A rush to boost profits and mollify clients eroded the independence of credit ratings with disastrous results, former executives of Moody's Investors Service Inc. testified, underscoring a notorious and still-unresolved defect in the financial system.
In the lead-up to the financial crisis, ratings agencies were like factories gone mad, the executives told a congressional panel on Wednesday, churning out high ratings on housing-related investments that soon turned to dust. At Moody's, the corporate culture morphed from "just say no" to "must say yes," in the words of one ex-employee.
The testimony highlights the abiding conflicts in a crucial corner of finance and raises broader questions about the reliability of ratings. It also boosts pressure on U.S. lawmakers, who are moving closer to final legislation aimed at fixing the flaws that led to the meltdown, including the key role played by ratings agencies.
Billionaire investor Warren Buffett, chief executive officer of Berkshire Hathaway Inc., long a major shareholder in Moody's, was compelled by subpoena to testify Wednesday before the Financial Crisis Inquiry Commission, which was appointed by the U.S. Congress to delve into the causes of the crisis.
Mr. Buffett said Moody's made "the wrong call" in many of its ratings, but painted the failure as a collective one. "They made a mistake that virtually everyone in the country made," including himself, he said, by neglecting to see that the housing market was a gigantic bubble poised to burst.
There is widespread agreement among investors, policy makers, and within the agencies themselves that something went badly wrong with ratings in the years prior to the financial crisis. Raymond McDaniel, CEO of Moody's the ratings agency's parent company, said Wednesday that he was "deeply disappointed" by the performance of the firm's ratings on mortgage securities.
Fixing those problems, however, is proving tricky. Few investors or bond issuers like the ratings agencies, but they are hard pressed to envision a world without them. The judgments of the major ratings agencies - Moody's Investors Service, Standard & Poor's, and Fitch Ratings - are enmeshed in regulations guiding banks, pension funds, insurance companies, and other institutional investors.
One significant reform proposal came from the U.S. Senate, which included in the version of the financial overhaul bill that it passed last month a measure to change the way ratings agencies function. Rather than letting issuers "shop" for ratings agencies - picking the one most likely to give them a higher rating - the proposal would create a panel overseen by the U.S. Securities and Exchange Commission that would assign a particular ratings agency to a deal.
Such a reform, if included in the final legislation now being hammered out by U.S. lawmakers, would apply only to complex structured products and not to ratings for bonds issued by corporations, municipalities, or countries.
Some experts say that a number of ratings still appear overly optimistic, whether for sovereign bonds issued by indebted European nations or those sold by cash-strapped municipal governments.
"There remain a number of ratings in the market that are inflated," said Sean Egan, managing director of Egan-Jones Ratings Co., a small ratings firm whose revenue comes from investors, rather than bond issuers.
But the scale of the problem is far less severe than it was in mortgage-related investments, he adds, which in some cases went from holding triple-A ratings to being classified as junk.
"I don't think in your lifetime you'll see the extraordinary [downgrades]that you saw in structured products," Mr. Egan said in an interview. "Investors looking for a 2-per-cent return per annum were told instead that they're not getting any money back, period."
Mr. McDaniel, the Moody's CEO, seemed to reject any suggestion that ratings agencies should serve as an early-warning system for investors. Ratings were a tool, he said, "not a buy, sell or hold recommendation."
Critics say that ratings agencies are still slow to incorporate new information and are loathe to cut their ratings. "It's in their DNA," said Lawrence White, an economics professor at New York University. "They've been slow to downgrade going all the way back to the 1930s. It's just not their favourite thing to do."
At Wednesday's hearing held in New York, Mr. Buffett added star power to the proceedings, guaranteeing the room would be packed with journalists and members of the public. He said he would have sold his Moody's stock had he realized that the housing debacle lay ahead. He also recalled that, prior to the crisis, several publicly traded home builders approached him about buying their companies, something he should have seen as a warning sign.
"Looking back, I should have figured out what I didn't figure out," he said.
Close: $19.90 (U.S.), up 60 cents