Ratings Agencies Screw-Up & Get Paid Anyway

With all the economic trouble that has resulted from the sub-prime debacle, a great deal of attention was paid to the ratings agencies that awarded high ratings to the debt instruments that later collapsed. In its investigation of the factors that led to this collapse, the New York Attorney General, Andrew Cuomo, also began an investigation into the credit ratings agencies themselves and a settlement in that investigation was just reached between the state and both Moody's and Standard & Poor's. That settlement, however, may leave some investors scratching their heads.

As usual, of course, no one admitted any wrongdoing. You may recall that I previously wrote that Moody's was quick to suggest that a computer bug had caused the ratings to be inflated in certain situations and it never assumed any of the blame otherwise. What is interesting about the settlement, however, is that it may mean greater revenues for these ratings agencies going-forward - yes, more money! The reason, however, actually makes sense.

It all comes down to incentives. Just as the top CEO's have a large part of their total compensation packages tied-up in stock options that align their interests with the performance of the company's earnings (that, of course, is a whole other story), the ratings agencies will be paid for initial analyses and assessments performed on new sub-prime issues. Currently, prior to the new rules, the ratings agencies were paid only if they were ultimately selected by the issuer as the final, official, ratings agency. This approach, of course, incentivized the agencies to give better ratings than they might have otherwise in order to win the business. Being able to earn some cash regardless of their ratings, therefore, should make them more willing to speak the truth ...of course, I'm not saying that they haven't been doing so in the past... you understand, right?