When I met Warren for the first time, I gave him a copy of another book that I had written, Collateralized Debt Obligations & Structured Finance (2003). It is a study of structured financial products in which I criticized holes so big in the rating agencies’ methodology that you can drive a semi through them. In particular, I highlighted serious problems with inflated AAA ratings in securitizations that have inherent structural flaws, problems with supposedly investment grade rated collateral, and conflicts of interest that hold investors’ capital hostage to the self-interest of “managers” and investment banks. Those conflicts of interest often result in substantial principal losses to investors, and the risk is not captured in the ratings. Cash flows held hostage to managers’ conflicts of interest result in investment casualties.
Investors should act like the Israeli Defense Force when rescuing hostages taken in an airplane hijacking to Entebbe—move fast, minimize hostage casualties, and never let it happen again. Unfortunately, instead of taking measures to correct these flaws, the rating agencies seemed to brush aside my concerns and ramped up their flawed structured products ratings business.
As Warren points out, everyone makes mistakes. I have found that most people will forgive you anything if there was no evil intent.You acknowledge the error and apologize, correct the error, if possible, and make a commitment to change. Forgiveness comes easier if you did not—inadvertently or otherwise—cause them to lose a pile of money, or harm their children by, say, losing a pile of money intended for their benefit.This works as well in finance as it does in daily life.
The rating agencies seem not to care about the market’s forgiveness since not only have they not apologized—a necessary, but not a sufficient condition—they seem to feel the market should change. Specifically, the market should change its point of view about what it expects from the rating agencies.Yet it seems that the market has the right to expect rating agencies to follow basic principles of statistics.
This tactic has mainly been successful because the rating agencies act as a cartel, leveraging their joint power to have fees magically converge and have ratings so similar that they have each participated in overrating AAA structured products backed by dodgy loans in 2007 that took substantial principal losses. Meanwhile, many market professionals, including me, pointed out in print that the AAA ratings were meaningless. The rating agencies presented a fairly united front in defending their methods (except for Fitch, which also participated in overrated CDOs and later seemed more responsive in downgrading structured products).
Furthermore, many investors have charters that require them to only buy products that have been rated by one or more of the top three rating agencies: Moody’s Corporation (Warren’s Berkshire Hathaway is a large minority investor); Standard & Poor’s (S&P), part of McGraw-Hill Cos., Inc.; and Fitch, owned by France-based Fimalac SA. “Ma and Pa” retail investors found that AAA product ended up in their pension funds and mutual funds because their money managers gave too much credence to an AAA rating.
Of the three rating agencies, Fitch has the smallest market share, but it has unique style. Fimalac’s chairman, Marc Ladreit de Lacharriere, and Veronique Morali, the chief operating officer, obeyed French disclosure requirements when she was paid a bonus of 8.7 million euros (around $9.94 million at the time) without board or compensation committee approval. According to the Financial Times, when the bonus was discovered in June 2003, the couple lived together, Fimalac’s finances were tight, and Mr. de Lacharriere had pledged 40 percent of his Fimalac shares as collateral to banks. Upon learning the news, a Fimalac director was more than a little concerned: “I said to myself, ‘Oh no, not this.’ . . . In the U.S. or UK, this would be very serious indeed.”3 “From a legal point of view,” said Ladreit de Lacharriere, “we have been meticulously correct.”4 In contrast,Warren Buffett suggested to his All-Stars that they should “start with what is legal, but always go on to what we would feel comfortable about being printed on the front page of our local paper.”5 I have to admit, though, French perfume on the “odor of impropriety”6 makes for entertaining reading.
Most of the market is dominated by Moody’s and Standard & Poor’s, especially the U.S. market, where these two U.S.-based rating agencies have been entrenched and have most of the historical data.
Moody’s awards a rating based on its estimate of expected loss, a single piece of information, and assigns a rating based on the safest (least expected loss) to the riskiest (highest expected loss): Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C. Anything above Baa3 is considered investment grade, and anything below that is considered speculative grade. Standard & Poor’s awards ratings based on default probabilities and label products AAA, AA+, AA, AA-, and so on. Fitch uses the same labels. As with Moody’s, anything above BBB- is considered investment grade and anything below is considered speculative grade. I’ll use AAA to denote the highest rating, but will specifically name Moody’s (which uses the Aaa notation) when I am making a point specific to them.
Since many money managers cannot buy bonds that are not rated investment grade, and since some are required to sell bonds that fall below investment grade, ratings have a huge impact. This is why when Moody’s admitted that impairment rates show no difference in performance between CDO tranches with a junk rating of BB- and an investment grade rating of BBB, it should have been headline financial news. It was not.7 Moody’s, Standard and Poor’s, and Fitch have an NRSRO designation, meaning they are “Nationally Recognized Statistical Rating Organizations.” Yet, when they rate many securitizations, particularly mortgage-loan-backed securitizations, they fail to follow basic statistical principles.
Statistics is the mathematical study of the probability and likelihood of events. Known information can be taken into account, and likelihoods and probabilities are inferred by taking a statistical sampling.The designation sounds impressive, but the rating agencies do not live up to it.
The rating agencies problems run deep. In late 2003, the Financial Times took rating agencies to task for misrating debt issued by scandal-ridden Parmalat, Enron, and WorldCom. Fitch protested that “credit ratings bring greater transparency.”8 Standard & Poor’s retorted that “rating agencies are not auditors or investigators and are not empowered or able to unearth fraud.”9
I responded that investors would be foolish to believe rating agencies provide greater transparency for structured financial products. In fact, the opposite is true. Investors relying on ratings to indicate structured products’ performance are consistently disappointed in a variety of securitizations. S&P downgraded Hollywood Funding’s deals backed by movie receipts from AAA, the highest credit rating possible, to BB, a noninvestment grade rating. Bond insurers raised fraud as a defense against payment, and S&P had thought payment was unconditional.10
Warren does not rely on the rating agencies since his fundamental analysis of a business’s value is superior to anything the rating agencies are doing. If you understand the value of a business, you do not need to rely on a rating agency.
If everyone followed this guideline, the global credit meltdown could have been avoided. In fact, the rating agencies had warning of the need for change through a series of similar mishaps in the past. In 1998, they downgraded around $2 billion in securitizations backed by charged-off credit card receivables managed by Commercial Financial Services. Ratings went from investment grade to junk overnight. Rating agency failures cropped up again in subsequent years with respect to securitizations by Parmalat, manufactured housing loans, metals receivables, furniture receivables, subprime, and more.
When rating agencies make mistakes in securitizations backed by debt, the losses tend to be permanent and unfixable. The sole source of income is the portfolio of assets. If you fail to understand the risk of the assets, you have blown the entire job.
Unlike Warren, the rating agencies failed to drill down and examine whether the assets could generate the cash to pay b
ack investors.
Rating agencies correctly point out that deal sponsors and investment bank underwriters are responsible for due diligence. Although the rating agencies do not perform due diligence for investors, they can demand evidence that proper due diligence has been performed before attempting to apply their respective ratings methodologies. In fact, it is not possible to perform a sound statistical analysis without it.
In the mortgage loan securitization market, a statistical sampling of the underlying mortgage loans should verify: integrity of the documentation, the identity of the borrower, the appraisal of the property, the borrower’s ability to repay the loan, and so on. Rating agencies should take reasonable steps to understand the character of the risk they are modeling.Yet, they seemingly rated risky deals without demanding evidence of thorough due diligence.
When rating agencies use old data for obviously new risks, it is financial astrology. When rating agencies guess at AAA ratings (without the data to back it up), it is financial alchemy.When rating agencies evaluate no-name CDO managers without asking for thorough background checks, it is financial phrenology. In other words, the rating agencies practice junk science.The result is that junk sometimes gets a AAA rating.
Since the rating agencies are effectively a cartel, investors do not have an alternative to this flawed system other than to do their own fundamental credit analysis. Like Warren Buffett, they should understand the investment.
The rating agencies are swift to point out that they do not perform due diligence on the data they use and take no responsibility for unearthing fraud; they merely provide an opinion. In past legal battles, rating agencies successfully claimed journalist-like privileges, refused to turn over notes of their analyses, and continued to issue opinions. Independent organizations exist, however, that perform rigorous due diligence for a fee. Underwriters can hire them, and rating agencies can demand to see the results.Yet it seems the rating agencies failed to do so for many structured finance transactions.The rating agencies protest they are misunderstood rather than miscalculating when it comes to rating structured products.They claim the market misapplies ratings by expecting ratings to indicate market price and liquidity, but the former are merely symptoms of the real problem. They take data at face value, slap a rating on a dodgy securitization, and pocket a fat fee.
The Bank for International Settlements (BIS) and the Federal Reserve (Fed) may have embraced the rating agencies because these institutions are chiefly made up of economists. The Securities and Exchange Commission is loaded with lawyers. I do not expect lawyers to be rigorous in their analysis, but I expect more of the BIS and the Fed. While there is such a thing as “junk economics,” economics itself is not considered a science. Even so, just because lack of rigor permeates economics, economists should not be allowed to let this seep into other fields, particularly when there is a scientific methodology that can be used as a basis. When they adopted the rating agencies labels as benchmarks, the BIS, Fed, and SEC enabled junk science.
Although they shouldn’t, many investors rely on the rating and the coupon when buying structured financial products. Whereas Warren views an investment like a business, many investors view their jobs as getting an investment meeting consensus. That is similar to allowing the manic-depressive Mr. Market to tell you the right price. If you do not understand the value, neither Mr. Market’s prices nor (sadly) the rating agencies will help you understand the value of a structured product any better. Many money managers feel buying a AAA investment is prudent; but if they do not understand these complex deals, they can quickly lose a chunk of principal.
Problems are not limited to mortgage loan securitizations. Ratings on leveraged synthetic credit products are often misleading, too. For example, when the products first appeared, I pointed out the triple A rating should never have been awarded to constant proportion debt obligations (CPDOs). These products are largely leveraged bets on the credit quality and market spreads of indexes based on U.S. and European investment-grade companies.
The high leverage of the products related to market risk puts investors’ principal at risk. Investors essentially take the risk of the first losses on leveraged exposure to the indexes, and that is the exact opposite strategy to Warren’s margin of safety. “Once again,” I told the Financial Times in November 2006, “the rating agencies have proved that when it comes to some structured credit products, a rating is meaningless. All AAAs are not created equal, and this is a prime example.”11
After rating an early CPDO transaction triple A, Moody’s was criticized by industry professionals, including me. Moody’s then changed its rating methodology, applying a different standard for subsequent transactions.12 Investors were attracted by the AAA rating and the high coupons. The investment banks selling them were attracted to upfront fees of 1 percent plus annual servicing fees of up to 0.1 percent.
I thought the rating agencies may have been turning over staff too quickly and using incompetent rookies—who could be pushed around by aggressive highly paid investment bankers—to rate these deals. In May 2007, the Financial Times put Moody’s actions in the harsh glare of a newly angled spotlight. It said Moody’s original AAA ratings for CPDO were the result of a computer “bug,” and the ratings should have been (according to Moody’s) four notches lower. Fur flew. A friend joked: Don’t they mean forty?
Moody’s documents showed that after it corrected the “bug,” it changed its methodology, resulting in the ratings staying AAA until January 2008, when the market fell apart and the original ratings seemed ludicrous.The CPDOs were downgraded several notches.
The part about Moody’s changing its methodology was not news to me. I had included that information in a letter to the SEC on proposed regulations in February 2007, and I specifically objected to the AAA rating on this product. I do not even recall who told me about the change. If it was a secret, it was an open secret. All three rating agencies’ models have more patches than Microsoft software.
The news is that the AAA rating seemed to be due to something more than a serious disagreement with my opinion. Moody’s internal memo said that the bug’s impact had been reduced after “improvements in the model.”13 This suggests that there may be a cause and effect—the inconvenient lower ratings may have been masked by the methodology change. Chairman of the House Financial Services Committee, Barney Frank, said: “Moody’s alleged conduct in this matter raises questions not only about its competence, but more importantly its integrity.”14
By January 2008, just under a year after my written comments to the SEC, Moody’s analysts wrote that two of the originally AAA rated CPDOs would “unwind at an approximate 90 percent loss to investors.”15 The CPDOs were projected to have a 90 percent loss from the rating agency that claims its AAA rating is based on expected loss.
Standard & Poor’s had also rated CPDOs AAA. In fact, it was the first to do so, and Moody’s followed suit. S&P vigorously defended their ratings methodology, even after it downgraded CPDOs. In the wake of the negative news, it put Moody’s commercial paper on credit watch. S&P later disclosed that it too found an error in its computer models, but said: “This error did not result in a ratings change and was caught and remedied by our ratings process.”16 Now we all feel better.
In February 2007, Bear Stearns research analyst Gyan Sinha wrote a report encouraging investors to take a long position in the ABX.HE.06-2 BBB- index (an index based on the value of BBB- rated residential mortgage-backed securities backed by subprime home equity loans).17 Simultaneously, I wrote a letter to the SEC recommending it revoke the NRSRO designation for the credit rating agencies with respect to structured financial products, asserting “ratings are based on smoke and mirrors.”18
On February 20, 2007, Gyan Sinha appeared on CNBC with Susan Bies, a Fed governor who had recently tendered her resignation. Bies thought it could take a year or two for housing inventory to be worked out, and housing had further to fall. She was concerned that hidden inventory was high, houses
built for investors were vacant, and the numbers did not reflect the problem. She was surprised that subprime mortgages originated in 2006 had gone bad so quickly. It usually took a couple of years for loan delinquencies and defaults to peak, but 2006 vintage loans were delinquent in just a few months. It seemed to her that loans were made that never should have been made. She echoed Warren Buffett’s 2002 complaint about mortgage lenders in the manufactured housing market.
Gyan Sinha agreed with Susan Bies’s assertion that subprime delinquencies could reach 20 percent or a bit higher. He too was concerned about the early delinquency trends, but said that based on his research, at 6 to 7 percent cumulative losses, only 1 of the 20 residential mortgage-backed securities in the ABX index would experience a write-down. Furthermore, he stressed that 75 percent of the capital structure of a CDO is AAA rated.19
It seemed to me Sinha only had part of the story. He did not mention that ersatz AAA rated tranches did not deserve that rating, or that prices of AAA rated tranches in the secondary market were trading at discounts among savvy investors. I projected a 21 percent cumulative loss rate for first-lien mortgage loans, and the ABX included home equity lines of credit and second liens, so losses would hit the loans backing the ABX much harder than that. Based on my projections, the ABX index would plummet.
Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street Page 14
