The Credit Rating Agencies' Moment of Shame

Investors ought to take a look at the embarrassing information that came out about the credit rating agencies' botched handling of subprime securities before the House Committee on Oversight and Government Reform.

Internal memos at the agencies, email exchanges, instant messages all point to how insiders at these companies knew they were botching the job-and did little to stop the worst credit crisis in history from happening.

Top executives of Moody's Investors Service, Standard & Poor's and Fitch Rating testified on the role that the different agencies played leading up to the current mess we've found ourselves in.

And all faced an intense grilling that they likely have never endured before. Running the credit rating agencies has been a rich endeavor for them--the three CEOs have made tens of millions of dollars at those companies.

The markets have known about this problem for years. The credit rating agencies were painfully slow to warn investors about the problems at Bear Stearns, Enron and WorldCom, just to name a few calamities.

But this time, their incompetence has been nothing short of derelict.

Mortgage Lending Explodes

The cash cow was there and waiting for the agencies to take advantage of. Total residential mortgage production in the United States grew from $639 billion in 1995 to $3.3 trillion in 2005. Subprime production grew from $35 billion to $807 billion over the same time frame. Alt-A loan volume, (Alt-A loans sit between risky subprime and less risky prime loans) was $676 billion in 2005.

Wall Street Steps In

Wall Street then took those loans, gathered them into pools, sliced and diced them and built bonds off of their cash flow streams. Depending on the type of mortgage product, underlying a given security, the pool could consist of 1,000 to 25,000 loans.  

Wall Streeters then paid the credit rating agencies to assign these bonds Triple-A ratings in order to sell them to investors as "safe." How a bond built on risky subprime loans is then gold plated as "safe" is the question now being investigated by market regulators.

The conflict was there from the get-go--the rating agencies were paid to assign ratings to bonds.

Egan Jones does not get paid by issuers of these securities. Another independent player to watch: Rapid Ratings International, an independent research and analytics firm that provides ratings of companies' financial health, using a proprietary quantitative ratings system based on global benchmarking and industry-specific risk.

The credit rating agencies are not a part of the government, despite the frequent use of the word "agency" to describe them.

Instead they are profit-making businesses who assign ratings, like Triple-A or Triple-B, to securities, letting investors know how safe they are. The agencies "are essential financial gatekeepers," as Rep. Henry Waxman (D-Calif.) noted in the hearing yesterday.

But Waxman also noted that "for Wall Street's investment banks, a Triple-A rating became the independent validation that turned a pool of risky home loans into a financial goldmine."

Credit Rating Agencies' Cash Cow

Total revenues for the three credit rating agencies doubled from $3 billion in 2002 to over $6 billion in 2007, according to the hearing's testimony. At Moody's, profits quadrupled between 2000 and 2007. Moody's had the highest profit margin of any company in the S&P 500 for five years in a row.

But the Triple-A ratings were handed out like Kleenex.

S&P has downgraded more than two-thirds of its investment-grade ratings. Moody's had to downgrade over 5,000 mortgage-backed securities.

When downgrades of these securities occurred, the banks who owned them had to pony up way more capital they had used to back them up, otherwise known as collateral. When they couldn't raise the capital, the downgrades then triggered massive writedowns.  

Execs on the Hot Seat

Ray McDaniel, the CEO of Moody's, testified that "we have witnessed events that many, including myself, would have thought unimaginable just two months ago."

According to McDaniel:

"The real problem is not that the market ...underweight[s] ratings quality but rather that in some sectors, it actually penalizes quality. ... It turns out that ratings quality has surprisingly few friends: issuers want high ratings; investors don't want ratings downgrades; short-sighted bankers labor short-sightedly to game the ratings agencies."

McDaniel then tells his board: "Unchecked, competition on this basis can place the entire financial system at risk."

Meaning, companies can take their bonds elsewhere to another rating agencies, or opinion-shop their bonds to get the rating they want.

McDaniel did aver to his board that Moody's has "erected safeguards to keep teams from too easily solving the market share problem by lowering standards."

But then he says: "This does NOT solve the problem." In his presentation, the "not" is written in all capitals.

We Drink the Kool-Aid

McDaniel then turns to a topic that he calls "Rating Erosion by Persuasion." According to McDaniel, Moody's "analysts and MDs [managing directors] are continually ‘pitched' by bankers, issuers, investors" and sometimes "we ‘drink the kool-aid.'"

It Gets Worse

A month earlier, in September 2007, Moody's McDaniel had participated in a "Managing Director's Town Hall."

McDaniel said at the time: "The purpose of this town hall ... [is] so that we can speak as candidly as possible about what's going on in the subprime market. ...[W]hat happened was, it was a slippery slope. ... What happened in '04 and '05...is that our competition, Fitch and S&P, went nuts. Everything was investment grade. It didn't really matter. ...We tried to alert the market. We said we're not rating it. This stuff isn't investment grade. No one cared because the machine just kept going."

The following day, a member of the Moody's management team commented on how things were slowly unraveling:

"We heard 2 answers yesterday: 1. people lied, and 2. there was an unprecedented sequence of events in the mortgage markets. As for #1, it seems to me that we had blinders on and never questioned the information we were given. ... As for #2, it is our job to think of the worst case scenarios and model them. ... Combined, these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue."

Standard & Poor's In Trouble Too

The documents from Standard and Poor's paint a similar picture.

In one document, an S&P employee in the structured finance division writes: "It could be structured by cows and we would rate it."

In another, an employee asserts: "Rating agencies continue to create [an] even bigger monster - the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters."

For more details, see email exchanges at bottom.

Voices Warning in the Wilderness

Waxman's statement notes that there were executives inside the credit rating agencies who called for change.

Frank Raiter from Standard & Poor's and Jerome Fons from Moody's were two.

In 2001, Raiter was asked to rate an early collateralized debt obligation called "Pinstripe." He asked for the "collateral tapes" so he could assess the creditworthiness of the home loans backing the CDO.

This is the response he got from Richard Gugliada, an S&P managing director: "Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don't have it and can't provide it. Nevertheless we MUST produce a credit estimate. ...It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so."

Raiter was stunned. He was being directed to rate Pinstripe without access to essential credit data. He emailed back: "This is the most amazing memo I have ever received in my business career."

Last November, Chistopher Mahoney, Moody's Vice Chairman, wrote Mr. McDaniel, the CEO, that Moody's "has made mistakes" and urged that "the manager in charge of the securitization area should be held to account." Mahoney's employment was terminated by the end of the year.

Vanguard on Guard

Investors, too, were stunned by the lax practices of the credit rating agencies.

Hearing documents show that a portfolio manager with Vanguard, the large mutual fund company, told Moody's over a year ago that the rating agencies "allow issuers to get away with murder." A senior official at Fortis Investments was equally blunt, saying: "if you can't figure out the loss ahead of the fact, what's the use of your ratings? ... [I]f the ratings are b.s., the only use in ratings is comparing b.s. to more b.s."

Some large investors like PIMCO tried to warn Moody's about the mistakes it was making. But according to the documents, they eventually "gave up" because they "found the Moody's analyst to be arrogant and gave the indication ‘We're smarter than you.'"

The Government Falls Down

Waxman notes that six years ago, Congress pressed the SEC to assert more control over the credit rating agencies. In 2002, the Senate Governmental Affairs Committee investigated the rating agencies and found serious problems. The Committee concluded that "meaningful SEC oversight" was urgently needed. The next year, the SEC published its own report, which also found serious problems with credit rating agencies.

Initially, it looked like the SEC might take action. In June 2003, the SEC issued a "concept release" seeking comments on possible new regulations. Two years later, in April 2005, SEC issued a proposed rule.

Yet despite the Senate's recommendation and SEC's own study, the SEC failed to issue any final rules to oversee credit rating agencies. The SEC failed to act and left the credit rating agencies completely unregulated until Congress finally passed a law in 2006.

The Memos and Emails Speak Volumes

*Billions of dollars worth of mortgage-backed securities were sold to investors on the premise that the securities were safe under most market conditions. "It seems to me that we had blinders on and never questioned the information we were given," an unidentified Moody's employee wrote as part of a survey after a September 2007 town-hall meeting. "Combined, these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue, or a little bit of both."

*An instant message between two Standard & Poors employees - Shannon Mooney and Ralul Dilip Shah in the structured finance division at S&P is revealing:

Shah: btw -- that deal is ridiculous

Mooney: I know right...model def does not capture half of the risk

Shah: We should not be rating it

Mooney: We rate every deal. It could be structured by cows and we would rate it.

Shah: but there's a lot of risk associated with it - I personally don't feel comfy signing off as a committee member.

*In one agency internal memo noting a conference call, Mabel Yu, an executive with Vanguard Investments, felt that the downgrades in the summer of 2007 from S&P "came about 1 ½ years too late" and expressed "frustration" with the ratings agencies' willingness to "allow issuers to get away with murder." She is finding the phenomenon particular to RMBS [subprime securities] and CMBS [commercial mortgage backed securities].

The memo continued: She feels that, particularly in the area of subprime, too much credit is given to indvidiuals who haven't had access to credit before. She felt that there wasn't enough historical data available to track the performance of thse more aggressive loans. Yu said that over time, Vanguard bought less and less of this asset class and stopped investing in it entirely by early 2006. Vanguard has witnessed the deals "getting worse and worse" and Yu reported that the market has been screaming for a while, "look at sub-prime!" adding that "the agencies are giving issuers every benefit of the doubt." Yu added that "I feel that if Moody's doesn't give the rating, the issuer can simply go elsewhere and get it somewhere else."