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Moody's CEO, Buffett Make Ratings Agencies Seem Pointless

Warren Buffett
Warren Buffett, Chairman and CEO of Berkshire Hathaway, testifies before the Financial Crisis Inquiry Commission, June 2, 2010, in New York. AP

First, the CEO of the ratings agency Moody's, which provided favorable ratings for billions in crappy subprime mortgages, says that investors shouldn't rely on ratings to buy or sell securities. In prepared testimony for the Financial Crisis Inquiries Commission (FCIC),  which is  probing the role of  Wall Street and government agencies in the financial meltdown, Moody's CEO Raymond McDaniel said his company's inaccurate ratings were "deeply disappointing." He explained that ratings are a "tool," and should not be confused with buy, sell or hold recommendations.

Then Warren Buffett, probably the most admired investor in the world, tells the FCIC in New York that investors like himself should not rely on ratings agencies for their due diligence.

At the same time Buffett, the chairman of Berkshire Hathaway, owns a significant chunk of Moody's, which must have looked like a good business to him at one point, even though he personally didn't need its services.

Buffett said that the ratings agencies should not be blamed for the financial meltdown.  "I would say in this particular case that they made a mistake that virtually everybody in the country made," he told the commission.

According to Phil Angelides, chairman of the FCIC,  Moody's revenue went from $600 million in 2000 to $2.2 billion in 2007 as the housing bubble evolved. The company gave its highest rating  to 42,625 residential mortgage-backed securities during the five-year period. Needless to say the securities were downgraded as the bubble burst.

"This comes as close as you can to the very product being fraudulent or of no use to the marketplace in reality," Angelides said at the FCIC hearing on Wednesday.

Clearly, the ratings are not meant to be buy, sell or hold recommendations, but they should at least give an accurate indication of risk.  And if Moody's ratings -- or those from Standard & Poor's or Fitch Ratings -- are an unreliable, but critical "tool" in an investor's decision process, then what's the point of having them?

Aren't the rating agencies, which are paid by companies who issue securities to determine (rate) their creditworthiness, geared to help investors understand the risk profile of a security?

Buffett didn't defend the issuer pays the ratings agency model. "As chairman of Berkshire, I hate issuer-pay, we pay a lot of money and we have no negotiating power,"  he said to the FCIC.  "It makes for a wonderful economic model for the business, but for a practical matter I have no negotiating power."

So, the ratings issuers could be perceived as too close to the securities issuers, and the Moody's CEO and Warren Buffett don't think that savvy investors should rely too much on the rating.  He trusts his own judgment, but where does that leave the vast majority of investors looking for credible risk assessment of securities?

Eric Kolchinski, former managing director for rating subprime mortgage securities at Moody's, blamed the ratings mismatch on company management. "Despite the increasing number of deals and the increasing complexity, our group did not receive adequate resources. My own attempts to stay on top of the increasingly troubled market were chided by my manager. She told me that I spent too much time reading research," he told the FCIC.

The blame game won't clear up the fundamental disconnect and conflict in the business model of the ratings agencies.

Sen. Al Franken, D-Minn., has proposed eliminating the conflict by setting up a government committee that would assign credit rating agencies to issuers. That might help alleviate one of the problems with ratings agencies, but not the lack of credibility that currently distinguishes them.

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