What Moody’s Settlement Means

First, it will cost Moody’s $864 MM plus other settlement-related expenses.

The civil penalties are $437.5 MM, and $426.5 MM will go to the states that joined the Department of Justice, of which (so far) $12.7 MM goes to Indiana, $6.7 MM to Delaware, $19.4 MM to Pennsylvania, $7.48 MM to Idaho, $26 MM to Mississippi, $7.2 MM to New Hampshire, $16 MM to North Carolina and $12 MM to Massachusetts.

Second, it will reshape Moody’s culture, again.

This is not the first time Moody’s has been called on the carpet by the Department of Justice, but it is the first time they haven’t had a righteous defense. In 2001, Moody’s pleaded guilty to DOJ anti-trust charges over an incident that took place in 1996, but there were some important differences. It wasn’t The People who filed the complaints. It was the broker-dealer lobby. And the complaint wasn’t about the sort of ratings linked to staggering losses. Quite the contrary, the complaint was motivated by sell side frustration with Moody’s exercising its right to issue unsolicited ratings—ratings designed to prevent investor losses—which it did at its own cost.

Third, it inspires disappointment in both Moody’s analysts and ex-analysts.

The power to downgrade, combined with special immunity from liability under Rule 436(g) of the Securities Act of 1933, put rating agencies beyond competition and reproach for decades, creating a sense of immunity from blame that became embedded in the corporate mindset and has continued since the rule’s repeal under Dodd-Frank.

Belief in one’s immunity from risk can make people arrogant and careless. Add to that Moody’s reputation for integrity, which was real and made the 90s work environment at Moody’s feel at times more like a university (some would say monastery) than a firm on the Street. Perhaps the only point in common with investment banks and hedge funds was the sense of intellectual inviolability inside Moody’s structured finance department at its peak. This was most likely exceeded only by LTCM in its heyday.

Even though Moody’s intellectual culture changed a long time ago, in 2000, and even though Moody’s press release does not admit to any violation of law or liability, the sense of disappontment now must be profound. Those of us who worked there in the past have not escaped the disappointment—we just went through it earlier.

Finally, it misses entirely the lesson from the Crisis.

Lust for revenge and aversion to change for fear of self-revelation are bringing America down. Our bureaucratically inspired financial rules and regs failed, and go on failing the public against the dark side of financial innovation, by censoring without understanding.

With regard to ratings, the 2006 Credit Rating Agency Reform Act’s effective intent is to promote equal access to all “opinions,” flawed or robust, so long as they enjoy popular support among large institutions, and so long as the agency issuing the ratings can afford the rising cost of regulation. Competition cannot survive and the result—not confined to how America designates rating agencies—is an institutionalized market for crap information.

Crap information has value. It enables financial players to profit by using their edge vis-a-vis what the public understands or is told. Specifically with regard to structured ratings, a plethora of models and methods developed over decades to rate deals with different structures and flavors, and produced different outcomes. Those who think this is a good thing are confusing ratings with research. A credit rating is a pricing benchmark. Flaws in rating models encode arbitrage opportunities in the pricing benchmark.

Rational financial arrangers will always seek to use the least rigorous rating approach available, to raise as much in proceeds as possible. “Rating shopping” can take place between rating agencies, or it can take place between groups inside rating agencies. Hence the sudden popularity of RMBS CDOs beginning in 2004 when all the NRSROs loosened their rating standards for RMBS: The “smart market” understood that CDO standards were even looser.

How can a market change for the better if the main admission criterion is popularity?There is only one real fix to the credit ratings problem, It isn’t more of the same, and it isn’t “skin in the game.” No one is immune from the risks introduced by fake measures in a closed system. Finance is a closed system: We all have skin in that game. The real meaning of Moody’s settlement is a lesson policy makers and financial players have yet to embrace.