Tuesday, March 31, 2009

Rating Agencies: Moody’s, S&P, and Fitch


Structured financial products, from RMBS to CDOs, lay at the heart of the global credit and financial meltdown. The process of creating, rating and selling this paper is complex. As we have learned after the fact, the rating agencies were not (as they claim) passive participants who just happened to misunderestimate the likelihood of future defaults. Rather, when they placed precious triple-A ratings on all sorts of mortgage-backed and related securities, they were active participants — collaborators, according to The Wall Street Journal:

“Helping spur the boom was a less-recognized role of the rating companies: their collaboration, behind the scenes, with the underwriters that were putting those securities together. Underwriters don’t just assemble a security out of home loans and ship it off to the credit raters to see what grade it gets. Instead, they work with rating companies while designing a mortgage bond or other security, making sure it gets high-enough ratings to be marketable.” 1

Jesse Eisinger of Portfolio was the first mainstream reporter to call the ratings agencies out in a substantive way. He noted that this collaboration, not surprisingly, led to “benign ratings of securities based on subprime mortgages.”2 Not only did the initial ratings prove to be too generous, the agencies were much too slow in downgrading housing-related bonds when mortgage defaults and foreclosures started to rise.

The paper that eventually collapsed found its way onto the balance sheets of many banks, funds and other firms. Had “the securities initially received the risky ratings” they deserved (and many now carry) the various pension funds, trusts, and mutual funds that now own them “would have been barred by their own rules from buying them.” 3

Nobel laureate Joseph Stiglitz, economics professor at Columbia University in New York observed:

“I view the ratings agencies as one of the key culprits. They were the party that performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.” 4

This error in judgment — placing AAA ratings on subprime-based loans and the structured products built on top of them — wasn’t merely the function of bad ratings judgment; rather, it was a conscious business decision. The Journal noted that rating agency fees were twice as big on subprime paper vs. prime-based loans. 5 Bloomberg estimated that from 2002 to 2007, the agencies garnered fees on $3.2 trillion in subprime-based mortgages and, yet, regulators found that Moody’s and S&P didn’t have enough people and didn’t adequately monitor the thousands of fixed-income securities they were grading. 6

In 2008, the House Oversight Committee opened a probe into the role of the bond-ratings agencies in the credit crisis and Congress held a hearing on the subject, featuring a now infamous instant message exchange: “We rate every deal,” one S&P analyst told another who dared to question the validity of the ratings process. “It could be structured by cows and we would rate it.” 7

While it was the investment banks that sold the junk paper, it was the rating agencies that tarted up the bonds. It was the equivalent of putting lipstick on a pig: This paper could never have danced its way onto the laps of so many drooling buyers without the rating agencies’ imprimatur of triple-A respectability.

Yet considering the massive damage they are directly responsible for, the rating agencies have all escaped relatively unscathed. Given their key role in the crisis — were they corrupt or incompetent or both? — one might have thought an Arthur Anderson-like demise was a distinct possibility. Warren Buffett should consider himself lucky — he is Moody’s biggest shareholder, and is fortunate the scandal hasn’t tarnished his reputation.

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