Two former senior employees spill the beans on inaccurate ratings and conflicts of interest in the run up to the financial crisis and beyond

Key whistleblower documents alleging serious problems at rating agency Moody’s have been unveiled at a hearing in the US.

Eric Kolchinsky, former managing director of Moody’s investor services, and Scott McCleskey, former senior vice president of compliance for Moody’s, both presented evidence to a public inquiry into the role the rating agencies played in the financial crisis.

Inaccurate credit ratings have been cited as a major contributing factor to the current financial crisis.

In a letter to the Securities and Exchange Commission, dated March 2009, McCleskey claimed that Moody’s was performing virtually no ‘surveillance’ of US public finance ratings (debt issued by states, counties, municipalities or school districts). The vast majority of frequent issuers received no reviews, he said.

Some ratings, said McCleskey, stood for decades without ever getting reviewed.

McCleskey revealed in his letter to the SEC that he raised his concerns internally but that his guidance was ignored, in fact he was specifically told by Moody’s Legal department not to mention the issue in any written form.

Only after the credit crisis did Moody’s take action to address the matter, according to the whistleblower document.

‘However, this only consisted of designating a small team to review alerts generated by a computer algorithm,’ said McCleskey.

Other senior managers also complained that the size of the ratings team was insufficient to perform all the ratings (around 30,000 according to Moody’s website).

In his evidence McCleskey warned that a wave of defaults on securities with high ratings could have wide ranging systemic effects on an already weakened financial system. ‘Investors may think they are holding investment grade bonds when in fact the issuer is teetering on the edge of bankruptcy,’ reads the letter.

Kolchinsky’s evidence covered a period in 2007 when he was managing director in charge of the unit of Moody’s that rated sub-prime backed CDOs (collateralised debt obligations).

He claimed to have been dismissed as a result of a warning he sent to the compliance group regarding what he believed to be a violation of securities laws within the rating agency.

In his testimony to the House Oversight and Government Reform Committee hearing Kolchinsky claimed that unresolved problems in the rating system still exist that will continue to cause problems.

Significant conflicts of interest still exist in the ratings agencies, claimed Kolchinsky. “Senior management still favours revenue generation over ratings quality,” he said.

In addition, he claimed that the credit policy group, charged with making sure the ratings process is sound, remains weak and short staffed and the compliance department lacks independence.

In many ways the incentives for rating agencies have become worse since the credit crisis, not better, said Kolchinsky. ‘There are now more rating agencies and they are all chasing significantly fewer transaction dollars. The new controls put in place by regulators are too weak to significantly alter this dynamic,’ he said.

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