Having branched beyond bonds into larger credit ratings, it’s quite arguable, as one person puts it in the story, a preview of a New York Times Magazine story for this coming Sunday, that Moody’s, along with Standard & Poor and Fitch’s, moved from “gatekeepers” to “gate openers.”
Arthur Levitt, the former chairman of the Securities and Exchange Commission, charges that “the credit-rating agencies suffer from a conflict of interest — perceived and apparent — that may have distorted their judgment, especially when it came to complex structured financial products.”
No shit. The next couple of webpages of the story read like the financial-world equivalent of politics’ infamous “sausage making” process of legislation.
Here’s stuff Moody’s ignored on one special-purpose vehicle, or SPV:
Moody’s learned that almost half of these borrowers — 43 percent — did not provide written verification of their incomes. The data also showed that 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside. That suggested a risky degree of concentration.
And more fun on this same bundle:
In the frenetic, deal-happy climate of 2006, the Moody’s analyst had only a single day to process the credit data from the bank. The analyst wasn’t evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle — a ghost corporation with no people or furniture and no assets either until the deal was struck — would purchase the mortgages.
In other words, a single guy just spent a business day playing the equivalent of the lotto with a $430 million bundle of papers.
Ironically, if you will, increased federal regulation of things like pension and mutual funds gave Moody’s more things to rate, setting the stage for the dereg hothouse of the late 1990s and on.
Issuers thus were forced to seek credit ratings (or else their bonds would not be marketable). The agencies — realizing they had a hot product and, what’s more, a captive market — started charging the very organizations whose bonds they were rating. This was an efficient way to do business, but it put the agencies in a conflicted position. As (Frank Partnoy, a professor at the University of San Diego School of Law), says, rather than selling opinions to investors, the rating agencies were now selling “licenses” to borrowers. Indeed, whether their opinions were accurate no longer mattered so much. Just as a police officer stopping a motorist will want to see his license but not inquire how well he did on his road test, it was the rating — not its accuracy — that mattered to Wall Street.
Problem is, even before the bubbles started bursting, CDOs were defaulting at a rate higher than traditional bonds, as page 5 notes. But, because a lot of these CDOs were coming from high-volume repeat customers, Moody’s kept the rubber stamp hot.
The Securities and Exchange Commission refused to look at the incestuous nature of the modern credit-rating agency after Enron blew up, despite a directive from Congress. And, of course, in both the House and Senate versions of housing bailout legislation, nobody in Congress is proposing a serious oversight reform bill, not just a nudge to the SEC.
More financial “sausage making” on page 6, from a subprime package called XYZ:
Moody’s monitors began to make inquiries with the lender and were shocked by what they heard. Some properties lacked sod or landscaping, and keys remained in the mailbox; the buyers had never moved in. The implication was that people had bought homes on spec: as the housing market turned, the buyers walked.
By the spring of 2007, 13 percent of Subprime XYZ was delinquent — and it was worsening by the month. XYZ was hardly atypical; the entire class of 2006 was performing terribly. (The class of 2007 would turn out to be even worse.)
But, although Moody’s started re-rating individual mortgage-based bonds by soon after this time, it still didn’t do anything about collateralized debt obligations, or CDOs. And, was using a different set of ratings analysts, and giving ratings without knowing what bonds a particular CDO would buy!
A CDO operates like a mutual fund; it can buy or sell mortgage bonds and frequently does so. Thus, the agencies rate pools with assets that are perpetually shifting. They base their ratings on an extensive set of guidelines or covenants that limit the CDO manager’s discretion.
One misrated CDO was estimated to have a loss potential of 2 percent at the time it was rated triple-A. Latest estimate? At 27 percent; a 16 percent slice of triple-A bonds downgraded all the way to single-B.
It’s clear that only major federal regulation can put this horse back in the barn and keep it there.
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