In preparation for the upcoming “SRI in the Rockies” convention, the Social Investment Forum (SIF) has posted highlights of its work over the past year. One of SIF’s most valuable 2009 efforts is a framework of its “Priorities for Financial Regulatory Reform.” Among these directives is a call to overhaul credit rating agencies. An October 19 report on the role of Moody’s in the subprime mortgage debacle explains why major changes are needed.

SIF’s Reform Agenda

SIF priorities include governance reform, better disclosure of both financial and environmental, social and governance (ESG) metrics, and stronger government oversight of the financial sector. Significantly, the major credit rating agencies are the only private firms singled out as systemic risks:

Improve Rating Agencies: The weakness of [the existing credit rating] system was made obvious by the fact that ratings agencies awarded AAA ratings to thousands of ultimately toxic subprime-related mortgage backed securities and collateralized debt obligations.

Additionally, there are inherent conflicts of interest in the current business models for credit rating agencies, including the fact that issuers pay the credit rating agencies for their ratings and that they provide other consulting services to those same corporations they rate. …

Serving Issuers “Swamped Earnings” from Serving Investors

Kevin G. Hall, in an article for McClatchy Newspapers, combines interviews with past and current Moody’s employees with a survey of how such agencies’ business model has evolved. (Thanks to Salon’s Andrew Leonard for directing readers to this piece.)

Mr. Hall writes that even “as Congress tackles the broadest proposed overhaul of financial regulation since the 1930s…lawmakers still aren’t fully aware of what went wrong at the bond rating agencies.” He explains how Moody’s, along with competitors like Standard & Poor’s and Fitch, developed the “inherent conflicts of interest” SIF mentioned:

To promote competition, in the 1970s ratings agencies were allowed to switch from having investors pay for ratings to having the issuers of debt pay for them. That led the ratings agencies to compete for business by currying favor with investment banks that would pay handsomely for the ratings they wanted.

Wall Street paid as much as $1 million for some ratings, and ratings agency profits soared. This new revenue stream swamped earnings from ordinary ratings.

AAA One Day, Junk the Next

This process may have begun decades ago, but it accelerated over the past ten years. Mr. Hall cites Moody’s 2000 public offering as one cause for this, as executives sought to boost the value of their stock options. The firm’s role in enabling mortgage-loan securitization led to record profits – and also contributed to the global financial crisis. Mr. Hall quotes a former Lehman vice president:

“In 2001, Moody’s had revenues of $800.7 million; in 2005, they were up to $1.73 billion; and in 2006, $2.037 billion. The exploding profits were fees from packaging . . . and for granting the top-class AAA ratings, which were supposed to mean they were as safe as U.S. government securities,” said Lawrence McDonald in his recent book, ‘A Colossal Failure of Common Sense.’

“How on earth could a bond issue be AAA one day and junk the next unless something spectacularly stupid has taken place? But maybe it was something spectacularly dishonest, like taking that colossal amount of fees in return for doing what Lehman and the rest wanted,” McDonald wrote.

What Lehman and other investment banks “wanted” was a larger supply of AAA-rated securities. Moody’s and its peers faced tremendous incentives to overstate the quality of paper that was backed by now-infamous subprime mortgage loans. The collapse in value of these securities helped precipitate the financial crisis of 2008.

“The Law Doesn’t Apply to Us”

Were these incentives balanced by any obligations to the purchasers of Moody’s-rated debt? In fact, the ratings agencies were “under no legal obligation since technically their job is only to give an opinion, protected as free speech, in the form of ratings,” writes Mr. Hall. He quotes Eric Kolchinsky, a former managing director at Moody’s:

“There was an attitude of carelessness, or careless ignorance of the law. I think it is a result of the mentality that what we do is just an opinion, and so the law doesn’t apply to us.”

The Social Investment Forum, in its priorities for reform, would shift agencies’ obligations back towards the investors who purchase agency-rated securities. “SIF believes…that rating agencies need improved supervision and must be held to higher standards of accountability, and changes must be made to their exemption of liability.”