Rating Agencies Settle – When Will They Call CR On Auditors Too?

I’ve written about the rating agencies and their conflicts and complicity in the credit crisis.

There is also an unholy alliance between the rating agencies, their auditors and the companies bonds they rate and the auditors of these companies.  The Big 4 are all over all of it.
And yet, no regulator or congressman or other politician will raise the issue of these conflicts.
And what about the fact that the auditors are paid by the companies whose financial statement integrity,  fairness, and accuracy they rate?  Somehow that’s ok?
If the mortgages were not being valued properly by companies and banks, who is the final judge?  The Big 4.
If the rating agencies were not following appropriate due diligence policies and therefore inflating fees based on bogus or conflicted business practices, who is the final judge?  Their auditors, the Big 4.
And what about the bond insurers?  Who audits them?  The Big 4.
S&P agrees to settlement over business practices

Major credit rating agencies were a step closer Tuesday to settling with New York Attorney General Andrew Cuomo to overhaul business practices in the aftermath of the subprime mortgage crisis.

Standard & Poor’s, the world’s largest rating agency, said late Tuesday that an agreement has been reached with Cuomo’s office. However, final details were still being worked out and an official deal could be announced as soon as Wednesday…Moody’s Investors Service and Fitch Ratings, the other two major agencies, did not comment about the negotiations.

Cuomo has been probing how all three agencies charge fees to the very bond issuers asking for ratings. The agencies have been criticized for failing to accurately assess — and warn investors about — the risks that mortgage investments posed to financial markets….Lawmakers in Washington and other critics say the agencies are vulnerable to conflicts of interest because they are paid by the companies whose bonds they rate. In response, the rating firms have announced steps to strengthen protections against conflicts…

10 replies
  1. James
    James says:

    I love the picture! While I understand the need to avoid the appearance of conflict of interest I’m not sure I know of a better compensation method. Would it help if the auditors were public employees? Maybe, but who listens to the GAO anyway? Its a tough situation, but in the meantime I think we can take some comfort in the fact that the “Big4” is mostly a marketing ploy and that integration between practices and offices (or between cubicle blocks in reality) – let alone across countries – is not what its made up to be.

  2. Independent Accountant
    Independent Accountant says:

    If CPAs were government employees, they would be under more pressure to ignore real problems. Look at the conflicts of interest at the: SEC, OFHEO and FDA for example. Look at the mess the DOJ is. I ain’t got a good answer.

  3. Anonymous
    Anonymous says:

    If the SEC scoped, received and paid for the audit I think there would be a different result. Similarly the banks or credit agencies would pay for the audits they demand of smaller not publically traded entities. These costs of course would be assessed against the companies. In addition the audit would consist not only of the auditors’ opinion but also of the BOD’s responses to recommendations. The responses would not necessarily be part of the public record.

  4. Anonymous
    Anonymous says:

    “If the mortgages were not being valued properly by companies and banks, who is the final judge? The Big 4.”

    Unless, I’m missing something, this statement makes absolutely no sense. On what basis would an auditor challenge the valuation of a market-traded mortagage backed security???

  5. Francine McKenna
    Francine McKenna says:

    Unless I’m missing something, much of the complaint about fair value accounting is that values were assigned to securities that did not have a ready market based on models, which are accounting estimates that the auditors have a responsibility to review. In addition, companies like Countrywide have models that were wrong. A Countrywide computer model used to gauge risks on mortgage securities didn’t take into account the possible effects of exceeding the loss levels that cut off reimbursements, for example. https://francinemckenna.com/2008/03/countrywide-and-risk-management-they.html

    This is another accounting estimate the auditors have a responsibility to review. So, unless I am mistaken, when it comes to assumptions, an auditor should never assume the client knows what they’re doing or that the client doesn’t have ulterior motives for valuing assets or liabilities more favorably or the client makes an ass out of you, the investor, and me, the auditor.

  6. Anonymous
    Anonymous says:

    Hindsight is 20-20. What model do you know of that would allow the auditor to forsee an unprecedented rise in mortgage defaults. Auditors can, and do, challenge managements’ estimates, but what your suggesting seems a little over-the-top.

  7. Francine McKenna
    Francine McKenna says:

    The auditor does not need to forsee, only to scrutinize and question such estimates when they appear to be lagging reality. An “unprecedented rise in mortgage defaults” ? Please. Have you been living under a cabbage? This bubble was obvious to everyone else for a long time.

    If Countrywide was the only example, I might concede your point. But if you look at the number of other financial institutions where auditors don’t seem to have challenged such estimates, including those for non-marketable securities and loan loss reserves, or updated fair values on a timely basis, the situation seems clear to me. The auditors are outmatched when it comes to these topics. So what’s the point of their “opinion” ?

  8. Justin Boland
    Justin Boland says:

    Francine, I think flawed computer models were far less of a problem than active fraud by the mortgage originators. When the biggest flaw with your model is that “we didn’t take into account all the lies involved in this process” that’s a fair indicator that your models might not be the real issue here.

    Also, the ratings agencies willingness to “audit” mortgage bonds they didn’t understand, have any actual data for, or even have models to evaluate…that’s just fraud. They’re parading Taleb around and talking about Black Swans to muddy the waters about this. It’s not “smart people making a mistake” it’s smart people knowingly participating in fraud.

    The biggest lesson I’ve learned from this crisis is that fraud becomes legal if you can distribute the culpability enough. The Subprime machine was very efficient at distributing responsibility so thinly that nobody, at any point in the system, actually felt responsible.

  9. PrivateDancer
    PrivateDancer says:

    “This bubble was obvious to everyone else for a long time.”

    So I guess you made 10’s of millions of dollars going short on companies with large mortgage exposure?

  10. anony
    anony says:

    “So I guess you made 10’s of millions of dollars going short on companies with large mortgage exposure?”

    Maybe Francine didn’t, but some hedge fund guys at Wall Street sure as hell did (see CNBC’s House of Cards). So I guess the bubble had to be obvious to someone, right?

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