On Sunday, McClatchy posted a very thought-provoking analysis of the actions of Moody’s Investors Service that contributed to the financial crisis last year. Sadly, one of the primary lessons that could have been learned from the Moody’s analysis was completely ignored when it was announced on Friday that Adam Storch of Goldman Sachs would head the enforcement division of the Securities and Exchange Commission.

As McClatchy points out, the roots of the bond ratings portion of the financial crisis were established very early:

To promote competition, in the 1970s ratings agencies were allowed to switch from having investors pay for ratings to having the issuers of debt pay for them. That led the ratings agencies to compete for business by currying favor with investment banks that would pay handsomely for the ratings they wanted.

Who could have predicted this result of such a move:

Wall Street paid as much as $1 million for some ratings, and ratings agency profits soared. This new revenue stream swamped earnings from ordinary ratings.

This inherent conflict of interest, where it is the issuers of debt who are paying for the analysis of its risk, rather than the purchasers paying for the analysis then played out to its obvious conclusion.

As subprime residential mortgage-backed securities and collateralized debt obligations linked to these securities gained popularity on Wall Street, the revenues of the bond rating agencies soared, as McClatchy cited data from Lawrence McDonald:

“In 2001, Moody’s had revenues of $800.7 million; in 2005, they were up to $1.73 billion; and in 2006, $2.037 billion. The exploding profits were fees from packaging . . . and for granting the top-class AAA ratings, which were supposed to mean they were as safe as U.S. government securities,” said Lawrence McDonald in his recent book, “A Colossal Failure of Common Sense.”

But then, as we know, the market collapsed quickly. Here is McClatchy quoting McDonald again:

“How on earth could a bond issue be AAA one day and junk the next unless something spectacularly stupid has taken place? But maybe it was something spectacularly dishonest, like taking that colossal amount of fees in return for doing what Lehman and the rest wanted,” McDonald wrote.

The McClatchy article provides substantial evidence that inside Moody’s, those who warned that risky debt was being given too high a rating were removed from the company and replaced with personnel who were willing to continue giving high ratings to risky debt.

One aspect of the McClatchy investigation stands out particularly in their analysis of the internal changes at Moody’s:

Another mid-level Moody’s executive, speaking on the condition of anonymity for fear of retribution, recalls being horrified by the purge.

“It is just something unthinkable, putting business people in the compliance department. It’s not acceptable. I was very upset, frustrated,” the executive said. “I think they corrupted the compliance department.”

This point stands out because it was just announced Friday that Adam Storch of Goldman Sachs will be the first Chief Operating Officer of the Securities and Exchange Commission’s enforcement division. That means that Storch is being given what amounts to Wall Street’s highest “compliance” position. What is his background? The New York Times article linked above gives Storch’s present position as “vice president in Goldman Sachs’ Business Intelligence Group”. That sure sounds to me like we are making the same mistake of putting another business person in charge of compliance.

Granted, later in the article we do learn that Storch is a certified fraud examiner, but that does not appear to be a part of what he does at Goldman Sachs, and his previous experience (he is very young) is listed as “senior consultant at accounting firm Deloitte & Touche”.

Doesn’t it seem that somehow, out of over 300 million people in our country, there would be someone with an established record of success in a compliance function who would make a much more credible candidate for this position? To me, the appointment of Storch to this position is condemning our country to another wave of failed oversight leading to market instability.

Further comments on the inappropriate choice of Storch can be found in this post by Glenn Greenwald from Friday.