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.

~~~~

Sources:

1. How Rating Firms’ Calls Fueled Subprime Mess
AARON LUCCHETTI and SERENA NG
WSJ, AUGUST 15, 2007

http://online.wsj.com/article/SB118714461352698015.html

2. Overrated
Jesse Eisinger
Portfolio, September 2007

http://www.portfolio.com/news-markets/national-news/portfolio/2007/08/13/Moody-Ratings-Fiasco

3. How Rating Firms’ Calls Fueled Subprime Mess

4. Bringing Down Wall Street as Ratings Let Loose Subprime Scourge (PART I)
Elliot Blair Smith
Bloomberg, Sept. 24 2008

http://www.bloomberg.com/apps/news?pid=20601109&sid=ah839IWTLP9s&#

5. As Housing Boomed, Moody’s Opened Up
AARON LUCCHETTI
WSJ, APRIL 11, 2008

http://online.wsj.com/article/SB120787287341306591.html

6. Bringing Down Wall Street as Ratings Let Loose Subprime Scourge (PART I)

7. TESTIMONY OF DEVEN SHARMA, PRESIDENT, STANDARD & POOR’S
BEFORE THE COMMITTEE ON OVERSIGHT AND GOVERNMENT REFORM UNITED STATES HOUSE OF REPRESENTATIVES
OCTOBER 22, 2008

http://oversight.house.gov/documents/20081022125052.pdf

ADDITIONAL BACKGROUND

Triple A Failure
ROGER LOWENSTEIN
NYT, April 27, 2008

http://www.nytimes.com/2008/04/27/magazine/27Credit-t.html

‘Race to Bottom’ at Moody’s, S&P Secured Subprime’s Boom, Bust (PART II)
Elliot Blair Smith
Bloomberg, Sept. 25 2008

http://www.bloomberg.com/apps/news?pid=20601109&sid=ax3vfya_Vtdo&

Ratings agencies ‘put system at risk,’ CEO says
Testimony shows watchdogs were ‘Kool-Aid drinking’ lapdogs
Rex Nutting
MarketWatch 5:19 p.m. EDT Oct. 22, 2008

http://tinyurl.com/5fjkpp

Credit Rating Agency Heads Grilled by Lawmakers
GRETCHEN MORGENSON
NYT, October 22, 2008

http://www.nytimes.com/2008/10/23/business/economy/23rating.html

Berating the Raters
Charles Gasparino
Trader Daily, December 2007

http://www.traderdaily.com/magazine/article/12150.html

Category: Bailouts, Books

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

3 Responses to “Rating Agencies: Moody’s, S&P, and Fitch (REVISED VERSION)”

  1. FrancoisT says:

    LOL!
    MH must have had a shock when they compared this version to the original.
    Like you said: “I don’t do diplomacy!”

  2. SWMOD52 says:

    Why would the fee on sub-prime vs prime be different? Either you rate the secrurity or not.

    How the people at these companies are not in jail but are in fact still in business is madness.

  3. foobar says:

    It’s not even half so simple. The real culprits were the pension portfolio managers and those who wrote the laws that mandated they own only investment-grade securities. The laws sucks if you’re a pension PM, because it means you cannot take risk, and hence your bonus always is lower than your friends’ bonuses at Fido. So, Investment Bankers (IBs) saw the need, and created products that carried investment-grade ratings yet had higher yields than Treasuries. But it was hardly the case of conniving bankers and raters ganging up to roll ‘conservative, trusting’ pension PMs. Instead, pension PMs, who themselves earn seven figures yearly and are hardly neophytes, bought the credits because they yielded the most of anything within the universe they were legally allowed to own. They didn’t do much due dilly of their own not out of doe-eyed trust of credit rating agencies, but because there was very little risk that anyone could complain later on, sort of the ‘no one was ever fired for buying IBM’ defense. If things went sour, the PMs could in effect point at the law and say ‘see, the state itself said it was OK to own these things’. The pension PMs knew exactly what they were doing — its called ‘regulatory arbitrage’. And the upside was more coupon income and a higher bonus for themselves. They also did not worry too much about being fired — public pension managers, well connected politically, can usually keep their job no matter what happens. The greed of the stewards of savings themselves, the pension PMs, is the still under-reported aspect of this mess. The rating agencies were at worst dupes and clueless abetters — relative to the $ flow they made almost nothing. The IBs did make bucks selling in what the market demanded, but the driver overall was the pension PMs thirst for higher-coupon investment-grade structured finance tranches, ie regulatory arbitrage product, that led to higher bonuses for awhile. The real story, as always, is what motivated the BUYERS with the bucks.