WASHINGTON — Moody’s Investors Service conducts “virtually no surveillance” of its municipal bond ratings, despite its claims to the public and Congress that it robustly monitors all the securities it rates, a former chief compliance officer warned the Securities and Exchange Commission in a March letter. 

The letter, which was publicly released yesterday by the House Government Oversight and Reform Committee, could have broad implications as state and local finances continue to plummet during the recession.

“In the current economic environment, this failure could have far-reaching systemic consequences,” Scott McCleskey, a former senior vice president and head of Moody’s compliance department, wrote in a March 12 letter to the SEC’s Michael Macchiaroli. “I am writing to urge the SEC to include a rigorous review of public finance rating surveillance in its annual examination of Moody’s and the other NRSROs.”

“Municipal authorities have been taking drastic measures — cutting their capital budgets to zero, laying off employees in critical sectors, etc. — just to keep afloat,” he wrote. “There is a real probability that there will be a wave of municipal defaults in the coming year. In the meantime, the ratings on their debt remain at the same level as when the debt was issued. Investors may think they are holding investment-grade bonds when in fact the issuer is teetering on the edge of bankruptcy.”

The letter was disclosed during the first of two hearings held to focus on the credit rating agencies. The first, before the oversight committee, focused on rating agency compliance failures, while the second, before the House Financial Services capital markets panel, dealt with a draft bill to mandate credit rating reforms.

The bill, sponsored by the panel’s chairman, Rep. Paul Kanjorski, D-Pa., would make it much easier for investors to sue rating agencies designated by the SEC as nationally recognized statistical rating organizations, or NRSROs.

The Kanjorksi bill also would require NRSROs to rate muni and other debt on the same scale. Specifically, the agencies would need to use standardized rating symbols for all securities that would be based on the same levels of assumed or expected loss. Expected loss is defined as the expected probability of default multiplied by the loss once the default occurs.

McCleskey — who testified during the first hearing and served as Moody’s head of compliance from April 2006 to September 2008 — said he was “pushed out” of Moody’s after officials “lost confidence” in him. But he said he was not terminated for whistleblowing, and wrote his letter to the SEC after he left the rating agency.

“I wanted to flag an issue to [the SEC] to make sure they were aware of it when they conducted their examination” of Moody’s, he said.

McCleskey said there were “tens of thousands” of munis that were “not getting the same level of scrutiny that you would expect” and that is received by corporate debt and other securities. He told the lawmakers that  Moody’s may need “algorithms that will pop up alerts” when ratings should be reevaluated.

He said he wasn’t concerned about big issuers like New York City, but rather small school districts and municipalities.

In his letter, McCleskey stressed that senior Moody’s management was unwilling to tell the public that virtually all municipal ratings were out of date, contrary to their representations in congressional hearings and public statements, a source of great concern in the current economy. Moody’s rates 29,000 issuers, he wrote.

Though most of his concerns were initially ignored, Moody’s did take some small but insufficient steps at addressing the problems after the financial crisis began and rating agencies were put under additional scrutiny, McCleskey said. A Moody’s spokesman did not respond to requests for comment.

Asked if the SEC staff responded to McCleskey, a spokesman said: “We are focusing carefully on the tips and complaints we receive and following up, where appropriate, with examinations targeting suspected problems.”

Rep. Gerald Connolly, D-Va., noted McCleskey told the SEC that Moody’s officials did not want any concerns to be put in writing and said the agency appears to have “a culture of avoidance of having anything in writing that’s traceable.”

The hearing also focused on claims from a former Moody’s analyst, Eric Kolchinsky, who testified that rating agency violated the securities fraud laws by knowingly issuing misleading ratings on structured finance products and that analysts were more concerned about revenues than quality ratings.

Connolly was furious that lawyers from Kramer Levin Naftalis & Frankel LLP, the outside law firm Moody’s hired to investigate Kolchinsky’s claims, found no merit in Kolchinsky’s charges but did not want to put its findings in writing.

“This [secrecy] might be alright if the credit rating agencies hadn’t played a starring role in the collapse of the financial system. For that reason, this cannot continue. It’s very clear to me at this point that effective legislation is needed, along with effective oversight,” said committee chairman Edolphus Towns, D-N.Y.

During the first hearing, Floyd Abrams, the First Amendment expert and senior partner at Cahill Gordon & Reindel LLP, who is also outside legal counsel for Standard & Poor’s and its parent company, the McGraw-Hill Cos., testified on behalf of himself and not his firm or clients.

He warned it would be wrong and inconsistent to lower the so-called pleading standards in a 1995 law to permit private parties from filings securities fraud lawsuits against the rating agencies based on allegations that they acted “unreasonably” rather than with “scienter,” or bad faith, which is the standard that applies to other market participants.

“Under such a framework, if a plaintiff’s lawyer were to bring a securities fraud suit against three defendants, a securities analyst, an auditor and an NRSRO, the plaintiffs would have to allege that the securities analyst and auditor acted in bad faith but, with respect to the NRSRO, would argue that it need to allege only that the NRSRO acted unreasonably,” Abrams said.

During the second hearing, Kanjorski said that by giving unduly high ratings to mortgage-backed structured finance ratings, the rating agencies “betrayed” investors that had come to rely on their judgement, “but also their special status under our laws.” Currently, the securities laws shield the firms from litigation.

“We can promote accountability in credit ratings through the threat of liability,” he said.

But New Jersey Rep. Scott Garrett, the ranking Republican on the panel, said he does not believe that “the solution to all of society’s ills is simply more lawsuits.”

He also noted with particular concern a provision that would institute collective liability among NRSROs.

“I am very concerned about the practicality of this provision, not to mention the constitutionality as well,” Garrett said. “I don’t see what positive can be attained by holding all of the NRSROs accountable for the bad actions of one.”

Standard and Poor’s president Deven Sharma said the provision would be anti-competitive.

Though they said that they welcomed some legislative proposals or regulatory changes, the heads of the top three NRSROs — Moody’s, Standard & Poor’s and Fitch — said they are deeply concerned about the joint liability proposal, which would require them to each verify other NRSROs information and be liable for the actions of their competitors even if they did not rate a bond that defaults.

“There is simply no truth to the popular notion that CRAs are somehow 'immune’ from liability,” said Moody's chairman and CEO Raymond McDaniel. “Moody’s and other NRSROs are in fact being sued as we speak in numerous cases in federal and state courts around the country. So, under the existing law, there is already substantial accountability.”

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