Who should we blame for the credit crunch and the subsequent worldwide recession? The banks, obviously, as well as absent financial regulators. Equally culpable were the big three credit rating agencies: Moody’s, Standard & Poor’s and Fitch.
They had a mandate to provide investors with objective and trustworthy guidance. The whole financial system hinged on the accuracy of their appraisals.
The housing boom over the past decade led to the issue of billions of dollars in mortgage-related securities. The rating agencies awarded a lot of these products – many of them extremely complex credit derivatives – high investment-grade ratings.
As a result, they permeated the entire financial industry. But in the second half of 2007 the agencies came clean: hundreds of billions of dollars’ worth of this debt had been misrated. To make matters worse a lot had been graded triple-A, the gold standard, when in reality they were close to junk. How did this happen? Why did these vital financial gatekeepers get it so wrong?
Conservative roots
At the start of the twentieth century John Moody, a former journalist with an entrepreneurial streak, saw a gap in the finance market. Investors too often bought on trust because they were in the dark about credit quality. Moody set about publishing information on stocks and bonds to help them.
His analysis of the debt markets proved particularly popular and in 1914 Moody’s Investors Service was born. Moody was an outspoken advocate
of investors’ rights and wrote books calling for greater transparency in the financial system.
The business grew but Moody’s maintained its founder’s hawkish devotion to accuracy and steadfast focus on investors’ long-term interests. It was renowned for erring on the side of caution when assessing risk and turned work down if it didn’t meet its lofty standards. If anything, the institution saw itself as a public servant.
Moody’s and Standard & Poor’s – among the handful of agencies approved by the SEC – grew to dominate the bond rating market. By the 1970s the financial sector had become more complex, increasing the agencies’ costs, so they began charging issuers as well as investors for rating services. But this shift laid the foundations for the conflicts of interest that would later undermine the rating agencies’ integrity. It was, in the words of one industry expert, “like cattle ranchers paying the Department of Agriculture to rate the quality and safety of their beef.”
The fact that the major financial institutions only trusted Moody’s and S&P to rate significant issues was propitious: most deals required two ratings. “We had no competition and a steady stream of work,” recalls a senior ex-Moody’s managing director. “It was perfect. I used to think to myself ‘there’s no way we can screw this up’.”
In the mid-1990s this duopoly was broken by the emergence of Fitch. An injection of private equity investment had propelled Fitch, previously a minor player, into becoming a serious rival.
Moody’s were still keeping to the judicious values of their founder. Under corporate chief Tom McGuire, an erudite ex-Jesuit priest, Moody’s culture mirrored its scholarly and aloof leader. Analysts were ill disposed to entering into dialogue with bankers and didn’t return calls.
But the entrance of Fitch had turned the market on its head. Keen to expand its market share, Fitch was happy to co-operate with issuers’ needs. This shift, in turn, encouraged S&P to be more accommodating. In contrast, issuers saw Moody’s as arrogant and inflexible and it began to lag behind the competition. In 1996, Fitch and S&P rated five times more commercial mortgage-backed securities’ deals than Moody’s.
Moody’s brought in a management consultant to try and fix its woes, and in the resultant shake-up, Tom McGuire departed along with other top people.
This created an opening for a clutch of senior players within Moody’s who argued it should pursue a more profit-focused direction. The company, they figured, possessed a first-rate brand and, in times of plenty, should cash in.
Business development chief John Rutherfurd – who became president in 1998 – pushed this bottom line-focused view. The advocates for change argued that Moody’s should develop more amicable relations with Wall Street and increase the number of deals it rated.
The management of the company was gradually wrestled away from older staffers who clung to its former values; the new guard’s victory was sealed in September 2000 when it took the company public.
Moody’s now faced short-term pressures to demonstrate earnings growth.
Moody’s dialogue with Wall Street improved. But this exchange of information gradually became a negotiation as the last vestiges of Moody’s old culture were broken down. It became normal in structured finance deals for analysts to tell issuers what they needed to reach investment grade, and analysts grew accustomed to tweaking the requirements on a deal a little to keep a banker happy.
The banks began playing the rating agencies off one another and shopping around to see who would rate an issue more favourably. Former Moody’s Asia structured finance chief Ann Rutledge explains: “An analyst would help the
banker that was issuing the debt by relaxing the constraints on the deal a tiny bit. But the impact on the rating could be huge.”
The effect, as the big three agencies fought to hold onto market share, was that thousands of deals were put together with costly levels of investor protection reduced. This corner cutting was exposed when the wheels came off the US housing market, sparking hundreds of billions of dollars’ worth of losses on under-collateralised debt.
The drive for market share
If there was one person who revolutionised Moody’s culture – and ultimately dragged it over the precipice – it was former president Brian Clarkson.
An ex-lawyer, Clarkson joined Moody’s in the early 1990s as an analyst and rose though the ranks. In the mid-90s he was appointed co-head of the structured finance division and within a few years had assumed total command. This was a time when structured finance grew from one fifth
of Moody’s revenues to become its biggest source of income. Clarkson was so instrumental in raising Moody’s profits that, in 2007, he was made company president.
Clarkson, however, was not a typical Moody’s staffer. He’d grown up in rural Michigan and had done a stint in the army. In his youth he boxed at amateur level and in his spare time he lifted weights. He was renowned for his confrontational and aggressive personality. “Brian Clarkson was the most competitive and driven person I have ever met,” recalls a former Moody’s vice resident. “He would not lose.”
Clarkson rejected many of Moody’s conservative traditions. Analysts were actively encouraged to communicate with issuers and much of the old bureaucracy was swept away. He hated turning deals down. “Clarkson cut through the old narrow-mindedness,” says former Moody’s analyst
Sylvain Raynes. “He found ways to rate deals that Moody’s would ordinarily have said no to. The company’s revenues shot up because of his changes.”
Clarkson wanted Moody’s to dominate every area of the market. In the late 1990s, it rated less than 50% of all residential mortgage-backed securities issues. For the ultra-competitive Clarkson this wasn’t good enough.
But if Moody’s wanted to ramp up its share, it would have to lower its standards. It lagged Fitch and S&P in the residential mortgage area because it required issuers to put in more credit enhancements.
In a deal an issuer is required to take steps – known as credit enhancements – to ensure senior investors are protected in the event of default.
These steps might include putting aside cash collateral or creating a third-party guarantee. Moody’s, in keeping with its lofty standards and conservative traditions, had required sizeable enhancements to guarantee investor security.
But the bigger the enhancement the greater the cost to the issuing bank.
It would look suspicious, of course, if Moody’s simply lowered its enhancement specifications overnight, so in the summer of 1997 a
young analyst was asked to undertake a loan-by loan study of previous mortgage pools to see if Moody’s could tweak its requirements. It could then justify lowering its enhancement levels. The analyst was promised a promotion if he succeeded.
The new model was launched and Moody’s market share shot up. By the early 2000s it was rating more than 75% of all residential mortgage-backed securities issues. It rated 91.8% in 2006, according to the Inside Mortgage Finance MBS Database.
Another example of Moody’s relaxed standards occurred between 2005 and 2007. Mortgage giant Countrywide Financial complained to Moody’s senior management that it had received a rating it viewed as too harsh. Moody’s responded by reconvening a rating committee and the enhancement was altered to satisfy Countrywide’s management. “This happened two or three times,” says a former Moody’s analyst.
A third example: in the late-90s a $140 million structured finance transaction for a Miami-based company freight company sought to securitise the cash flow on the long-term leases of 14 aeroplanes.
Unfortunately the numbers didn’t work. The notes backed by the leases only rated as triple-C, or non-investment grade. This meant the deal could not fly.
To resurrect the transaction, the triple-C ratings would have to be raised to triple-B. “A leap, in order of magnitude, equivalent to turning a Robin Reliant into a BMW,” recalls former Moody's analyst Sylvain Raynes who worked closely on the deal.
To get around the problem, Moody’s extended the predicted useful life of the 14 planes from the normal 25 years to 30 years to generate more cash flow. “In the normal chain of events, such a significant change would have had to pass through rigorous processes, but that did not happen,” says Raynes. “Moody's simply redefined the longevity of an aeroplane to generate the right rating.”
For a while, Moody’s shift in direction paid handsome dividends. Its share price quadrupled in five years, driven by soaring revenues in Clarkson’s structured finance division. By 2007 structured finance accounted for 53% of
Moody’s turnover compared with 28% in 1998. Moody’s total revenues topped $2.3 billion.
Overstepping the mark
This shift in standards might have mattered little if it had only affected the shelf life of a few aeroplanes. But, from 2002 onwards, structured finance witnessed the rapid rise of the collateralised debt obligation. By 2006 CDO issues topped half a trillion dollars. CDOs’ opaque methodology took already
sliced-up bonds and sliced them up further into new tranches based on risk and return. This meant certain tranches could be rated triple-A despite the fact that lots of sub-prime mortgages had been squeezed into the overall package.
Moody’s, however, overlooked some of the inherent risks. There was little data about how sub-prime mortgages would perform over the medium term and its models did not allow for a sharp fall in home prices. “The deals got so complex that they were difficult to analyse,” admits John Speaks, former senior credit officer at Moody’s. “We didn’t have the backbone to admit to issuers that we had no track record on something and we didn’t know what would happen.”
By 2007 Moody’s dominated the CDO market, rating 94% of issues. But the following year it downgraded 90% of all asset-backed CDO investments issued in 2006 and 2007, including 85% of the debt originally rated triple-A.
“In a CDO simulation it got to the point where analysts were just throwing different potential losses on the underlying collateral,” continues Speaks. “The deals got so complicated that if we hadn’t stretched the limits, the deals would not have got done. “In hindsight you can make the argument that many of those deals should not have been done. We went too far.”
Systemic problems
Moody’s was not the only one guilty of putting a short-term focus on profits ahead of investors’ long-term interests. In the early 2000s, analysts at Standard & Poor’s developed a sophisticated new model – taking in a much larger amount of loan-by-loan data – to determine how many new mortgage-backed derivative products might perform.
But its implementation would have cost more than $1 million plus additional staffing costs. S&P’s management baulked. “It would have provided earlier warnings about the problematic performance of many of the new products
that subsequently led to such huge losses,” says Frank Raiter, former mortgage-backed securities chief at S&P. “But the company’s main focus was on generating profits.”
As for Moody’s, it denies any wrongdoing. It responded to our two-page list of questions with this brief statement: “Moody’s does not take commercial considerations into account when developing our methodologies or assigning a rating. Our ratings process is rigorous, disciplined and transparent – we have long disclosed publicly the methodologies on which we base our ratings, and our adherence to those methodologies on any given security can be assessed by market participants.”
Brian Clarkson was among a number of senior departures in the summer of 2008, as the financial crisis worsened. He did not reply to repeated voicemails requesting comment for this article.
The new administration in Washington has vowed to address the ratings system. High on the agenda is tackling the conflicts of interest that result from the agencies being paid by the issuers of the debt.
The SEC has already moved to prohibit agency executives providing both ratings and advice on how to structure securities. The EU meanwhile has announced its intention to directly regulate ratings agencies for the first time. Other countries have vowed to set up independent domestic agencies to reduce reliance on the big three.
It’s clear that the days are past when Moody’s boasted a $20 billion market cap and had profit margins in excess of 50%. “I think their franchise is over,” says former Asia structured finance head Ann Rutledge. “The rating agencies served a very important function in capital markets, but by failing to keep their discipline they sowed the seeds of their own destruction.”