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Moody's Proposal Falls Short

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As long as ratings agencies are paid by the issuers of securities rather than investors, they will be financially motivated to hand out generous ratings.

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Ted: But why do they put a guarantee on the box then?
Tommy: Because they know what the sold ya was a guaranteed piece of [excrement]. That's all it is. Hey, if you want me to take a dump in a box and mark it guaranteed, I will. I got the spare time.

- Tommy Boy

Amid criticism of high ratings placed on mortgage backed securities, Moody's (MCO) is considering a new methodology to better inform investors of the risks inherent in structured finance investments.

The Wall Street Journal reports the credit ratings firm is considering making a separate ratings scale to be used for evaluating debt backed by mortgages and other products that may be less stable than traditional corporate, government or municipal debt. In addition, Moody's may place labels on particular debt instruments, such as "SF" for structured finance products, or "v2" for debt that may be extra volatile to clarify the risks of specific investments.

Moody's recently downgraded 22% of the triple-A rated CDO securities issued between 2006 and 2007 by an average of eight notches, even though AAA ratings are typically awarded to only the most secure debt – like that backed by the U.S. government – with an extremely low chance of default. Higher than expected defaults and falling home prices have impacted the performance of debt backed by subprime first lien and prime second lien mortgages, resulting in bonds with similar ratings not behaving in a uniform manner.

Moody's is also considering adding a warning label on certain structured products describing the limitations of the rating, cautioning investors that the investment may warrant additional due diligence and a higher risk tolerance. One fund manager quoted in the Journal said "If you're going to put a bunch of warning labels on the rating, I'm going to say 'What is the value there?' "

While the proposed measures are a step in the right direction in that it marks the first formal admission made by either Moody's or S&P that its ratings process is seriously flawed, the solutions do not target the root of the problem. As Professor Shedlock notes, the ratings agency model will not work as long as agencies are paid on the volume of deals analyzed rather than the accuracy of its ratings.

The problem is one of incentives. As long as ratings agencies are paid by the issuers of securities rather than investors, they will be financially motivated to hand out generous ratings. No amount of new labeling, fancy packaging or legal ruses can disguise the fact that in the for-profit business of rating debt, business is awarded to the firm that provides the best ratings.


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