Rating Agencies' Game Worse Than Madoff's Scheme

By Shah Gilani

Underlying the credit crisis gripping the U.S. and world economies is a crisis of confidence. Blame has been laid at the feet of the U.S. Federal Reserve, and an investment banker's brew of toxic financial products. Ultimately, however, it was the supposedly trustworthy rating agencies that got everyone to drink the poisoned Kool-Aid.

The sheer fraud and greed of rating agency analysts and executives is staggering. That no one has gone to jail, and none of the agencies has been shut down is a travesty of justice on an infinitely larger scale than Bernie Madoff’s Ponzi scheme. Until depositors, bankers and investors regain confidence in the quality of ratings we rely upon to measure financial stability and creditworthiness, the tremors that underlie the credit crisis will drag on indefinitely.

Letter and number ratings – such as AAA, Aa1, BBB and Caa1 – are financial shorthand for the due diligence supposedly done by rating agencies after they’ve examined an issuer or a security’s financial structure, and evaluated the likelihood of its being able to pay interest and principal at maturity. Investors rely on the objectivity and fiduciary responsibility of the rating agencies to publish fair, accurate and uncompromised assessments.

By law, certain investors must rely on the ratings of a handful of Securities and Exchange Commission designated “Nationally Recognized Statistical Rating Organizations” (NRSROs). For example, most state insurance regulators require that only assets rated in the top four ratings categories by NRSROs are eligible investments. Similarly, money market funds can only invest in securities with the highest NRSRO ratings. In fact, innumerable institutions – public and private, and domestic and international – mandate asset quality levels predicated on the major rating agencies’ due diligence.

Standard & Poor’s Ratings Services, Moody’s Investors Service (MCO) and Fitch Ratings Inc. are all SEC-designated NRSROs. They are the largest, best-known and most-profitable ratings firms in the tiny, $5 billion-a-year universe of ratings firms. S&P is a part of The McGraw-Hill Cos. Inc. (MHP), while Fitch is a subsidiary of France’s Fimalac SA.

Moody’s was spun out of financial publisher Dun & Bradstreet Corp. (DNB) as a public company in 2000. Warren Buffett’s Berkshire Hathaway Inc. (BRK.A), apparently having spotted a diamond in the rough, bought into D&B before the divestiture, and ended up with a hefty 19% stake in Moody’s after the spin-off was completed.

The problem with the business of rating the issuers of securities, and rating the securities they issue – such as mortgage-backed securities and collateralized mortgage-backed obligations – is that the rating agencies are paid by the issuers to rate them. Objectivity aside, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. It’s like all the contestants in the Miss World pageant paying the judges with country funds… who’s not going to be judged beautiful?

What was even more problematic in the scheme of the ratings business model was that analysts didn’t understand how to analyze and rate the very complex cash flow structures of these new collateralized mortgage-backed securities. Not wanting to lose business to their competitors, who were all in the same boat, they used the same rating model structures that they used to rate corporate bonds, though the two different securities had nothing in common.

It was like asking your local car mechanic to certify your Citation V jet – just before you take off for a transatlantic flight to London. God help you if there’s a problem.

And there were problems. Lots of them. According to a Feb. 15 “Review & Outlook” piece in The Wall Street Journal, Joseph Mason, professor of finance at Drexel University, studied collateralized debt obligations rated “Baa” by Moody’s and determined that they were 10 times more likely to default than equivalently rated corporate bonds. The article went on to say that an S&P spokesperson, when asked if they actually examined the underlying mortgages in the pools, answered: “We are not auditors; we are not accounting firms.”

While S&P – and to a lesser degree, Fitch – were just playing the game, Moody’s actually ran away with the ball. An eye-popping and brilliant April 11 Journal article by Aaron Lucchetti exposed the unseemly underbelly of Moody’s greed. What stood out the most in the article was Moody’s willingness – under the direction of Brian Clarkson, who joined the firm in 1991 and became president and chief operating officer – to bend over backwards to accommodate issuers of mortgage-backed and structured finance paper. Clarkson was willing to switch analysts if clients complained, which several did, including Credit Suisse Group AG (CS), UBS AG (UBS), and Goldman Sachs Group Inc. (GS).

Under Clarkson, Moody’s expanded and grabbed a huge piece of the deal-ratings market pie. By 2006, the company was rating $9 out of every $10 raised in mortgage securities. For all of that year, the firm’s structured finance group generated more than $881 million in revenue, about 43% of Moody’s revenue. And in 2007 it was estimated that the firm rated 94% of the approximately $190 billion in mortgage and structured-finance CDOs floated during the year.

But there was some concern, including some from insiders. Former Moody’s analyst Mark Froeba told The Journal that “there was never an explicit directive to subordinate rating quality to market share. There was, rather, a palpable erosion of institutional support for rating analysis that threatened market share.” In the same article, former Moody’s executive Paul Stevenson was quoted as saying that “the most recent problem is that the rating process became a negotiation.”

Clarkson, Moody’s president and COO, didn’t do too badly negotiating his compensation, either. In 2006 he made $3.8 million, while the firm’s chief executive officer, Raymond McDaniel, made $8.2 million. Clarkson “retired” under pressure this past May and McDaniel, the CEO, added the title of president to his mantle.

Eventually, the always-late-to-the-dance SEC awoke to the realization that it was supposed to be watching the watchers – the ratings agencies. While hundreds of billions of dollars around the world were invested in Wall Street’s pay-to-play version of Illinois gubernatorial politics, many heartbroken and flat-out-broke investors discovered that what the rating agencies had determined to be “AAA” rated securities were not the princely investment-grade securities those three letters said they were, but were toxic Amazon frogs instead. Of course, that calls for an investigation. And so it was.

A 10-month “examination” by the SEC, concluded in July, uncovered, believe it or not, “poor disclosure practices and procedures guiding the analysis of mortgage-related debt and insufficient attention paid to managing conflicts of interest.” Brilliant!

According to the report, which included as exhibits several e-mail exchanges between analysts at unnamed ratings firms, there was an obvious degree of knowledge and complicity in playing the ratings game. In one exchange, an analyst said that their ratings model didn’t capture “half” of the deal’s risk but that “it could be structured by cows and we would rate it.” And in another, even more famous exchange, dated Dec. 15, 2006, a manager wrote that the firms continued 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.”

Have any heads rolled? No. Have any fines been levied or any firms closed down? No. The SEC apparently went back to sleep, having since been intermittently aroused by the failure of The Bear Stearns Cos., the bankruptcy of Lehman Brothers Holdings Inc. [OTC: LEHMQ], the nationalization of American International Group Inc.(AIG), and a few other minor nap-interrupting events, including the bailout of Citigroup Inc. (C). I’m only sorry that the Commission’s disjointed hibernation should once again be interrupted by the petty crime of a simple Ponzi scheme artist. Well, maybe now they can finally get some rest. For the sake of our future, someone please disband this band of sleeping fools.

Shortly after the July examination was made public, in an acknowledgement that it might be under unwarranted attack, S&P announced that it was considering ways to take volatility and stability into account in its ratings. But, in a simultaneous burst of clarity, S&P suggested that it feared that a more disciplined and functional ratings model would make it harder for issuers to raise capital. Only days later, in fact, S&P went on the offensive, calling SEC proposals to boost disclosure and mitigate internal conflicts of interest too costly for the ratings businesses. Among the proposals that were pushed back was one to require a separate ratings structure and ranking system for structured products.

Fast-forward to Dec. 3, and the unveiling of the SEC’s latest proposed rules changes. While the toothless wonder folded up like a pup tent once again on all substantive changes that would have created a more transparent and honest playing field, it did manage to sneak in some suggestions, including those that said:

• The rating agencies can’t rate debt they help structure.
• Analysts can’t participate in fee negotiations.
• Analysts can’t be given gifts worth more than $25.
• Analysts must disclose a random 10% sampling of their ratings within six months.
• The ratings agencies must maintain a history of complaints against analysts.
• And that the agencies must record when an analyst’s rating for structured debt differs from a quantitative model.

Calling these proposed rules changes baby steps is like calling the Grand Canyon a ditch.

Because Wall Street didn’t like the idea, what got dropped from the proposed changes were rules to create different structures for rating different products. And the most egregious of the dropped rules was a proposal that ratings firms make public all underlying information they use in making their ratings. Which is exactly the transparency needed.

There is an overwhelming heaviness to the credit crisis that bears on our economic future. It is the inordinate weight of established, self-serving power brokers driving dump trucks full of ill-gotten gains over any clarion call for transparency. The underlying currency of capital markets must be clearly and objectively rated instruments, whose value is determined by free markets. Until confidence is restored in the producers, products and the purveyors of financial services, thirsty investors are unlikely to partake of any new punch.

Original post

Comments

[venividivici:]

Excellent article.

2008 Dec 18 10:53 AM

[James Wilson:]

BECAREFUL BUYING THE ULTRA SHORTS !!!!

THE SHORTS ARE SHORTING THE SHORTS !!

CAN YOU BELIEVE THAT ?

SHORTS SHORTING SHORTS SHORTING SHORTS.

2008 Dec 18 12:06 PM

[Ben Barnes:]

How come all of a sudden the market is waking up to the fact that the rating agencies are well behind the curve. The fact of the matter is they get paid far too much for the ratings they charge corporates (plus other entities like sovereign debt), the ratings are too reactive (i.e. change rapidly in the midst of market turmoil) and should be forward/predictive looking, and when things go wrong - they blame others for their poor rating analysis (i.e. the accountants who signed the company's accounts in the first place).
What a great business! A lot of people (including financial journalists) knew what was going on in the ratings business at least a decade ago. Conflicts of interest?
How about the U.S. Fed stepping in to regulate this industry properly and stop the practice of agencies selling (a) the actual rating on an entity for the organisation they are rating; and (b) the research on such entities and sectors, which they have basically stripped out from the doing (a) in the first place. They could also regulate the fees charged but the agencies.
All this should have been done a long time ago. The fact that it has not happened might well indicate there something rather ineffective happening on the part of these regulators. Now it takes a crisis to make change happen! Trouble is the damage has been done.
On Dec 18 10:53 AM venividivici wrote:

> Excellent article.

2008 Dec 18 12:30 PM

[Brian Lee:]

Fantastic article. Thanks for bringing light to a major issue that has unjustifiably flown under the radar.

2008 Dec 18 01:37 PM

[Reddenbacher:]

nonsense. if there was proof of fraud, show it. in terms of greed, many many others along the chain profited much much more than the rating agencies. bottom line- the mortgage originators new what they were selling and lied to the investment banks and the rating agencies about what was in there. they take the most blame

2008 Dec 18 01:53 PM

[Michael Fit...:]

As I have also written about many many times, the 3 ratings agencies (Moody's, Fitch, and S&P) were central to the entire credit problem. Without the AAA slapped on the re-packaged sub-prime debt, that debt would not have been tradeable. If the debt hadn't been tradeable, banks and other loan originators would have had to have *held on* to that debt (and so, they never would have made some of the incredibly bad loans they made). The fact that they could trade the crappy loans (and make commissions along the way), and get them off their books leaving someone else (no-one else) liable for the problems, *that* was the entire scheme in a nut shell. Moody's, Fitch, and S&P should all be put out of business and the whole idea of the fox watching the henhouse is simply ludcrous financial structure.

2008 Dec 18 01:58 PM

[k9s-4-k8:]

I think the CNBC interview with Arthur Levitt was very telling. He said regulators only act after the fact. The disconnect of so many have is some kind of expectation that the SEC ought to be able to keep fraud from ever happening. That's not realistic with their paltry staff. They investigate, draw conclusions on what if anything that can be done to keep fraud from happening again through new regulations.
Another thing Leviitt recommended was to change the emphasis of the SEC to one of evaluating risk from one of conducting the 'check the box' inspections.

2008 Dec 18 04:40 PM

[monday1929:]

The ratings agencies are obviously bought and paid for. Along those lines,
fraudster Harvey Pitt ex- SEC made comments defending the uselessness of the SEC and that Madoff could not be detected because he kept a false set of books. The ratings agencies also come right out and say they do not look for fraud.
ANY Fiduciary investing in these corrupt/opaque markets with other peoples money should be considered negligent and liable for all client losses.

2008 Dec 19 08:53 AM

[monday1929:]

When they are convicted will you concede they are scum? They sold ratings and the execs. pocketed their bonuses. The ratings agencies and the criminal banks should be tried for Treason. They looted the economy of Trillions.


On Dec 18 01:53 PM Reddenbacher wrote:

> nonsense. if there was proof of fraud, show it. in terms of greed,
> many many others along the chain profited much much more than the
> rating agencies. bottom line- the mortgage originators new what they
> were selling and lied to the investment banks and the rating agencies
> about what was in there. they take the most blame

2008 Dec 19 08:56 AM

[bondboy:]

This artcle is a good summary of what others have written.

The article's conclusions, however, are both inflammatory and asinine.

Clearly the author has little first hand knowledge of the bond business.

2008 Dec 19 09:02 AM

[Nick Gogerty:]

The ratings agencies are a component in a system that failed. Until the component is fixed, expect more of the same. I think the special designation of the ratings agencies and the attendant restrictions in SEC code that requires only "investment grade companies" should be removed. It is more dangerous to fly a plane falsely relying on broken gauges than no gauges. the only greater danger is when all the pilots fly using faulty guages (ratings). Get rid of the faulty gauges and get back to people doing their own due diligence. The NRSRO monopoly on truth is either going to be broken or we will have another Credit Moment in the future.

2008 Dec 19 11:54 AM

[Moonraker:]

While majority of the population huddle and brace through the tornado lashing out across the industry, at least there seem to be a couple of brave folks like these who have gone into the eye of the Tornade and managed to give us this brilliant insight on the origins of this tornado :)

Brilliant article.

2008 Dec 21 02:57 AM

[roadwarriors57:]

Rating agencies are needed otherwise no one would invest in securities.

So my question is, if rating agencies were not paid by the issuers to rate them then who should pay?

Individual Investors? Brokrage firms?

2008 Dec 23 04:02 PM

[JoePlumber:]

The fix to the problem is obvious to all but the SEC: simply strip the NSNRO requirement, and ratings triggers will begin to dwindle in contracts. Firms in need of credit analysis will need to either do it themselves or pay others to do same, just as is done already in virtually all other areas of security analysis.

2008 Dec 25 09:38 AM