By Zachary A. Goldfarb
Wednesday, September 1, 2010; A10
Moody's, one of three major credit-rating firms that misjudged many of the securities at the center of the financial crisis, escaped legal action Tuesday when federal regulators said they would not sue the company for fraud despite finding evidence that the firm misled investors.
The Securities and Exchange Commission said Moody's executives discovered they had issued overly optimistic ratings but decided not to correct them out of concern that "downgrades could negatively affect Moody's reputation."
The SEC said it chose not to file suit because of "jurisdictional" limitations. The activities at the center of the SEC investigation took place in Europe, beyond the agency's reach at the time.
But the agency said it might have made a different decision under the terms of the legislation enacted this summer to overhaul financial regulations. The bill gave the SEC the power to sue credit-rating firms engaged in "otherwise extraterritorial fraudulent misconduct."
"Moody's is pleased that this matter has been resolved and that the commission determined the investigation should be closed without pursuing any enforcement action," Michael Adler, a Moody's spokesman, said Tuesday.
The SEC seldom issues a report when it concludes an investigation without taking action. But agency officials said they wanted to send a message in reviewing their findings in the Moody's probe that credit-rating firms would face increased scrutiny.
The SEC's release of the report was one of the most significant steps regulators have taken to shed light on the conduct of credit-rating firms in the years leading up to the financial crisis.
The big three firms - Moody's, Standard & Poor's and Fitch Ratings - have faced far less regulatory and legal action than banks and other financial firms implicated in the meltdown. Federal regulators haven't sued any of the credit-rating firms. And the new financial regulatory law does not require an overhaul of the industry.
In the years leading up to the crisis, these firms issued letter grades to the complex securities that later contributed to the meltdown. In many cases the firms gave high grades to securities that turned out to be excessively risky, such as subprime mortgage-backed securities that received the highest AAA rating.
Congressional investigators have revealed that some employees of the credit-rating firms knew they were giving high grades to overly risky securities. Regulators also have warned that the firms may have been more interested in generating fees from banking clients who paid for securities to be rated than in offering an unbiased assessment.
At the same time, though, the credit-rating firms have enjoyed a privileged status with federal agencies. Regulators often make use of credit ratings to assess the financial health of banks and other financial firms and put limits on what they can do.
Credit-rating agencies, for their part, say they have revamped how they operate. They also say that they are simply issuing opinions on the quality of securities and that investors should not rely solely on their judgments.
In summer 2006, Moody's developed a method for assessing the risk of a new type of security that allowed investors to bet on corporate bonds. Moody's gave these securities its highest rating, and they were sold throughout Europe.
But several months later, a Moody's analyst found a mistake in the computer model that Moody's used to grade the securities, according to the SEC. The mistake made the securities seem less risky than they were.
Moody's executives subsequently held meetings to discuss whether to disclose that the ratings had been in error. They decided not to make such an announcement, according to the SEC.
One Moody's executive wrote in an e-mail: "In this particular case we seem to face an important reputation risk issue. To be fully honest this latter issue is so important that I would feel inclined at this stage to minimize ratings impact . . . than even allow for the possibility of a hint that the model has a bug."
After the passage of a 2006 law that required that credit-rating firms register with the SEC, Moody's filed paperwork stating that it would only take into account the credit quality of securities when issuing ratings and not consider the effect of a rating on Moody's itself.
In its investigative report, the SEC said that Moody's did the opposite of what the company pledged it would do.
The SEC said that Moody's did not change its approach until it was revealed publicly in a report by the Financial Times in May 2008.
"Investors rely upon statements that [credit-rating firms] make in their applications and reports submitted to the Commission, particularly those that describe how the [firm] determines credit ratings," the SEC enforcement director, Robert Khuzami, said in a statement. "It is crucial that [credit-rating firms] take steps to assure themselves of the accuracy of those statements and that they have in place sufficient internal controls over the procedures they use to determine credit ratings."
Adler, the Moody's spokesman, said his firm agrees.
"Moody's fully supports the commission's message that every rating decision must be based only on credit considerations," he said, "and Moody's is committed to maintaining robust procedures to ensure that our internal company policies are followed."