There had long been tension between the corporate bond side of Moody’s and the structured finance side; Clarkson’s ascension signaled that structured finance had won. More than that, the culture of the structured finance side had won. Bond analysts, even in the good old days, regularly faced pressure to issue favorable ratings, but Moody’s had always backed them when they resisted. Not anymore. Soon after Clarkson took charge, Moody’s began making a point of informing its analysts of the company’s market share in various structured products, according to a lawsuit filed in 2010 against Moody’s by the state of Connecticut. If Moody’s missed out on a deal, the credit analyst involved would be asked to explain why. (“Please … advise the reason for any rating discrepancy vis-à-vis our competitors,” read one e-mail.) Michalek, who had a reputation as a stickler, said that Goldman Sachs once requested that he not be assigned to its deals. Gary Witt, the Moody’s executive who took the call from Goldman, later testified that he was told that not complying with its request “would result in a phone call to one of my superiors.”
“When I started there, I don’t think Moody’s managers knew what their market share was,” says one former employee. “By the peak of subprime, there were regular e-mails every time Moody’s didn’t get a deal.” Another former managing director says that Clarkson used to tell people, “We’re in business and we have to pay attention to market share. If you ignore market share, I’ll fire you.”
“When I joined Moody’s in late 1997,” Mark Froeba told investigators, “an analyst’s worst fear was that he would contribute to the assignment of a rating that was wrong, damage Moody’s reputation for getting the answer right and lose his job as a result. When I left Moody’s, an analyst’s worst fear was that he would do something that would allow him to be singled out for jeopardizing Moody’s market share, for impairing Moody’s revenue or for damaging Moody’s relationships with its clients, and lose his job as a result.” (In prepared testimony for the Financial Crisis Inquiry Commission, Clarkson denied that “Moody’s sacrificed ratings quality in an effort to grow market share.”)
Examples:
• In August 1996, after Commercial Mortgage Alert noted that Moody’s share of commercial mortgage-backed securities was just 14 percent—largely because it was being tougher in certain areas than S&P or Fitch—Clarkson responded by saying, “It’s the right time to take a second look.” Moody’s market share soon rose to 32 percent.
• In 2000, Moody’s had 35 percent of the mortgage-backed securities market, according to Asset Backed Alert. By the first half of 2001, it had jumped to 59 percent. Rivals claimed Moody’s had lowered its standards, but Clarkson attributed Moody’s rise to a “reshuffling” of its analysts. Several former Moody’s executives say that analysts weren’t “reshuffled.” They were fired. (Clarkson said that complaints by rivals that Moody’s had lowered its standards were “sour grapes.”)
• Another example: Moody’s was initially more conservative on securitizations in cases where, in addition to the first lien, there was a second-lien mortgage. But that was a problem because S&P had a different, looser standard: it concluded in 2001 that as long as second-lien loans were attached to no more than 20 percent of the mortgages in the pool, it would treat the entire pool as if it didn’t have additional risk. “The other agencies took the same position shortly thereafter,” Richard Bitner, a former subprime lender, later told the Financial Crisis Inquiry Commission. He added, “The rating agencies effectively gave birth to the subprime piggyback mortgage.” Those were subprime mortgages in which the homeowner avoided putting up any cash and got two loans—one for the mortgage itself and another for the down payment.
The great advantage issuers had in seeking triple-A ratings is that they rarely needed all three agencies to be involved in any one deal. Investors liked having two agencies rate a deal, but nobody cared about having all three involved. So issuers could play the agencies off each other. They didn’t really care which rating agencies bestowed the rating. All that mattered was the rating itself. “The triple-A was the brand, not Moody’s,” says a former Moody’s structured finance managing director.
Like everyone else utilizing risk models, the rating agencies used the mathematics of probability theory to arrive at their ratings. A given mortgage-backed deal might contain as many as ten thousand mortgages. As every investor is taught, diversification spreads risk, so one question was, how diversified were the mortgages? If they all came from California, they were less diversified than if some were from California, some from Idaho, and some from Connecticut. The working assumption was if home prices dropped in California, they would remain stable, and even keep rising, in other parts of the country. The Wall Street term for spreading risk this way—and there are more complex variants—is correlation. Correlation is essentially a way of describing, in numerical terms, the likelihood that if one security defaults, others would default in tandem. Zero correlation means that one default would have no effect on anything else in the security; 100 percent correlation means that if one defaults, everything else would, too. The closer the mortgage-backed security came to zero correlation, the greater the percentage of tranches that could be labeled triple-A. Underwriters often added credit enhancements to boost the percentage of triple-A tranches.
One obvious flaw of this approach is that nowhere in the process was anyone required to conduct real-world due diligence about the underlying mortgages. As the SEC later noted, “There is no requirement that a rating agency verify the information contained in RMBS loan portfolios presented to it for rating.” (RMBS stands for residential mortgage-backed security.) A second problem is that the rating agency models were built on a series of assumptions. One assumption was that if housing prices declined, the declines would not be severe. Another was that the housing market in California was indeed uncorrelated with the housing market in Connecticut. And then there was the fact that assumptions could be changed. If the bankers didn’t like the outcome of the analysis, maybe a little rejiggering might be in order.
For instance, UBS banker Robert Morelli, upon hearing that S&P might be revising its RMBS ratings, sent an e-mail to an S&P analyst. “Heard your ratings could be 5 notches back of moddys [sic] equivalent,” he wrote. “Gonna kill your resi biz. May force us to do moodyfitch only …” Internally, the rating agencies had a term for this: ratings shopping. Even Clarkson acknowledged that it took place. “There is a lot of rating shopping that goes on,” he told the Wall Street Journal. Of course, he saw nothing wrong with it. “People shop deals all the time,” he shrugged.
Ratings shopping was a classic example of why Alan Greenspan’s theory of market discipline didn’t work in the real world. The market competition between the rating agencies, which Greenspan assumed would make companies better, actually made them worse. “The only way to get market share was to be easier,” says Jerome Fons, a longtime Moody’s managing director. “It was a race to the bottom.” A former structured finance executive at Moody’s says, “No rating agency could say, ‘We’re going to change and be more conservative.’ You wouldn’t be in business for long if you did that. We all understood that.”
“It turns out ratings quality has surprisingly few friends,” Moody’s chief executive, Raymond McDaniel, told his board in 2007. “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, ratings quality is proving the least powerful.” He added, “In some sectors, it actually penalizes quality by awarding ratings mandates based on the lowest credit enhancement needed for the highest rating.”
Just as LTCM exposed the dangers of derivatives in 1998, there also came an early moment when the failings of the rating agencies were exposed for all to see. The moment was December 2, 2001, the day Enron filed for bankruptcy. Although Enron had been faking a portion of its profits for years—and though it had been in precipitous decline since October, when the outl
ines of its fraudulent practices were first revealed—the rating agencies didn’t downgrade the company’s debt until four days before its collapse. Investors in both Enron’s stock and its bonds lost millions. The Enron bankruptcy—quickly followed by similar debacles at WorldCom, Tyco, and a handful of other companies—became a huge, ongoing news story. And the fact that the rating agencies had failed to sniff out any of them was a big part of the scandal narrative.
Government investigators put together thick reports about the failings of the agencies. The rating agencies were excoriated in congressional hearings. Senator Joseph Lieberman said they were “dismally lax” in their coverage of Enron. At one hearing, the S&P analyst who had covered Enron confessed that he hadn’t even read some of the company’s financial filings. There was a strong sense that something was going to be done to reform the rating agencies.
Perhaps to appease Washington—and fend off regulation—Moody’s agreed to adopt a code of conduct. Among other things, the code stated that “the determination of a credit rating will be influenced only by factors relevant to the credit assessment.” It also stated that “The credit rating Moody’s assigns … will not be affected by the existence of, or potential for, a business relationship between Moody’s and the issuer.”
In its lawsuit, the state of Connecticut alleged that shortly after Moody’s unveiled its code of conduct, two experienced compliance officers were fired and replaced by employees from the structured finance department. The head of the department later complained, “My guidance was routinely ignored if that guidance meant making less money.” Investigators also allege that during a dinner party after a board meeting, the president of Moody’s walked by the head of compliance and said, quite loudly, “Hey … how much revenue did Compliance bring in this year?”
In other words, nothing changed. Not a single analyst at either Moody’s or S&P lost his job as a result of missing the Enron fraud. Management stayed the same. Moody’s stock price, after a brief tumble, began rising again. The ratings remained embedded in all the rules and regulations. The conflict-ridden business model didn’t change. “Enron taught them how small the consequences of a bad reputation were,” says one former analyst.
The dirty little secret was that nobody really wanted to reform the rating agencies. Investment bankers needed to be able to continue gulling, cajoling, and browbeating the agencies into handing out triple-A ratings. Investors wanted to be able to rely on ratings instead of having to do their own research. Regulators found that in devising rules about risk taking, using ratings was the easiest path.
“Most of the big investors—they like ratings to be scapegoats,” says Jerome Fons. “They say, ‘Oh, we do our own analysis,’ but then when things go bad—well, it’s the fault of the credit rating agencies.” Or as Clarkson later ranted to other Moody’s executives during an internal meeting in the fall of 2007, “It’s perfect to be able to blame us for everything…. By blaming us, you don’t have to blame anybody else.”
Of all the securities whose existence depended on their ability to get a triple-A rating, none would become more pervasive—or do more damage—than collateralized debt obligations, or CDOs. CDOs, which had first been invented in the late 1980s but didn’t become wildly popular until the 2000s, were a kind of asset-backed securities on steroids. A CDO is a collection of just about anything that generates yield—bank loans, junk bonds, emerging market debt, you name it. The higher the yield, the better. Just as with a typical mortgage-backed security, the rating agencies would run the CDO’s tranches through their models and declare a large percentage of them triple-A. There would also be a triple-B or triple-B-minus slice, which was called the mezzanine portion, as well as an unrated equity tranche, which got paid only after everyone else had collected their returns. One astonishing fact is that the CDO managers didn’t always have to disclose what the securities contained because those contents could change. Even more astonishing, investors didn’t seem to care. They would buy CDOs knowing only the broad outline of the loans they contained. So why were they willing to do so? Because the way they viewed it, they weren’t so much buying a security. They were buying a triple-A rating. That’s why the triple-A was so key.
Like so many of the other financial products bursting onto the scene, CDOs weren’t necessarily a bad idea. Done correctly, they could give investors broad exposure to different kinds of fixed-income assets at whatever level of risk they desired. But CDOs were fraught with risks and conflicts. Debt was being used to buy debt. CDO managers were paid a percentage of the money in the CDO, meaning they had an incentive to find stuff to buy—good, bad, or indifferent. Wall Street firms, who usually worked hand in glove with the managers, could earn hefty fees. According to one hedge fund manager who became a big investor in CDOs, as much as 40 to 50 percent of the cash flow generated by the assets in a CDO went to pay the bankers, the CDO manager, the rating agencies, and others who took out fees.
What’s more, CDOs could also give banks and Wall Street securities firms both the means and the motive to move their worst assets off their balance sheets and into a CDO instead. And since the rating agencies could be counted on to rate a big chunk of the CDO triple-A, nobody would be the wiser.
Is it a surprise to learn that just as the rating agencies had failed to sniff out Enron and WorldCom, they also drastically misjudged the first batch of CDOs? Perhaps not. Sure enough, in 2002 and 2003 the rating agencies were forced to downgrade hundreds of CDOs—in no small part because they contained the bonds of certain companies the agencies had also woefully misjudged. A handful of investors sued the CDO managers and the firms that had underwritten them. But because the CDO issuance was still small, neither the lawsuits nor the losses made headlines. For a short while, CDO volume declined.
And how did Wall Street respond? By devising a new type of CDO, one that would be backed not by corporate loans, but by mortgage-backed securities. The idea, says one person who was prominent in the CDO business, was that the original rationale for CDOs—loan diversification—had proven to be flawed. But if you bought real estate, he said, “you were golden. You were safe.”
There were a few critical differences between CDOs composed of securitized mortgages and CDOs composed of corporate loans. The former contained not two but three levels of debt. Instead of “merely” using debt to buy the debt of a company, CDOs were using debt to buy the debt from a pool of mortgages, which was itself homeowner’s debt. A second critical difference was that bonds backed by mortgages generally had higher yields than similarly rated corporate bonds. Defenders of mortgage-backed securities tended to explain away this anomaly, once again, by claiming that investors didn’t understand mortgage-backed bonds as well as corporate bonds, and thus demanded a higher yield for what was really a very safe asset. And to be sure, that was one possibility. Another possibility, though, was that the market understood quite well that mortgage-backed securities were riskier than corporate bonds and was compensating by insisting on a higher yield.
Wall Street didn’t really care which explanation was correct. All it cared about was that it had discovered an anomaly it could take advantage of. And, oh, did it ever. Firms bought mortgage-backed bonds with the very highest yields they could find and reassembled them into new CDOs. The original bonds didn’t even have to be triple-A! They could be lower-rated securities that once reassembled into a new CDO would wind up with as much as 70 percent of the tranches rated triple-A. Ratings arbitrage, Wall Street called this practice. A more accurate term would have been ratings laundering.
Soon, CDO managers were buying the lowest investment-grade tranches of mortgage-backed securities they could find and then putting them in new CDOs. Once this started to happen, CDOs became a self-perpetuating machine, like cells that won’t stop dividing. From the very beginnings of the mortgage-backed securities business, marketers had always had to work hard to find enough investors to buy the lower-rated tranches. The triple-As were easy to sell because investors around
the globe that were legally confined to conservative investments, or didn’t want to hold the capital against a higher-risk investment, embraced their higher yield relative to their super-safe rating. The triple-B and -B-minus tranches were a harder sell, with a much smaller universe of potential investors. But once the CDO machinery itself became the buyer of the triple-Bs, there were suddenly no limits to how big the business could get. CDOs could absorb an infinite supply of triple-B-rated bonds and then repackage them into triple-A securities. Which everybody could then buy—banks and pension funds included. It really was alchemy, though of a deeply perverse sort.
In time, CDOs became by far the biggest buyers of triple-B tranches of mortgage-backed securities, purchasing and reassembling an astonishing 85 to 95 percent of them at the peak, according to a presentation by Karan P. S. Chabba, Bear Stearns’s structured credit strategist. Among other consequences, this practice helped perpetuate the worst, most dangerous securities, because they were the ones that had the highest yield relative to their rating. One Wall Street executive would later liken CDOs to “purifying uranium until you get to the stuff that’s the most toxic.”
Lang Gibson, a former Merrill Lynch CDO research analyst, wrote a novel after the crisis in which a character describes the CDO market as a Ponzi scheme. You can see his point. As the triple-Bs were endlessly recycled, CDOs begat CDO squareds (in which triple-B portions of CDOs were reassembled into a new CDO) and even CDO cubeds (reassembed triple-B tranches of CDO squareds). The rise of ratings arbitrage helped push sales of CDOs from $69 billion in 2000 to around $500 billion in 2006. It was an endless cycle of madness.
All the Devils Are Here Page 17
