On Wednesday, the House Oversight Committee of the US Congress held a hearing on the rating agencies. And it released some explosive material - the implications of which don’t yet seem to have quite sunk in. The evidence presented is extremely damning.
There are exchanges like this, via instant message:
Administrator: This IM session is being recorded and may be reviewed for compliance by McGraw-Hill through its several divisions.
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Thursday, April 05, 2007 3:56:35 pm EDT Mooney, Shannon: i didn’t really notice…but now that I think about it i kindof tune out when she talks.
Thursday, April 05, 2007 3:57:39 pm EDT Shah, Rahul Dilip (Structured Finance - New York): well she just is too political… and she doesn’t have anything of substance to say… but keeps thinking that she does.
Thursday, April 05, 2007 3:57:53 pm EDT Shah, Rahul Dilip (Structured Finance - New York): (I’m done venting now) 
Thursday, April 05, 2007 3:56:35 pm EDT Mooney, Shannon: k go take a nap.
That’s right, literally asleep at the wheel.
Thursday, April 05, 2007 3:58:42 pm EDT Shah, Rahul Dilip (Structured Finance - New York): btw that deal is ridiculous
Thursday, April 05, 2007 3:59:05 pm EDT Mooney, Shannon: i know right…model def does not capture half of the risk
Thursday, April 05, 2007 3:59:09 pm EDT Shah, Rahul Dilip (Structured Finance - New York): we should not be rating it
Thursday, April 05, 2007 3:59:17 pm EDT Mooney, Shannon: we rate every deal
Thursday, April 05, 2007 3:59:30 pm EDT Mooney, Shannon: it could be structured by cows and we would rate it
Thursday, April 05, 2007 3:59:54 pm EDT Shah, Rahul Dilip (Structured Finance - New York): but there’s a lot of risk associated with it - I personally don’t feel comfy signing off as a committee member
While everyone is focusing on the “rated by cows” quote, the important part in this exchange is actually in the final message: the analysts were clearly uncomfortable, but felt there was nothing they could do. The story is similar at Moody’s, where members of the CPDO rating committee, for example, were perfectly aware of grave flaws in the rating model, but felt there was nothing that could - or should - be done.
Why?
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It turns out the above exchange is really only the frosting on the cake. Among the numerous documents released is a confidential presentation given to the board of Moody’s corporation in October 2007, by Chairman Raymond McDaniel.
The presentation is a discussion of a big problem facing Moody’s - and indeed, all the rating agencies: how to reconcile the desire for the business to be profitable and gain market share, with the need to produce accurate ratings (emphasis FT Alphaville’s):
Ideally, competition would be primarily on the basis of ratings quality, with a second component of price and a third component of service. Unfortunately, of the three competitive factors, rating quality is proving the least powerful given the long tail in measuring performance. Were that the extent of the problem - that it is hard to measure quality and hence price and service are disproportionately weighted - it would pinch profitability, forcing rating agencies to spend more on service and take less in fees. But that is no different than for most other businesses and we can cope. The real problem is not that the market does underweights [sic] ratings quality but rather that, in some sectors, it actually penalises quality by awarding rating mandates based on the lowest credit enhancement needed for the highest rating. Unchecked, competition on this basis can place the entire financial system at risk.
And indeed, it did. Continued McDaniel:
Moody’s has struggled for years with this dilemma… For the most part, we hand the dilemma off to the team MDs to solve.
And so we begin to get closer to the question of why Rahul and Shannon acquiesced and allowed a deal structured by cows to be rated.
Those in charge of the rating agencies - like McDaniel - were aware of problems and potential conflicts “for years”, but they chose to ignore them. They allowed, instead, their MDs to take care of things. It was known, too, that passing the buck was no solution: “entire committees, entire departments, are susceptible to market share objectives” wrote McDaniel:
Analysts and MDs are continually “pitched by bankers, issuers, investors –all with reasonable arguments — whose views can color credit judgement, sometimes improving it, other times degrading it.
We “drink the Kool-aid”.
The MDs - those in charge of people like Rahul and Shannon - were drinking the most. They were highly incentivised to see the company turn a profit.
At all the agencies, MDs were typically well remunerated with generous share packages in lieu of cash-bonuses (the agencies could not compete with the banks for analyst talent using cash, so stock was a good alternative).
To boot, most MD-level staff at the agencies in 2005/6/7 had all risen through the ranks over the past decade. They were a generation of managers which progressed with the corporate matra that, above all else, client-friendly, “service-orientated” behaviour was rewarded most - a cultural position rating agencies dramatically came around to in the mid-1990s.
Jerome S Fons, a former Moody’s executive, testified to the House Committee:
An article in Treasury & Risk Management, titled “Rating the Rating Agencies” appeared in the summer of 1994 and had a profound impact on the firm’s thinking. It raised questions about who our clients were and how best to deal with them. Management undertook a concerted effort to make the firm more issuer-friendly, since issuers largely paid the bills by then. In my view, the focus of Moody’s shifted from protecting investors to being a marketing-driven organization. The company began to emphasize customer service and commissioned more detailed surveys of client attitudes.
Stock options and other incentives raised the possibility of large payoffs. Managers who were considered good businessmen and women - not necessarily the best analysts - rose through the ranks.
So people like Rahul, who did not feel “comfy” with deals, were led by people who did.
And the influence of MDs on the teams they led and the rating committees they chaired was great. Rating votes were rarely formal, decisions were often by acclamation, and in some instances, meetings were not even properly held - just arranged and executed by email. If the MDs chairing the committee wanted deals done - the deals got done. Even in cases where the analysts were outspoken. An email exchange from S&P between analysts on rating a CDO without access to data on the underlying collateral ends thusly, with a message from the ranking committee member:
Any request for loan level tapes is TOTALLY UNREASONABLE!!! Most investors don’t have it and can’t provide it …
It is your responsibitity to provide those cred¡t estimates and your responsibilily to devise some method for doing so. Please provide the credit estimates requested!
Still though, we’re not yet into the really juicy stuff released by the Oversight committee.
Here’s an email exchange within Moody’s, the subject of which is the attitude of some of the world’s biggest bond market investors to Moody’s and the other rating agencies.
A few choice excepts - from July 07:
PIMCO and others (he mentioned Blackrock at WAMCO) have previously been very vocal about their disagreements over Moody’s ratings methodology. He cited several meetings they have had with Pramila Gupta questioning Moody’s rating methodologies and assumptions. He found the Moody’s analyst to be arrogant and gave the indication that “We’re smarter than you.” Despite wanting to work with Moody’s as a “good ally with good discussions,” eventually they “gave up.”
Josh [PIMCO] then became very passionate in the call - almost emotional… He feels that Moody’s has a “powerful control over Wall Street” but is “frustrated that Moody’s doesnt stand up to Wall Street.” They are disappointed that in this case Moody’s has “toed the line” “Someone up there just wasn’t on top of it,” he said. … in the case of RMBS, its mistakes were “so obvious - you have to step back.”
Yu [Vanguard] expressed “frustration with the rating agencies willingness to “allow issuers to get away with murder”
I asked Ron [Blackrock] how his participation in sub-prime has changed over time. He said that he began to notice “disturbing trends” in mid-2005.
Such complaints and warnings from investors went right to the top. Here’s another exchange, with the Global CDO CIO of Fortis Investments. Possibly the best of the lot (emphasis ours):
All -
I just got off a tough call with Maryam Muessel fom Fotis lnvestments. She’s the Chief lnvestment Officer of Global CDOs. She requested to speak to someone very senior, very quickly. She and other investors (blackrock is one of the names she mentioned) ‘have formed a steering group to try to get the rating agencies to listen to the needs of the investors. She is extemely frustrated. Had a few choice words for me, here’s a recap:
“If you cant figure out the loss ahead of the fact, whats the use of using your ratings?”
“you have legitimized these things” referring lo subprime & abs cdos and “leading people into dangerous risk.”
“if the ratings are b.s. the only use in ratings is comparing b.s. relative to more b.s.”
“luckily I avoided Moody’s ratings, didn’t buy into your ratings, but 91 sucker managers did and were punished yesterday.”
[- worth noting here that this exchange - from July 12, ‘07 - comes after the first big downgrade of structured bonds by Moody’s.]
… she said that here group came to Moody’s last fall to discuss our rating methodology and she believes we’re missing the layered risks.
Reading all this, a number of things become clear:
The story of the credit rating agencies is a story of colossal failure. The credit rating agencies occupy a special place in our financial markets. Millions of investors rely on them for independent, objective assessments. The rating agencies broke this bond of trust, and federal regulators ignored the warning signs and did nothing to protect the public. The result is that our entire financial system is now at risk
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 implication is that the SEC too has failed. Waxman’s committee questions Chris Cox today.
Related links
When junk was gold - FT
Exclusive: Moody’s error gave top ratings to debt products - FT Alphaville
Moo! Let’s make a deal - LOLFED
