All the Devils Are Here [76]
Ratings shopping was a classic example of why Alan Greenspan’s theory of market discipline didn’t work in the real world. The market competition between the rating agencies, which Greenspan assumed would make companies better, actually made them worse. “The only way to get market share was to be easier,” says Jerome Fons, a longtime Moody’s managing director. “It was a race to the bottom.” A former structured finance executive at Moody’s says, “No rating agency could say, ‘We’re going to change and be more conservative.’ You wouldn’t be in business for long if you did that. We all understood that.”
“It turns out ratings quality has surprisingly few friends,” Moody’s chief executive, Raymond McDaniel, told his board in 2007. “Ideally, competition would be primarily on the basis of ratings quality, with a second component of price and a third component of service. Unfortunately, of the three competitive factors, ratings quality is proving the least powerful.” He added, “In some sectors, it actually penalizes quality by awarding ratings mandates based on the lowest credit enhancement needed for the highest rating.”
Just as LTCM exposed the dangers of derivatives in 1998, there also came an early moment when the failings of the rating agencies were exposed for all to see. The moment was December 2, 2001, the day Enron filed for bankruptcy. Although Enron had been faking a portion of its profits for years—and though it had been in precipitous decline since October, when the outlines of its fraudulent practices were first revealed—the rating agencies didn’t downgrade the company’s debt until four days before its collapse. Investors in both Enron’s stock and its bonds lost millions. The Enron bankruptcy—quickly followed by similar debacles at WorldCom, Tyco, and a handful of other companies—became a huge, ongoing news story. And the fact that the rating agencies had failed to sniff out any of them was a big part of the scandal narrative.
Government investigators put together thick reports about the failings of the agencies. The rating agencies were excoriated in congressional hearings. Senator Joseph Lieberman said they were “dismally lax” in their coverage of Enron. At one hearing, the S&P analyst who had covered Enron confessed that he hadn’t even read some of the company’s financial filings. There was a strong sense that something was going to be done to reform the rating agencies.
Perhaps to appease Washington—and fend off regulation—Moody’s agreed to adopt a code of conduct. Among other things, the code stated that “the determination of a credit rating will be influenced only by factors relevant to the credit assessment.” It also stated that “The credit rating Moody’s assigns . . . will not be affected by the existence of, or potential for, a business relationship between Moody’s and the issuer.”
In its lawsuit, the state of Connecticut alleged that shortly after Moody’s unveiled its code of conduct, two experienced compliance officers were fired and replaced by employees from the structured finance department. The head of the department later complained, “My guidance was routinely ignored if that guidance meant making less money.” Investigators also allege that during a dinner party after a board meeting, the president of Moody’s walked by the head of compliance and said, quite loudly, “Hey . . . how much revenue did Compliance bring in this year?”
In other words, nothing changed. Not a single analyst at either Moody’s or S&P lost his job as a result of missing the Enron fraud. Management stayed the same. Moody’s stock price, after a brief tumble, began rising again. The ratings remained embedded in all the rules and regulations. The conflict-ridden business model didn’t change. “Enron taught them how small the consequences of a bad reputation were,” says one former analyst.
The dirty little secret was that nobody really wanted to reform the rating agencies. Investment bankers needed