Tuesday, May 11, 2010

Moody's Sings the Blues: Securities & Exchange Commission Issued Wells Notice to Moody's Back in March for False and Misleading Statements

Many have been blasting the credit rating agencies for sometime now. The three major agencies Standards & Poors, Moody's and Fitch have jointly and severally been blamed for being as responsible as the banking industry for the financial meltdown, and current deep recession. The link between credit rating agencies and the financial crisis continues to be analyzed. A flow chart illustrating the link is available here. Surprisingly, the credit rating agencies have managed to retain their government-mandated oligopoly status, and there has not been much regulatory action taken against the credit rating agencies. All of that is about change. Moody’s disclosed late Friday afternoon, in its 10Q that the SEC has issued a Wells Notice, which means that the SEC has decided that it “may” bring a civil action against Moody's. The Wells Notice provides the recipient an opportunity to say why enforcement shouldn’t take place. Although, it is not a formal allegation or finding of wrongdoing, it basically means that the SEC intends to file a formal complaint against Moody's for providing false and misleading information to the SEC.

As it turns out Moody’s disclosure of the Wells Notice to investors was fairly tardy. The SEC issued a Wells Notice to Moody’s back on March 18th and Moody’s simply declined to disclose to investors that it may be under a pending investigation by the SEC. What was Moody's thinking? Where is Moody's securities legal counsel? As a publicly traded company, Moody’s has an affirmative on-going financial reporting duty to inform the public of “Other Events” that the company considers to be of importance to security holders in Section 8 of Form 8K "within four days of the occurrence of the event." Arguably a two-month lag is a very long time not to inform investors that Moody’s had been issued a Wells Notice for providing false and misleading information to regulators. To make matters even more interesting, Moody’s CEO Raymond McDaniel sold one hundred thousand shares of Moody’s stock during Moody's failure to disclose period. McDaniel was allegedly unaware that Moody’s had been issued a Wells Notice. Even more interesting, Berkshire Hathaway, a la Warren Buffet, is Moody’s largest investor with approximately a 36 percent ownership interest. However, Berkshire Hathaway sold nearly one million shares of Moody’s stock, reducing its ownership position to approximately 28% almost immediately after Moody’s received the Wells Notice back in March, but prior to Moody’s disclosing the information to the public months later in May. Does the Securities Exchange Act Section 10(b) and Rule 10b5 insider trading violation mean nothing anymore? But I digress.

The real story is that Moody’s received a Wells Notice from the SEC, which is an administrative civil charge alleging that Moody’s may have provided false and misleading statements to regulators when Moody’s filed its registration statement under the Credit Rating Agency Reform Act of 2006 to receive a credit rating agency license back in 2007. Credit rating agencies have been criticized recently for giving “high investments grade credit ratings” to financial instruments that were used to “enhance”—that is to say, lower the "perceived" riskiness of securities, collateralized by subprime mortgages only to have these "enhanced high investment grade credit ratings" investments emplode within a matter of months, which in part, assisted in creating the current financial crisis. Moody’s registration statement detailed how Moody’s determines credit ratings of particularly risky investments. The SEC alleged that Moody’s registration statement “was rendered false and misleading” by a subsequent admission that the company’s credit coding policy was violated.” Moody’s disagrees with the SEC and “believes an enforcement action is unwarranted.” The Wells Notice also stated that the SEC is considering cease-and-desist proceedings against Moody’s.

The underlying false and misleading statements in Moody’s registration statement arise out of Moody’s incorrectly rating certain European investments. Back in 2008, Moody's acknowledged that a computer error resulted in employees incorrectly rating 11 fixed-income investments worth about $1 billion. Moody's also admitted that employees failed to cure the errors after discovering them. When Moody’s discovered a fault in its credit rating model, it fired the head of its structured finance unit when it determined that employees did not comply with internal rules by failing to change the “coding” related to the way “constant proportion debt obligations” were analyzed for certain European securities. As a result, Moody’s erroneously awarded its highest “Aaa” rating to at least $4 billion of European securities whose liquidity were backed by credit-default swaps, within weeks the European securities had lost as much as 90 percent of their "rated" value. Two months later, Moody’s revealed a second error in the way it assessed the risk of certain securities, which were sold to investors by banks including ABN Amro, JPMorgan Chase, and the investment firm formerly known as Lehman Brothers. Despite these credit rating errors, Moody’s is adamant that its licensing registration statement was accurate. Executives from Moody's and S&P testified before Congress last month about their role in rating risky collateral debt investments that were, in part, responsible for the financial crisis. Some critics argue that credit ratings agencies were too close to the companies whose debt issuance they were evaluating to be able to provide fair, and accurate credit rating assessments. It is the classic conflict of interest dichotomy inherent with every credit rating analysis.

Separately but in connection with Moody's credit rating errors, Moody’s rated the financial instruments that are currently at the crux of the SEC's civil fraud investigation against Goldman Sachs who packaged billions of mortgage-backed securities, and other complex derivative investments which also collapsed under the weight of their own erroneously rated collateralized debt valuation. Not surprisingly, all three major credit ratings agencies have been sued by investors who relied on Moody’s “high investment grade credit ratings” when they decided to invest in particular securities to their detriment.

In the current climate of increased financial regulation, Moody’s, Standard & Poor’s and Fitch face enhanced scrutiny by Congress and state insurance regulators after their “high investment grade credit ratings” to subprime-mortgage bonds issued just before the market collapsed in 2007. Professor Elizabeth Nowicki, a former lawyer with the SEC, and currently a visiting professor at Boston University School of Law stated that “the SEC doesn’t usually go after the ratings agencies…It’s impossible to ignore the fact that folks at the SEC have indicated they’re concerned with the role the credit ratings agencies had in supporting the crisis.” Several members of Congress have stated that they want to overhaul the credit-rating industry. The House Financial Services Committee passed a measure in October 2009 that would make it easier to sue credit-rating companies while aiming to rein in conflicts of interest concerns.

In the interim, state regulators are actively pursuing litigation against credit rating agencies. Ohio Attorney General Richard Cordray sued Moody’s, S&P and Fitch in November 2009 on behalf of five state retirement funds, alleging that “improper” credit ratings cost the State of Ohio more than $457 million. State insurance regulators, led by New York and Illinois, are seeking to reduce their reliance on credit ratings firms, and in November they hired Pacific Investment Management Co., manager of the world’s largest bond fund, to replace Moody’s and S&P analysis on home-loan investments held by insurers in New York and Illinois. We may be witnessing the death of the credit rating agency oligopoly.

Lydie Nadia Cabrera Pierre-Louis


  1. Terrific post.

    The credit rating agencies played a critical role in the financial market crisis, enabling Wall Street recklessness.

  2. No one really understood what credit rating agencies were doing and how their ratings impacted the markets until recently. Boy were we asleep at the switch.

  3. credit agency are great until they say something we dont like