Mortgage-backed securities, or MBS, played a pivotal part in the recent galloping real estate market and in its eventual and memorable collapse. These bonds get rated based on risk before they are offered for sale so that potential investors - pension funds, university endowments, international investors, among others - know what they are fiddling with. Moody's is one of the top three in U.S. to do that, the others being Fitch Ratings and Standard & Poor's.
When Moody's was spun off from Dun & Bradstreet early in the decade, the long-time corporate philosophy of honest and quality ratings was supplanted with a more pro-business one. In essence it would now pay more attention to the bottom line than accurate mortgage and other bond ratings. It needed to keep its market share, and possibly even increase it regardless of the means. That looks like a dangerous shift in corporate strategy. And it was.
Writing countless AAA ratings for mortgage bond issues - and also doing packaging of securities - earned Moody's superb fees. Later on many of the issues were rated no more than junk. The ratings were based on mathematical models that were far from accurate and often hopelessly out of date. Perhaps so by design. Anyhow, life was good. Not only for Moody's but the other players as well. Global investors trusted their advice, liked the yields and were writing checks left and right. And then the unthinkable happened. A thermonuclear event blew up the mortgage industry.
Another aspect about the mortgage bond rating regimen that skews its results is how the agencies are compensated. For decades now Wall Street itself has been paying the fees, the same investment firms that benefit from top ratings - no matter how erroneous - when marketing their products. That smells of a major conflict of interest. How objective can a rating be when it's done this way? Not very. Decades ago, before the new setup was approved it was the investors who plunked down cash for the ratings. That makes much more sense and should be considered for revival.
Government regulation - currently through Securities and Exchange Commission (SEC) - of this particular segment needs to be carefully assessed and preferably tightened. The big investors were badly scorched in this recent home loan and real estate meltdown. They formed the backbone of the secondary mortgage market here and they are needed there again. But to convince them to return requires new procedures and rules that would assure them the securities they are considering are thoroughly and competently researched and then rated accordingly. After all, the Fed, having largely replaced the no-show investors to keep the secondary mortgage market alive and liquid, can only do it for so long.