Credit Rating Agencies Again

The SEC issued its annual report on credit rating agencies last month. And it's not good. It does not seem as though the agencies have changed their way of working very much. For example, the report says that two of the larger companies “failed to adhere to their ratings policies and procedures, methodologies, or criteria, or to properly apply quantitative models.”

We all make mistakes, but the agencies don't tell anyone about theirs or their implications. And then some agencies outright lie. They do not accurately describe the methodology used to determine some of its official grades. Statements made in rating publications directly contradict internal rating records. Management has a say in the final rating, sometimes it is to change the original rating by the staff. Of course, is there anything wrong when the agency gives an unsolicited rating to an issuer?

The agencies really helped create the Great Depression. It looks like they are trying to repeat.

The rating services share the blame

Joshua Rosner, managing director of an investment research firm, has some interesting observations with regards to the sub-prime problem and the rating services, Standard & Poors, Moody's and Fitch.

Perhaps his most interesting observation:

Only slightly more than a handful of American non-financial corporations get the highest AAA rating, but almost 90 percent of collateralized debt obligations that receive a rating are bestowed such a title. The willingness of Fitch, Moody’s and S.&P. to rate as investment grade many assets that are apparently not has made structured securities ratings their fastest-growing line of business. Are we to believe that these securities are as safe as those of our most honored corporations?

Rosner further implies that these ratings are given largely as the result of the rating agencies advice to the issuer as to how the debt should be structured, for rating structured securities is now the agencies' fastest growing business.

Inside a Subprime Pool

Roger Lowenstein was able to watch Moody's value a subprime pool and gives an eye-shattering view of the process. Rather, I should say a mind boggling view as all rationality and analysis seems to have gone out the window.

The pool consisted of 2,393 mortgages with a face value of $430,000,000. Some issues that should have concerned Moody's:

• 75% of the mortgages carried an adjustable rate
• 43% of the borrowers did not provide written proof of their income
• Almost half had a second mortgage.

The analyst had one day to rate this offering. Given the above three points, that should have been more than enough time to say no. But, hey, Moody's would not have gotten the fee from the investment bank that requested the rating. So, Moody's gave twelve different ratings to the package, from AAA to BA1. Less than two years later - after Moody's had downgraded 5,000 of these pools - this particular pool could boast that 27% of the mortgages were delinquent.

Lowenstein does not think that only the rating agencies are at fault. Securities regulators, such as the SEC, outsourced their regulatory functions to "officially designated rating agencies". But, still it was the ratings agencies that decided to negotiate with their customers, investment banks, as to what the rating should be. It was the rating agencies that rated securities using mathematics rather than common sense. It was the rating agencies who did not understand the dramatic changes in the financial world.

Clearly, the ratings agencies are responsible for a large part of our current situation.

Correcting the Credit Rating Agency Problem

Kevin Hall continues his reports on the credit rating agencies with an analysis of the Accountability and Transparency in Rating Agencies Act, which is being proposed for approval by the House Financial Services Committee. This analysis is not as deep as Hall's previous work. He cites three deficiencies with the p

Image by Getty Images via Daylife

roposed legislation:

• there is no independent due diligence with regard to a proposed offering
• the position of compliance officer needs to be strengthened considerably
• the SEC should work with the compliance officer.

My question is - does the legislation ensure that the agencies do their job or does it enable them to continue their pursuit of money?

Money and Congress

Insider has been studying the finances of our Congressmen. These are some of their conclusions:

48 members of Congress and 182 senior-level congressional staffers have violated a federal conflicts-of-interest law. 

Nearly 75 federal lawmakers held stocks in COVID-19 vaccine makers Moderna, Johnson & Johnson, or Pfizer in 2020, with many of them buying or selling these stocks in the early weeks of the pandemic. 

15 lawmakers tasked with shaping US defense policy that actively invest in military contractors. 

More than a dozen environmentally-minded Democrats invest in fossil fuel companies or other corporations with concerning environmental track records. 

Insider's "Conflicted Congress" is also rating every member of Congress on their financial conflicts and commitment to financial transparency. Fourteen senators and House members have received a red "danger" rating on our three-tier stoplight scale, while 112 get a yellow "borderline" rating.

Negligent Homicide

Image by Getty Images via Daylife

Ross Levine of Brown University has performed an 'autopsy' of the Great Recession and concludes that 'negligent homicide' played an important role in the demise. By negligent homicide Levine is referring to the silence and inactivity of the regulatory agencies in the late 1990s and early 2000s. In Levine's opinion, these agencies - mainly the Fed and SEC - and Congress designed, implemented and maintained "policies that spurred excessive risk taking and the eventual failure of the financial system". He is not saying that greed and overly complex financial products did not play a role in the failure, but they would not have been able to play that role if the regulators had done their jobs. The regulators knew that problems were looming, however they did nothing to prevent them.

The first agency Levine looks at is the SEC and its decision to establish Nationally Recognized Statistical Rating Organizations (NRSRO), which essentially meant anointing Moody's, S&P, Fitch etal as gatekeepers to the securities markets. The SEC used the ratings of the NRSROs to establish the capital requirements for institutions the SEC regulated. Eventually, these ratings became de rigeur for any company that wanted to play in the big leagues. At heart, the NRSROs were given the "right to sell license to issue securities". The money for these licenses was quite good and the rating agencies succumbed to the temptation. If you paid enough money, you got the rating you wanted. Is there any wonder that so much garbage was rated AAA? Did the SEC do anything to get the NRSROs to produce realistic ratings?

The Fed is the next agency Levine looked at. He considers the effect of the Fed's decision in 1996 to allow banks to use credit default swaps to reduce their need for capital, which enabled the banks to invest in higher-risk situations. The Fed did not keep a close watch on the derivative markets, although in 1992 the NYFRB noted their concerns about the markets and did threaten to do something about them. And in 2004 my friend, Tim Geithner, as head of the NYFRB, was concerned about the lack of information on these swaps. Plus the Fed was aware that the subprime mortgage market was getting shakier. Did the Fed do anything to try to get banks to increase their capital?

Levine goes on to talk about the Brooksley Born fiasco where Greenspan, Rubin, Summer and the SEC put the kibosh on Born's attempt to bring some transparency to the derivatives market.

Back to the SEC. In 2004 they made it easier for the five largest investment banks to gamble; the SEC ruled that these banks were exempt from the net capital rule and, thus, were able to take more risks. Then, the SEC allowed the banks to use their own risk assessment models. Levine really slams Christopher Cox, the previous head of the SEC. Cox eliminated the risk management office, and did not inspect any investment banks in the 18 months before Armageddon. Why should Cox have bothered? The banks were only handling $4 trillion in assets.

Fannie Mae and Freddie Mac - and ultimately Congress - are also blasted for their lack of control.

Levine has certainly done a fine job in making his points.

More Bad News About Rating Agencies

The beat goes on. Now we hear that Moody's etal ignored several situations where securities did not meet the underwriting criteria the Wall St. firms claimed. Yet, fearful that they would lose fees if they gave a true rating to the securities, the rating agencies said everything was okay, for they operated in the land of Lake Woebegone.

Mortgages: The Good and The Bad

You have to agree that Wall Street has imagination. They have figured out a way to unload some of their downgraded mortgage investment packages and make money doing so. And, as with so many of their scandalous schemes, Wall Street has a weird name for the transaction - re-remic, which stands for resecuritization of real-estate mortgage investment conduits.

They've been able to sell billions of this crap by waving a magic wand and dividing these downgraded bonds into two pieces - the good (which a rating agency will rate as AAA or close to it) and the bad (which will get a junk rating). How they're able to make such a division escapes me, but they claim to know people who can do this and, naturally, they pay these people well. And, of course, the new packages need a rating from the firm's friends at Moody's etal, who extract their fee.

Why does the firm want to do this? They need to put up less capital as backing for the original crap. Somehow, the wand has reduced the firm's risk although the assets after the waving are the same as those before the waving.

And these guys don't need more regulation? What planet do our leaders live on?

McClatchy Reports on the Credit Agencies Hearing

It's a pretty strong example of greed overcoming obligations to the financial community.

My emphases.

WASHINGTON — The chairman and chief executive of Moody's Corp. said Friday that he didn't know that his company continued to give investment-grade ratings to complex financial instruments backed by shaky subprime mortgages even after it downgraded billions of dollars worth of such deals in the summer of 2007.

His admission came during a daylong hearing by the Senate Permanent Subcommittee on Investigations, which is looking into the origins of the nation's worst financial crisis since the Great Depression.

Moody's chief Ray McDaniel, under questioning, said that he didn't think his company had continued to rate complex deals backed by U.S. mortgages after it and competitor Standard & Poor's jolted the markets in July 2007 with massive downgrades of earlier deals.

"I apologize, I do not recall that," McDaniel said.

The panel's chairman, Sen. Carl Levin, D-Mich., then presented him with documentation that both Moody's and S&P gave investment-grade ratings to a Citigroup deal in December 2007, worth almost $400 million, backed by shaky subprime loans that by then clearly were toxic.

The point Levin was making — and made repeatedly — is that credit-rating agencies did whatever was needed to get lucrative fees, some as high as $1.4 million, for rating complex deals.

Later, McDaniel stressed that preserving market share "is not as important as ratings quality."

While other Wall Street executives have expressed contrition when they appeared before Congress, McDaniel and former S&P President Kathleen Corbet were unapologetic on Friday.

Throughout the day in earlier testimony and in e-mails released by Levin, however, former Moody's and S&P officials told how they were pushed out or quit in frustration because managers badgered them to "massage" complex deals until they could land the business.

A McClatchy investigation in October documented how top managers from the structured finance division, which rated the complex deals, were moved into the top executive suites at Moody's and effectively took over the company.

McDaniel and Corbet said they were unaware that their analysts felt pressured to sacrifice the quality of investment-grade ratings to maintain market share and earn the huge accompanying fees.

Investment-grade ratings gave investors the illusion of safe bets, allowing big Wall Street firms such as Goldman Sachs to peddle the securities across the globe. Moody's and its chief competitors were key players in the prelude to a near meltdown of global finance in September 2008.

Called to appear before the panel, Richard Michalek, a former Moody's vice president and senior credit officer, described the ratings process for deals that could bring more than $1 million in fees as a "must say yes" atmosphere.

Frank Raiter, a former managing director at S&P and the head of the group that rated pools of residential mortgages, told the panel that analysts routinely sought direction from top management about the shaky deals they were being asked to rate.

"The guidance was not forthcoming from the top," he said, later adding, "I retired because I got tired of the frustration."

Levin read e-mail after e-mail from inside the ratings agencies about deals that never should have been rated, much less received investment-grade ratings.

"These e-mails are just devastating to the kind of culture that is going on here," he said.

Most striking was testimony from Eric Kolchinsky, a Moody's managing director who in 2007 was in charge of the division that rated the complex deals called collateralized debt obligations. CDOs are securities backed by pools of U.S. mortgages that have been packaged together into bonds and sold to investors.

Kolchinsky recounted how in the first two quarters of 2007, his group generated more than $200 million in revenue for Moody's by giving complex deals investment-grade ratings _ which told investors that they were safe bets. In the late summer of 2007, however, Kolchinsky was informed by superiors that bonds issued a year earlier were about to be severely downgraded.

That should have required a new methodology for ratings on deals that were still pending, but when he tried to do that, he was told not to. It amounted to securities fraud, in his opinion.

"My manager declined to do anything about the potential fraud, so I raised the issue to a more senior manager," he testified. He said that the complaint resulted in a change to methodology. "I believe this action saved Moody's from committing securities fraud. Because of the culture, I knew what I did would possibly jeopardize my role at Moody's."

He was right. A month later, he was sent a nasty e-mail asking why his market share slipped from 98 percent to 94 percent in the third quarter. The e-mail came, he said, just days after Moody's had downgraded more than $33 billion in bonds backed by subprime mortgage loans. Less than two months after challenging the integrity of the ratings, Kolchinsky was removed from his post and given a lower-paying job elsewhere in the company with far less responsibility. He eventually left.

Under questioning from Levin, Kolchinsky acknowledged that he and his staff rated the complex Goldman Sachs deal that this month became the subject of fraud charges brought against Goldman by the Securities and Exchange Commission.

The SEC alleges that Goldman failed to disclose to investors that hedge fund mogul John Paulson helped pick the mortgages in the deal with an eye toward betting that they'd fail. Kolchinsky said this information was never shared with Moody's.

"I did not know and … I am fairly certain my staff did not know either," Kolchinsky said.

Asked by Levin whether that would have affected the rating the deal received, Kolchinsky said yes.

"From my perspective it is something I would have wanted to know. It is more of a qualitative, not quantitative assessment. It changes the incentives of the structure," Kolchinsky said. "It just changes the whole dynamic of the structure."

In one e-mail presented by Levin, an S&P employee inquiring about evidence that subprime lender Fremont General was showing problems with poor underwriting was told not to worry about it. Levin seized on this e-mail when grilling Susan Barnes, an S&P managing director, angrily asking her why relevant information and poor performance was discarded.

"Why doesn't the supervisor say, 'Damn right, it's relevant,'?" demanded Levin, eventually coaxing a response from Barnes.

Barnes said that, "The assumptions we use in our criteria have obviously not panned out the way we had expected."

In written remarks, Corbet gave no ground. She said all deals were rated by teams of analysts, who were supervised by individual managers. Her role as president, Corbet said, was to set overall strategy and work with her parent company, McGraw-Hill.

McDaniel also offered no apology. Instead, he said that his company took steps to remedy what was going wrong as information became available. Former Moody's executives testified to the contrary.

McDaniel said that Moody's warned of declining underwriting standards for mortgages as early as 2003. However, Moody's continued to rate the complex deals backed by U.S. mortgages, which became a huge portion of the company's business.

Moody's is under pressure on many fronts. California Attorney General Jerry Brown this week filed a court action seeking to force Moody's to comply with a subpoena he issued for information seven months ago. A special Financial Crisis Inquiry Commission, charged by Congress to report on the causes of the crisis, issued a subpoena to Moody's, complaining that the company has failed to provide information in a timely manner.

Report on the Rating Services

Here's an interesting chart from the FT.Com site. It shows the current rating of CDOs originally rated AAA. Note that only 24% are still rated AAA. Almost as many are now rated CCC. Add in those rated C and D and you've got to wonder what really happened when these 'securities' were rated.

Maybe it will do some good

Okay, S&P cut their rating of the U.S. financial picture from AAA to AA+. Yes, it's true that S&P, as believers in Lake Woebegon, also rated 75% of the securities issued by mortgage lenders as AAA, so one must question their competency. They over-rated the mortgage securities because the lenders paid them. Maybe the Tea Party has paid them now to lower the country's rating. Who knows? And in the current climate I would not be quick to rule it out.

However, this downgrade may also give our idiotic leaders some pause and cause some of them to start working for us, rather than their re-election.

The SEC acts against the rating agencies

The only problem is that it has not acted against Moody's and the big rating agencies.  It's gone after a firm I've never heard of, Egan-Jones.  Egan-Jones makes its money from those who use its ratings. The big agencies get paid by the issuer, which is one of the reasons why their ratings were so skewed towards the Lake Woebegon proportions that were a major factor leading to the Great Recession.

The SEC is going after Egan-Jones because of problems with the firm's application to be a "nationally recognized statistical ratings organization."  The firm claims that one application matter stems from a different method of counting the number of ratings they had made. The other SEC concern involves investments in securities being rated; the firm claims these investments were of long-standing and were brought to the SEC's attention.  

It's possible these matters were sufficient to deny the firm's application. But the real question is why the SEC is going after a piddling firm and is doing nada about the big guys.  It looks like the major ratings agencies have been evaluated as TBTBI, Too Big To Be Indicted.

Norma: an unlucky name?

Norma, the star of Bellini's opera of the same name, winds up swimming with the fishes. Norma Desmond of Sunset Strip fame winds up in the loony bin. And Norma CDO I Ltd. is the cover girl for an inside look by the Wall Street Journal at a devastated CDO.

Norma is a CDO that started out with rating agencies assigning a AAA rating to 75% of its securities in March of this year. By November the bloom was off the rose and Norma was thrown on the junk pile.

Norma started life being 'worth' $1.5 billion. However, only a small part of Norma was real, i.e., actual securities that you could touch and feel. Most of it was made up of derivatives that acted as insurance on BBB-rated mortgage securities. These derivatives (in this case called credit-default swaps) 'insured' BBB-rated subprime bonds, but the actual bonds were worth only about a third of what they were valued at in the CDO. So that, for example, $1500 in Norma represented only $500 in real assets. Furthermore, some of the pieces of Norma were themselves slices of other CDOs.

What were they smoking?

"Structured by cows and we would rate it"

That's how one analyst at Standard & Poors spoke of a proposed structured finance deal in an e-mail appearing in an SEC report on the ratings agencies. Another analyst called a deal "ridiculous" and commented "we should not be rating it". A manager of a group rating CDOs referred to this market as a house of cards when he wrote in an e-mail, " Let's hope we are all wealthy and retired by the time this house of cards falters."

And we wonder why this market has blown up!

There is not one culprit

The President's Working Group on Financial Markets is part of the Treasury but has representatives from the Fed, SEC and CFTC. In its latest update it concludes that there is more than enough blame to go around. Here are what they assert as the major reasons for the current disaster:

• a breakdown in underwriting standards for subprime mortgages;

• a significant erosion of market discipline by those involved in the securitization
process, including originators, underwriters, credit rating agencies, and global
investors, related in part to failures to provide or obtain adequate risk disclosures;

• flaws in credit rating agencies’ assessments of subprime residential mortgage-backed securities (RMBS) and other complex structured credit products, especially collateralized debt obligations (CDOs) that held RMBS and other asset-backed securities (CDOs of ABS);

• risk management weaknesses at some large U.S. and European financial institutions; and

• regulatory policies, including capital and disclosure requirements, that failed to
mitigate risk management weaknesses.

In summary, it's greed and people not doing their jobs.

Leave it to the ratings agencies

The Basel Committee on Banking Supervision decided to allow banks to include weaker securities in computing their liquidity coverage ratio, which, as the name implies, is a measure of the riskiness of banks' investments.  Of course, the committee did not say "weaker securities", but it is still relying on the supposedly independent ratings agencies to actually provide a realistic rating, just as they did when rating 90% of CDOs as AAA.

Harvard cancels the soccer season

Although they are in first place in the Ivy League, Harvard University has suspended its men's soccer team for the rest of the season. Why? Because the players made sexual comments about members of the women's team. Comments were written, as well as verbal. One document rated the attractiveness of female players and included sexually explicit comments. This rating is not the first. In the past male soccer players at Harvard circulated documents with pictures of their female counterparts, rating their attractiveness from one to 10 and giving reasons for their decisions. They also noted which sexual position they thought the women in question would prefer.

Regulating a Key Player

Bloomberg points out that hardly any of the talk about financial regulations mentions the rating agencies, yet they are a key player in the game. As the TARP IG said in his latest report, “The wholesale failure of the credit rating agencies to rate adequately such securities is at the heart of the securitization market collapse, if not the primary cause of the current credit crisis.”

Is there a need for them? If so, we need to devise a better system to rate securities.

Repeating 2008?

This is from a post of mine from August 2013:

One of the major causes of the Great Recession was the failure of the ratings agencies (S&P, Moody's, Fitch) to properly rate securities.  In order to secure business the agencies did not publish unbiased ratings; they gave AA ratings to securities that should have been unrated or D.  It looks like this practice is starting to return.   

Well, the practice has definitely returned. One measure is the number of analysts who have moved from the credit-reporting agencies to investment bankers.  SEC records show more than 300 have done so since 2008. That's in a universe of 4,000 analysts. So, about 7.5% of credit-reporting analysts have gone to the companies who issued the securities these analysts rated. And, it looks like the number is increasing as 80 moved in 2014.

Since there is no rule establishing a waiting period for analysts moving to a company you were rating, the question becomes: can credit analysts be impartial about grading bonds while looking for employment at banks that underwrite them?

A study by some academics found that "when an analyst is hired by one of the top 20 banks, rankings rise by 0.35 level on average compared with an average 0.18 grade increase for all analysts switching positions. If that bump-up elevates the bond to investment grade from a speculative, or junk, rating, the borrower would save $85 million in interest over the life of a $1 billion 10-year bond, according to data compiled by Bloomberg."

Looking for a job

Brett Talley, a deputy assistant attorney general, has been nominated by Trump to a federal district judgeship. Talley would be able to hold this position for life, which, he being 36-years-old, could be quite a long time. One 'slight' problem with this nomination is that he has never tried a case. Further, he was unanimously deemed “not qualified” by the American Bar Association. 

He is the fourth judicial nominee under President Trump to receive a “not qualified” rating from the bar association and the second to receive the rating unanimously. Since 1989, the association has unanimously rated only two other judicial nominees as not qualified. 

Just another indication of Trump's management talents.