On my mind . . .: The Moody's Blues

More good times might be ahead for us . . . I write rather sarcastically. News sources again have been harbingers of doom: the speculation is that Moody’s is preparing to announce a downgrade in the United States credit rating. We frequently read about Moody’s and how important its credit ratings are. Moody’s is like the Federal Reserve: the market religiously follows its announcements. If the Moody’s rating is good; the market reacts positively. If the Moody’s rating goes down a notch; the market reacts negatively. And so follows the value of your 401K and any other investment you might have, including your home.

Just as I asked about the Federal Reserve, I ask about Moody’s: who monitors them? As a corporation Moody’s engages KMPG LLP, a noted tax and advisory firm, as its auditor. However, I’m not interested in the corporate auditor. I am not interested in the obviously public financial statements. I want to know who is watching the executives, the decision makers, to insure that they are not profiting personally from their credit rating designations. Major corporations are held accountable for their business dealings and holdings; executives of major corporations are not. Moody’s has too much of an influence for its executives not to be held accountable for personal finances.

A week ago I emailed Moody’s asking what procedures have been put in place to prevent insider trading on the part of its executives, and, no surprise, I have yet to receive a response.

Moody's was founded by John Moody in 1909 to produce manuals of statistics related to stocks, bonds and bond ratings. Following several decades of ownership by Dun & Bradstreet, Moody's became a separate company in 2000, and Moody's Corporation was established as a holding company.

Moody's Corporation is the parent company of Moody's Investors Service, which provides credit ratings and research covering debt instruments and securities, and Moody's Analytics, which offers software, advisory services and research for credit and economic analysis and financial risk management. In 2011 they had revenue of $2.3 billion.

Moody’s ranks the credit worthiness of borrowers using a standardized ratings scale which measures expected investor loss in the event of default. Moody's rates debt securities in several market segments related to public and commercial securities in the bond market. These include government, municipal and corporate bonds; managed investments such as money market funds, fixed-income funds and hedge funds; financial institutions including banks and non-bank finance companies; and asset classes in structured finance. Securities are assigned a rating from AAA to C, with AAA being the highest quality and C the lowest quality.

There are basically two ratings business models: unsolicited (where Moody’s issues a rating unsolicited by that company) and issuer paid (where a company has paid for a Moody’s rating.

In the mid-1990s, the Justice Department investigated to determine whether Moody’s “unsolicited” ratings amounted to an illegal exercise of market power. However, the investigation was closed with no charges filed. Moody's pointed out that it has assigned unsolicited ratings since its beginning in 1909, and that such ratings are the market's "best defense against rating shopping" by issuers. In 1999, it announced it would identify which ratings were unsolicited as part of a general move toward greater transparency. In 2005, unsolicited ratings were at the center of a subpoena by the New York Attorney General's office, but again no charges were filed. Following the 2008 financial crisis, the SEC adopted new rules for the rating agency industry overall, including one to encourage unsolicited ratings to counteract potential conflicts of interest by ensuring a "broader range of views on the creditworthiness" of a security or instrument.

The "issuer pays" business model (paying for a credit rating) adopted in the 1970s has been criticized for creating a possible conflict of interest, supposing that rating agencies may artificially boost the rating of a given security in order to please the issuer. Other alleged conflicts of interest, also the subject of a Department of Justice investigation the mid-1990s, raised the question of whether Moody's pressured issuers to use its consulting services upon threat of a lower bond rating. Moody's has maintained that its reputation in the market is the balancing factor. Thomas McGuire, a former executive vice president, said in 1995 that: "[W]hat’s driving us is primarily the issue of preserving our track record. That’s our bread and butter.”

The following three are Moody’s leading executives, the presidents of its companies.

Raymond W. McDaniel, Jr. is President and Chief Executive Officer of Moody's Corporation. He holds a J.D. from Emory University School of Law and a B.A. in political science from Colgate University. He was admitted to the New York State Bar in 1984. From his corporate bio page it would appear that Mr. McDaniel has only worked for Moody’s.

Michel Madelain is President and Chief Operating Officer of Moody's Investors Service. He is a graduate of the Ecole Superieure de Commerce de Rouen, Rouen, France, and holds an MBA in management from Northwestern University. He is qualified as a Chartered Accountant in France. Prior to joining Moody's in 1994, Madelain was a partner of Ernst & Young.

Mark E. Almeida is the President of Moody’s Analytics. He holds a BA from St. Joseph's University in Philadelphia, and an MBA from the Leonard N. Stern School of Business at New York University. Prior to joining Moody's, he worked in marketing and in regional economics for Chase Econometrics, a consulting subsidiary of The Chase Manhattan Bank.

Let’s review other information about the above three that is not echoic regurgitation from the Moody’s website.

Raymond W. McDaniel, Jr. has been the subject of scrutiny for the timing of his stock sales. "If you look at his major sales in 2007, 2009, 2010, they are all around price peaks and followed by large declines. The likelihood that this is just 'lucky' is very low — it appears he is using inside information to time his trades,” said Jesse Fried, a Harvard University law professor who studies stock trading by CEOs. In one instance, McDaniel executed a trade for some 100,000 shares of stock on the day the firm received notice from the Securities and Exchange Commission that the company was the subject of probes by the regulatory agency. The day the announcement of the SEC "Wells Notice" was made public (and following McDaniel's transactions), Moody's stock dropped by 6.807.

In 2010, Business Insider named McDaniel one of the fifteen worst CEOs in American history. Business Insider reported that, since he became CEO in 2005, Moody’s had gone from being one of the most respected credit agencies to being the target of public criticism, law suits and investigations . . . that outdated models were used, they were influenced by their clients, and they waited too long to downgrade investments as the collapse in the housing market intensified. The Financial Crisis Inquiry Commission issued a subpoena to Moody’s complaining that they had not complied with its request for documents and e-mails to aid in its investigation. The Business Insider wrote that during McDaniel’s watch, Moody’s century-long sterling reputation for integrity vanished and it is almost certain that the value of its brand can never be regained.

In 2011, Huffington Post carried a Reuter’s report in which Michel Madelain said that a European Union plan to impose tougher rules on credit rating agencies is "dangerous" as it is bound to limit the "quality and independence" of the rating process. "I see it as reflecting an obsession to challenge the rating process itself, and to hold rating agencies responsible for the European debt crisis," Madelain is reported to have said in an interview. "These proposals cannot make investors confident again nor facilitate the access of companies and European states to credit markets.”

Madelain has been fighting the European Union’s efforts to deny investors access to informed, independent credit views. He closed a 2011 speech at a Euro Finance Week event by saying “Neither the interests of investors nor the long-term growth prospects of European economies are well served by such policies.”

In an April 2012 letter to the Federal Reserve Board of Governors, Mark E. Almeida recommended that market signals should not serve as automatic triggers for heightened early remediation, that peer comparisons are essential for effective early warning, and that credit default swap implied default probabilities should be considered in the set of market-based triggers. His full letter can be read at: http://www.federalreserve.gov/SECRS/2012/May/20120510R-1438/R-1438_043012_107224_613995658948_1.pdf.

Almeida is on the Board of Trustees of the Battery Conservancy which is dedicated to the preservation of the Battery Park in New York. (I wanted to mention this because it makes at least one of these three guys seem a little bit more human.)

There we have it. Yet another major financial influence is not held fully accountable. Together with the Federal Reserve, they make a truly unholy alliance. Until individuals are called upon to be accountable for their personal financial dealings, you and I will never know exactly upon what they are basing their decisions, decisions that affect you and I, our todays and our tomorrows. Even if you have no savings, no investments, no mutual funds, you are affected through your cost of living, what you pay for groceries, what you pay at the pump, the price tag on your clothes, and the cost of your health care.

I say, let the revolution begin.

Until the next time, LLAP!