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Moody's: The Arthur Anderson of Credit and Real Estate

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May 26, 2008 – Comments (7) | RELATED TICKERS: MCO

I'm writing this blog about Moody's Corp.  I'm going to go by a bit of personal history, and try to influence you, the reader, and hopefully the Fool.com community at large.

The first time I ever heard about Moody's was in an old fool.com article.  It has been updated time and again, but here is a link to the article as it appeared just last September (9/13/2007; writer: Paul Elliott):

http://www.fool.com/investing/small-cap/2007/09/13/is-it-time-to-sell.aspx 

Here is the quote that stands out:

'A while back, I asked Motley Fool co-founder Tom Gardner for the one stock I should buy for my IRA. "I love Moody's," Tom replied, "but it's a little pricey at these levels." I bought it that instant. (Moody's is also off its recent highs, but it's still up more than 70% since I bought.)'

Since reading that article, I have seen Moody's mentioned, time and again, in many many fool.com articles, oftentimes linking it with Buffett.

Frankly, I am disgusted by this.

Mr. Elliott makes the assertion that Moody's is a great company.  Let's look at some facts, shall we?

"An analyst in a group that rated collateralized debt obligations was moved off an investment bank’s deals after bankers requested an analyst who raised fewer questions about their deals, the newspaper said.

Moody’s also moved another investment banking official to its surveillance unit, which monitors the performance of deals already rated, after an official agreed with an investment banker’s opinion that the analyst was too fussy, the newspaper added...

Moody’s, S&P and Fitch are paid by issuers for the securities they rate, and critics regularly question the conflict of interest they say this arrangement poses for the rating agencies."

My Comment: This is classicly reminiscent of the shady accounting practices of Enron, and the policies of Arthur Anderson, when accountants with either Enron or Anderson would bring up irregularities, they were shuffled off to other projects or otherwise silenced.  The difference is instead of one multibillion dollar company, Moody's is responsible for rating trillions of bonds and debt instruments.  This is potentially much more far-reaching and destructive.

"Moody’s awarded incorrect triple-A ratings to billions of dollars worth of a type of complex debt product due to a bug in its computer models, a Financial Times investigation has discovered.

Internal Moody’s documents seen by the FT show that some senior staff within the credit agency knew early in 2007 that products rated the previous year had received top-notch triple A ratings and that, after a computer coding error was corrected, their ratings should have been up to four notches lower.... 

On discovering the error early in 2007, Moody’s corrected the coding glitch and instituted methodology changes. One document seen by the FT says “the impact of our code issue after those improvements in the model is then reduced”. The products remained triple A until January this year when, amid general market declines, they were downgraded several notches."

My Comment: The implication here is clear: Moody's was covering their butts, changed the software so they wouldn't have to report these faulty ratings, and then did the close your eyes and ears and go "nyah nyah nyah nyah nyah I can't hear you" to those of us who have been blogging and reporting about the illogical nature of these ratings, and prayed that the economy would recover so that the debt would hold value.  When they didn't, the bury-your-head-in-the-sand-and-shred-your-documents tactic was no longer viable, they were forced to report this and now you've seen the recent selloff.  Actions like this are criminal - this is a deliberate fraud against debt consumers.  I will not personally be happy unless and until the management of Moody's are led away by the FBI in handcuffs and prosecuted to the fullest extent of the law.

"The two biggest credit rating agencies denied that they gave inflated ratings to sub-prime mortgage debt and other discredited bonds in order to attract more lucrative business from Wall Street banks..

Senator Jim Bunning, a Republican from Kentucky, described the process as "like a movie studio paying a critic to review a movie and then using a quote from his review in the commercials". A Democrat, Robert Menendez, said the agencies were "playing both coach and referee".

But Vickie Tillman of Standard & Poor's credit market services said that the agencies took every care to try to ensure accurate ratings, and that no analyst was ever paid according to the amount of business he or she generated, or the types of ratings given."

My Comment: Senator Bunning is right on the mark.  Mish also talks about "shopping around" debt to whomever would rate it the highest, which was also blatantly occurring, especially in conjuction with mortgage insurers.  We can see how well that has worked out for the mortgage insurers.  When a company or organization does something that is so obviously flawed that everyone can see it, but it benefits their own self-interest, we have but 2 choices to think of when considering the root cause of the action: 1. The individual(s) or company are incompetent, or 2. The individual(s) or company are dishonest.  My contention is that you do not build a multi-billion dollar enterprise by being incompetent, which leaves only one other option.  Unfortunately, ethics, integrity, and honesty oftentimes can be easily thrown out the window for a quick buck, and the evidence I am presenting here should make it clear that Moody's made clear and intentional choices in how to operate their business.

While I don't like to depend on other blogs, Mish's blog post Time to Break Up the Ratings Cartel  outlines many of these crimes that all ratings agencies have committed against it's customers.  And who are it's customers?

"A pension fund sued Moody's on Wednesday, alleging the credit-ratings agency misrepresented or failed to disclose that it had assigned "excessively high ratings to bonds backed by risky subprime mortgages."

In the suit filed yesterday in U. S. District Court in Manhattan, the Teamsters Local 282 Pension Trust Fund says Moody's compromised subprime home loans, including bonds packaged as collateralized debt obligations, by assigning them such ratings...

The Securities and Exchange Commission is examining the accounting and disclosure issues to see if the credit-rating agencies followed proper protocol in rating the mortgage-backed securities, the SEC chairman, Christopher Cox, told a Senate committee yesterday."

My Comment: While the lawsuit was a shareholder lawsuit, the clear fact remains that Moody's intentionally inflated ratings has done significant damage to the credit and equities markets, and the current SEC investigation is the smoke that is signifying a significant fire, a fire fueled by greed, unethical behavior, and outright fraud.  I have no faith that the SEC will find anything of significance as the SEC has it's own issues; my preference would be for the FBI to raid Moody's and have their forensic accountants and computer analysts take a look at Moody's business practices.

Now, after all this information, I wonder if Mr. Elliott and Tom Gardner still believe that Moody's is a "great company."  Based on the bullish slant that Moody's continues to get in all the fool.com mentions in conjunction with Buffett and Berkshire, I can only assume the answer is yes.  I have also posted replies to David Gardner's bull pitch on the Moody's CAPS page, and my pitches there have not been answered as of yet.

My contention is that Moody's is not only as bad as Arthur Anderson, they are in fact the worst perpetrators of the ratings fraud that has been part-in-parcel of the worlds biggest real estate bubble ever, and consequently will be a major factor in the current and coming severe downturns.  Furthermore, I will not be satisfied until the executives of Moody's are arrested and prosecuted to the fullest extent of the law.  While I do not expect most of fooldom to be as strong in their opinions of this as I am, I would love to see eveyrone's opinions, and to have people talking about this more.

Moody's made millions upon millions of dollars based on clearly fraudulent activity.  They are receiving their comeuppance, and I would not be surprised to see their stock price take further hits as more evidence is uncovered.

7 Comments – Post Your Own

#1) On May 26, 2008 at 1:29 AM, hondo928 (99.50) wrote:

I agree Moody's is a bad poorly run, company, but unless the government steps in which I doubt they will the fact is they still operate in what is pretty much a Duopoloy, and that is not going to change.  It's an issue of competition if they put Moody's out of business who is left McGraw with S&P and Fitch...unless A.M best were to step up, which would still lead to S&P being a huge leader over those two companies.

 I think you can see that they won't step in since they barely punished KPMG, and they commited a crime against the gov't!  Someone will be hung out on the bond ratings, but I don't think it will be Moody's as a whole, that would require lynching of Buffett along with it.

 I personally hope MCO stock continues its rock like fall, so I can get it cheap, the fundamentals are fine, and Mr. Market is punishing it.  But I think he/you are being a little pessimistic, when the fact still remains they have a huge Economic Moat which allows them to make money.  And for me that goes beyond all the fundamentals, and  technicals.  Moody's isn't alone in it either they just maybe were the worst, but  if  you want to make a play on the issue it's the  purest way to go long, which is why I am keeping an eye on especially under 3.  Fitch isn't public and McGraw hill has many other operations

 And honestly people shouldn't depend solely upon the ratings of others, so if everyone wants to point the finger at MCO, and S&P, while I'm sure it's rather labor intensive, in comparison, I don't go down MSN stock scouter buying every 10 rated stock, and then sue them if it goes bankrupt do I?

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#2) On May 26, 2008 at 1:52 AM, DemonDoug (35.21) wrote:

hondo, read the link about breaking up the ratings cartel.  what the government needs to do is to GET OUT of stepping in - it was a "regulating body" that created this tri-opoly to begin with.  If you or I wanted to start a ratings agency, we couldn't.

Please explain to me what fundamentals are "fine" - yahoo stats show that quarterly revenue and earnings are down significantly yoy, and with bond isnsurers going the way of the dodo, that is a lot of business going down the drain.  A lot of municipalities are not buying insurance and a lot of overseas governments are not trusting or using ratings anyway - more lost revenues.  Not to mention that the credit default swap, derivtives, and CDO/MBS markets are also dying - this is where a lot of that ratings money was made.  Why would I want to go long on a company that relies heavily on financial industries and products that are severely contracting?  Especially with legal and lawsuit risk?

And to your last point, there is a difference between an analyst and a ratings agency.  Many pensions and bond funds are required to hold debt rated at certain levels or higher; no stock fund requires analyst ratings.  If it was found that there were kickbacks or real intent do defraud investors, that certainly would be actionable in a civil court.  Furthermore, I believe collusion of this type is not just civilly actionable but criminal fraud.

Incidentally, if an analyst was found to be part of a pump-and-dump scheme, he also would be liable.  One would have to prove intent (which is very difficult), but technically he would be.

One of the hallmarks of a company that is going down is irregularities inaccounting and mis-reporting adverse events.  Like I said, where there's smoke, there's fire.  If you choose to invest in a company with these types of business practices, best of luck, but I would remind you of what Andrew Left of citron research always says: "Cautious investing to all." 

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#3) On May 26, 2008 at 3:19 AM, AnomaLee (28.71) wrote:

I own a small amount of "junk bonds" in my portfolio, and I was questioned about it at an investment club. I said their analysis  was probably just as good as what the rating agencies do. I got mocked for that, but in the end we discovered... Moody's, Fitch, S&P are terrible and I got paid for my risk and DD.

Until this month Countrywide bonds were rated three tiers higher than Chesapeake Energy and even XTO Energy - WTF?! There are still plenty of these ratings discrepancies.

That says enough... I don't solely trust the analysis of anyone -- Fitch, Standard & Poors, Moody's, Warren Buffett, Tom Gardner, or even Noah telling me to hammer this nail in this ark. Especially, if I am buying securities with my own hard-earned money.

MBIA and Ambac still enjoy a large moat as well. I don't understand why Moody's or any other rating agency is much different. There have been casualities through every downturn in the history of stock exchanges. Companies come and they go. You can have fun riding this merry-go-round if you want, but I'll pass. You'll probably waste all this time going up and down only to end up where you started.

Besides, who cares if Warren Buffett owns it? Who should feel the need to blindly buy everything he owns when he's already earned his massive fortune. I'm pretty sure his financial situation is much different than any of ours here. More importantly he's stated that Moody's "certainly lost significant intrinsic value." and he's now fully aware of the deliberate amount of neglect within the company. He's been one of the biggest bears on the markets and the entire financial system over the past year.

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#4) On May 26, 2008 at 7:05 AM, hondo928 (99.50) wrote:

Doug: I understand that they aren't the same thing as an analyst,but there is no proof that "it was found that there were kickbacks or real intent do defraud investors, that certainly would be actionable in a civil court."  And last time I checked this is America.

 As for the fundamentals I don't think Revenue and Earning yoy can ever tell the whole story, or are you saying you won't go long on pretty much any financial until they have posted a good quarter?  That's one way to play it but your missing a lot of potential upside...and by the way I noticed you have Starbucks as an outperform for "reasonable valuation" at $19 a share and they had negative earnings growth.

 Financials are down all across the board? But do you really think they will stay there and never return?  Because I don't...and if they do I think there aer much bigger problems for America as a whole than a Moody's "computer glitch".

And as for investing in a company "with these type of business practices" it is probably the biggest reason why I don't that and if the government were to step in and break up the rating agencies, monopoly, I wouldn't want to touch Moody's if someone was giving me shares.  But that's a very big if, and a lot to ask for, from a government, that usually like to appear like it's getting something done, without having to do anything.

 P/E on MCO is 13.5, PEG is 1.65, the numbers aren't value bin cheap but I think they are starting to represent a little bit of value.  Notice I said I am keeping an eye on it, if it were to dip below $30 a share, I think it would be too much discount to pass-up, not to mention some technicals point to it being oversold.  But since neither of those are really what I see as their biggest asset, unless they oligopoly gets split up, I would be very suprised if Moody's didnt return. 

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#5) On May 26, 2008 at 12:04 PM, mandrake66 (48.58) wrote:

The business of the ratings agencies isn't just at strong risk of conflict of interest, it is actually built upon it. Like the monoline insurers, they evolved into nothing but another essential stage of putting makeup on the pig -- the monolines were the mascara, and the ratings agencies were the lipstick. Both of them have lost whatever credibility and respect they may have once had. I think the business of the monolines will disappear entirely, and the ratings agencies will need to be re-invented in some way to regain the position they used to have. I can't see either group coming back without making enormous changes in the way they do business.

I briefly considered investing in Moody's a few months back, when they were somewhere around their current price and were "oversold" and "unfairly punished", but I can't bring myself to go either long or short now. They don't have a credible business model anymore, and I don't know what will become of it. I don't see how it's possible to derive a "value" for them anymore to invest in, based on earnings and cash flow. They've basically shown themselves to be valueless, and perhaps criminal. I won't spend much time explaining why they are 'corrupt' because it is inherent to a business in which you get paid by those you rate. Corruption is their business model.

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#6) On May 26, 2008 at 11:35 PM, anchak (99.86) wrote:

MCO the stock and Moody's the company - well you can have a love-hate relationship with them.

Their rating arm generates majority of the revenue - and they have wide  moat with global presence. But what conflict of interest - if ever there was one.

When a full gamut of general populace and industries ( with real money to shift markets) - Insurance, Pension Funds etc start depending on someone with that inherent conflict - one should do 2 backward somersaults and talk about some independent oversight etc.

Moody's is trying very hard to deflect "reputation" and credibility risk here - this "comp glitch" is in my opinion just that - folks dont be too shocked - they can take this bump in the road with the stock price - the one thing they do not want , is their lucrative clients to start questioning their  intellectual capacity and judgement - well on the street when the going is good and somebody gives you glitter and everybody says its gold -who's there to question. Now everyones wary - Moodys just doesnt want to loose that arbitrating position - lest say someone like Abit and Demon in ABC company comes along and starts calling things $hit and grades them by color and texture ( please pardon - I myself am trying to partition that part of the brain right now - which visualizes) - anyway more outfits will spring overnight with smart people and looking at risk from a  different light and then its all downhill from there.

So here is what they want to sell now " Oh you know, we sincerely apologize, that idiot programmer in Russia/Hungary or some other Eastern Europian nation didn't know what he was doing. Teaches us a lesson about quality of people in emerging economies , doesn't it?"

That sure deflects the topic onto off-shoring and other things -which in these hard times are hot topics too - the only thing that it leaves out possibly maybe the fact that the idiot programmer in Russia probably holds a Ph.D in Pure Math and could teach partial differential equations to some right from when he was at his mohter's knee - but draws a measly salary anyway.

And the fact that Moody's by its own admission ( this was last Nov-Dec) put a huge weightage on FICO score and were overriding other risk on tranches based on that.They were releasing it to the press ta that time that FICO doesn't work. I am not too fond of Fair Issacs either - however, I dont think they ever claimed that the FICO score covers more than anything but creditworthiness ( intention to pay)  - amongst the Cs of Credit. Collateral and Capacity are meant to mean something. And just by some twist of faith - what with all the Neg-Am exotic ARM products which increased leverage to an extent hitherto unthinkable - they made Capital also pertinent - especially due to the packaging of those in the securities Moody's rated.

Anyway - love and hate as I say - I am green thumbing MCO - just because - I think people will buy this story - they provide a convenience - otherwise people have to do their own work in valuing the risk - and the sheer difference in opinion creates arbitrage/pricing risk -which the street doesn't like while dealing.

Maybe I'll able to close it in green - I dont think I still will muster the courage to actually put real money on it yet - maybe another sharp drop.

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#7) On May 29, 2008 at 11:01 PM, nuf2bdangrus (< 20) wrote:

The difference between using ratings agencies for bonds and using stockscouter recs for stocks is thast many large institutions and insurance companies, pension funds etc have certain criterion they must follow when owing bonds.  They relied on the ratings agencies, and the dd would be extremely cost prohibitive.  The conflict of interest was disgusting, and lots of people got fabulously wealthy on debt securities tnat anyone with common sense knew were going to be problmeatic.  But our financials system is supposed to run on integrity and trust...problem is, the money makers are smarter than the regulators, because the smartest people go to the private sector, and the second tier take governmental and other regulatory positions.  It has always been that way.  The grave dagner here is that trust, which takes so long to establish, is harder still to re etablish.  Our system has been corrupted, and as people lose faith in the system, everybody loses.  Government is supposed to establish a level playing field.  They wee asleep at the switch, as were all of the regulatory agencies.

 

As for the Gardeners stockpicking....their ads show some great gains, but my experiences were terrible.  DOwn 75% with VDSI.  Other losers I escaped from were SBUX, and NFLX (which later recovered after a 20% hit the day their rec came out and I bought)  UMPQ down a good 50%, luckily by that time I learned about technical analysis and toehr things and I have stayed away untile the price is right.  I will NEVER own MOodys or any other of those corrput agencies. 

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