joining NPRI, Steven worked as a news reporter in California and Nevada, and a political cartoonist in Nevada, Hawaii and North Carolina. For 10 years he ran a successful commercial illustration studio in New York City, then for five years worked at First Boston Credit Suisse in New York as a technical analyst. After returning to Nevada in 1991, Steven worked as an investigative reporter before joining NPRI.