Moody’s Flawed Business Model

18 06 2010

Recently, Buffett has been parading around defending Moody’s from congressional and public scrutiny. Since so much money was contingent upon the rating given by the rating agencies, it’s quite understandable that people would be upset. And certainly, the rating agencies do deserve some blame. After all, who thought it was a good idea to give, what essentially amounted to a crappy loan, a AAA rating? People cite Moody’s so called “conflict of interest” that arises from its business model.

Companies that want their debt rated by a rating agency pay the agency, and the agency issues a rating. Not too complicated. However, a lot of people contend that there arises a “conflict of interest” because Moody’s can take more money (essentially be bribed) to issue a higher rating than is deserved. To declare that there is a “conflict of interest” implies that it is actually in Moody’s best interest to take these bribes. But is it?

In a market free of government force, would a rational business man accept these bribes? Clearly not. A rational company management should have the ultimate goal of producing shareholder value. The way to do that is by growing the business over the long-term. Keep in mind that we are discussing an industry where a company’s most important asset is its reputation. If a rating agency can’t be trusted, it’s going to be out of business. Plain and simple. It would be a terribly short-sighted and irrational for a company to sacrifice its reputation (and therefore long term viability) in order to make a little extra money in the short term. Anyone who says that screwing over the future of a company is ever in the company’s self interest is probably trying to sell you on the idea of more government regulation.

Unfortunately, Moody’s does not exist in a free market. Government regulations and rules decree that certain companies and funds need to hold debt with a minimum rating. In other words, the government creates the vast majority of the rating agency’s market. And worst of all, the government only allows the companies and funds to use government sponsored rating agencies. Currently, there are 10 firms that are classified by the government as Nationally Recognized Statistical Rating Organizations. These 10 firms that are lucky enough to get government sponsorship have guaranteed market share. When market share is guaranteed, a firm no longer has to worry about its reputation. Because of the government, these companies can essentially do whatever they want and still keep their customers. All of a sudden, it actually IS in Moody’s interest to sacrifice its reputation for bribes. The only reason this is a real “conflict of interest” is because Moody’s exists as part of a government created oligopoly.

So, while Moody’s is partly to blame, there is a more fundamental reasons for the failure of the rating agencies. That reason is the government.

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