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Subprime Errors 'Disappointing;' Moody's CEO Vows Change

The chief executive of Moody's says his company's inaccurate ratings of mortgage-related investments were "deeply disappointing" but investors shouldn't rely on ratings to buy or sell securities.

Tim Graham | The Image Bank | Getty Images

"Moody's is certainly not satisfied with the performance of these ratings" and is taking steps to improve its rating process, says CEO Raymond McDaniel in prepared testimony.

Still, McDaniel says investors should use ratings as a tool, "not a buy, sell or hold recommendation."

McDaniel will testify Wednesday alongside billionaire investor Warren Buffett before the Financial Crisis Inquiry Commission. Berkshire Hathaway , which Buffett leads as chairman and CEO, is Moody's largest shareholder.

Rating agencies like Moody's, Standard & Poor's and Fitch Ratings have been criticized for giving unrealistically high ratings to complex investments backed by risky mortgages and other assets. When homeowners defaulted on their mortgages, the rating agencies downgraded billions of dollars of investments at once. That helped spark the financial crisis.

Lawmakers have also accused the industry of having a conflict of interest because the agencies are paid by the banks whose investments they rate.

Despite his company's stake in Moody's, Buffett has said he never relies on credit ratings when making investment decisions because he makes his own judgments on companies.

The FCIC issued its first subpoena in April to Moody's, saying the company failed to provide documents it requested. FCIC chairman Phil Angelides said the company started to comply with the request after receiving the subpoena.

In opening remarks, Angelides noted that Moody's profited greatly from rating mortgage-backed securities. Revenue soared from $600 million in 2000 to $2.2 billion in 2007, just as the housing bubble peaked.

But as the company profited, "the investors who relied on Moody's ratings didn't do very well," Angelides said.

Former and current Moody's executives testified early Wednesday. Asked why Moody's ratings failed leading up to the housing crisis, former managing director Eric Kolchinsky blamed a "factory mentality" where resource-strapped employees were pressured to rate as many deals as possible to grow the company's market share.

Bankers, in turn, knew they could get their investments rated quickly, even if they didn't provide Moody's with enough advance notice to properly evaluate the product, Kolchinsky said.

"Bankers knew we couldn't say no to a deal," he said. "They took advantage of that."

One transaction that could come up is a Goldman Sachs deal called Abacus, a complex mortgage-related investment that later plunged in value. Both Moody's and Standard & Poor's gave the Abacus deal a AAA rating, the safest rating they offer.

The government has filed civil fraud charges against Goldman, alleging it failed to tell investors that one of its clients, hedge fund Paulson & Co., was betting against the securities.

Credit rating agencies came under fire in April from the Senate Permanent Subcommittee on Investigations, which is also probing the causes of the financial crisis. The panel's chairman, Sen. Carl Levin, said the Senate's regulatory overhaul should curb the industry's inherent conflicts of interest.

Banks generally want higher ratings to make the securities they offer more attractive to investors. Former executives have acknowledged that competition within the industry often led the agencies' analysts to rate high-risk securities as safe.

To tackle the conflict of interest problem, the Senate's version of the financial overhaul would end banks' ability to choose the agencies that rate their investments. An independent board, appointed by regulators, would choose the rating firms. Critics point out that the agencies would still be paid by the banks whose products they rate.

Others have questioned whether regulators—who themselves missed warning signs leading to the crisis—should choose which agencies rate which financial products.

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