Mad-Eye Moody's
The All-Seeing Oracle of Credit
“Founded to endure and investors make secure” — founding motto, Moody’s Investors Services, 1914
Net Interest turns five today! I had planned on writing a piece that reflects on the past half decade but just as I was putting last week’s issue to bed, Moody’s announced that it is cutting the sovereign credit rating of the United States from Aaa – a seal it awarded way back in 1919 – to Aa1, one notch below. Normally, this wouldn’t interfere with celebrations, but I have a fascination with Moody’s that dates back many years. So I’m going to put the champagne on ice while we explore a financial institution whose decisions reverberate through markets worldwide. An itch worth scratching, I promise.
My history with Moody’s stretches back to a meeting in Lower Manhattan towards the end of 2007. As a hedge fund analyst tracking financial stocks, I found myself in the World Trade Center, sitting across from Linda Huber, the company’s chief financial officer of nearly three years. The financial crisis was just beginning to unfold, and Moody’s had already started downgrading swathes of subprime mortgage-backed bonds that it so enthusiastically rated just one year earlier. Grading structured products on behalf of paying banks had become a big business that grew to generate over half Moody’s ratings revenue in 2006. This created a perfect storm for the company – its fastest-growing revenue stream was evaporating just as questions about its rating methodology were intensifying. I was bearish. It seemed to me the firm was fast losing credibility and that’s what its model was based on, right?
Wrong.
The firm’s reputation did indeed take a hit. All-told, 83% of the mortgage securities rated triple-A in 2006 were ultimately downgraded. After a long investigation conducted by the Department of Justice, the firm confessed that it used a more lenient standard for awarding Aaa ratings than it let on, and that its entire process was riddled with conflicts. Yet while structured finance revenue fell off a cliff, the company’s other ratings businesses continued as if nothing had happened. By 2012, revenues within Moody's ratings arm had recovered to their 2007 highs, and they’ve doubled again since. By 2014, the company’s market cap had fully recovered from the financial crisis, and today it stands at four times its pre-crisis peak.
This wasn’t the first time Moody’s had navigated a credibility crisis. In November 2001, the firm downgraded Enron from investment-grade mere days before the energy firm declared bankruptcy. During the 1997 Asian financial crisis, it maintained investment-grade ratings for vulnerable economies until markets were already in free fall. And back in 1970, the bankruptcy of railroad Penn Central put a spotlight on the entire credit rating industry. But this time was different – Moody’s wasn’t just late to spot trouble, it was complicit in creating it.
When I expressed my concerns about Moody’s reputation to Linda Huber during our meeting, she seemed unfazed. Having Warren Buffett as her largest shareholder gave her a veneer of protection against carping hedge fund analysts like me. The irony wasn’t lost on me: Buffett himself had famously declared that “it takes 20 years to build a reputation and five minutes to ruin it.” The man who warned his own employees that losing even “a shred of reputation” would be met with ruthlessness had become a long-term holder in a company whose credibility was repeatedly questioned.
Buffett’s partner Charlie Munger offered a clue to this apparent contradiction at the Berkshire annual meeting in 2000: “Moody’s is a little like Harvard. It’s a self-fulfilling prophecy. I hate to think of how much you could mismanage Harvard now and still have it work out pretty well.”
But just as the value of a university degree faces more scrutiny today than in the past, Moody’s institutional armor might be showing similar vulnerabilities. Treasury Secretary Scott Bessent’s dismissal of the recent US debt downgrade was direct: “I don’t put much credence in Moody’s… by the time they get to a downgrade, everything’s already in the market.”
Is the ratings giant’s self-fulfilling prophecy status beginning to fade? Or will Moody’s continue to demonstrate its remarkable durability? To understand why Moody’s has proven so resilient despite repeated credibility challenges, we need to look deeper at the company’s unique position in global finance.