After living through the housing crisis and reading and watching news, books and movies, I read with interest that one of the biggest culprits has been punished – the rating agency Moody’s. In my view and the view of others, Moody’s failed in its job to forewarn investors of the true risks of packaged together mortgage loans. They fell into a “pay to play” modus operandi.
What is pay to play? Per an article in Reuters, “Moody’s ratings were ‘directly influenced by the demands of the powerful investment banking clients who issued the securities and paid Moody’s to rate them,’ Connecticut Attorney General George Jepsen said in a statement on Friday.” This would be akin to you paying off the inspector of the house you just built and want to sell. The buyer would not know the inspector was gaming the system against him or her.
So, individual investors, pension funds, 401(k) funds, states, and countries all fell prey to this pay to play ratings approach. Iceland had to declare bankruptcy, e.g. As a result of their actions, Moody’s was fined $864 million which will be distributed to twenty-one states and the federal government, who were part of the lawsuit.
We should not lose sight of an industry who became enamored with riskier investments and did not ask enough questions. Executives did not fully understand the risk they were taking on and it brought them down, along with the housing market, stock market and economy. An excellent movie to watch is called “The Big Short,” based on Michael Lewis’ book, which takes a complex topic and explains it with the dialogue, but also with clever sidebars which use laymen’s terms to define what things mean.
In essence, mortgage loans were given out to anyone who could fog a mirror, then these lesser risks were packaged together to spread risk and sold to investors. The problem is packaging bad risks does not make the risk less, it makes it concentrated bad risk. The law of large numbers to mitigate risk is only effective if good risks are mixed with some bad risks. Moody’s stamped these packaged loan investments with much higher ratings than they deserved. And, investors who trusted Moody’s and the seller bought them in good faith.
We rely on Moody’s and other rating agencies to take their job with seriousness of purpose and ethics. If they cannot shoot straight with us, they will let us down. And, that is precisely what they did. In my view, that fine may not be enough for the damage they helped perpetuate.