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Bad Credit: How S&P, Moody's and Fitch Helped Cause the Housing Bubble

"I spoke to Osmin earlier and confinned (sic) that Jason is looking into some adjustments to his methodology that should be a benefit to you folks [Chase]."
"Heard you guys are revising your residential mbs rating methodology - getting very punitive... heard your ratings could be 5 notches back of mo[o]dys equivalent. gonoa (sic) kill your resi biz. may force us to do moodyfitch only cdos!"
The first statement is from a February 2007 email from an employee of Moody's (MCO), one of the three major credit ratings agencies, to a banker at JPMorgan Chase (JPM). The "methodology" in question refers to the way Moody's rated mortgage-backed securities deals the banking giant was involved in. The second statement is from a May 2006 message from a UBS (UBS) banker to someone at McGraw-Hill (MHP) unit Standard & Poor's, another major ratings agency.

Together, they're evidence of a con David Mamet would admire (there are hundreds more such exchanges for any conspiracy buffs out there). If large financial firms masterminded the scam, stuffing junk mortgages into securities, CDOs and other instruments, the credit agencies were their able shills, rubber-stamping whatever paper came their way with an investment-grade rating.

As Sen. Ted Kaufman, D-Del., said this morning in a congressional hearing on the role of the rating agencies, "The big thing that was missing was the referees on the field."

Or more accurately, the referees were paid off.

The ratings agencies business model is based on a flagrant conflict of interest -- they're paid by the firms whose credit they evaluate. That makes them vulnerable to pressure from investment banks and securities issuers, which naturally want a bullet-proof rating in order to attract investors.

In the years leading up to the housing bust, Moody's, S&P and Fitch passed out AAA ratings like candy bars at Halloween. In mid-2007 and early 2008, with the real estate market in free-fall and mortgage delinquencies soaring, they suddenly started downgrading scads of formerly top-rated securities. In January of '08, for instance, S&P lowered ratings on more than 6,300 and 1,900 CDOs -- in a single day. Then, the deluge. The bottom fell out of the secondary market for subprime loans, and the rest is history.

Why did this happen? An 18-month congressional inquiry into the debacle has identified a host of reasons. Here are five of the leading causes, as summarized by the Senate subcommittee on investigations, the panel hosting today's hearing:

  • Competitive Pressures. Intense competition, including the drive for market share and need to accommodate investment bankers bringing in business, affected the credit ratings the agencies issued.
  • Failure to Reevaluate. By 2006, Moody's and S&P's knew their ratings of residential mortgage backed securities and CDOs were inaccurate and revised their rating models to produce more accurate ratings, but then failed to use the revised model to reevaluate existing RMBS and CDO securities. That delayed thousands of rating downgrades and allowing those securities to carry inflated ratings that could mislead investors.
  • Failure to factor in fraud, laxity or the housing bubble. From 2004 to 2007, Moody's and S&P's knew of increased credit risks due to mortgage fraud, lax underwriting standards and unsustainable housing price appreciation, but failed adequately to incorporate those factors into their credit rating models.
  • Inadequate resources. Despite record profits from 2004 to 2007, Moody's and S&P failed to assign sufficient resources to adequately rate new products and test the accuracy of existing ratings.
  • Failed ratings. Moody's and S&P each rated more than 10,000 RMBS securities from 2006 to 2007, downgraded a substantial number within a year, and, by 2010, had downgraded many AAA ratings to junk status.
  • Legal pressure for AAA ratings. Legal requirements that some regulated entities, such as banks, broker-dealers, insurance companies, pension funds and others, hold assets with AAA or investment grade credit ratings, created pressure on credit rating agencies to issue inflated ratings.
It was interesting during the hearing to hear former ratings agency execs express various shades of regret at their part in the mess. "I had this somewhat naive idea when I joined Moody's that it was a particular quality Moody's was offering, and that was something that the company was going to seek to defend over time," said Richard Michalik, a former VP in Moody's structured derivative products group at Moody's. As it turned out, he went on to suggest, it was really all about the Benjamins.

For a change. Yet their testimony underscores a key lesson of this -- and any -- financial crisis: For all the focus on individual vampire squids, greedy CEOs and other villains in this affair, the collapse was systemic. It wasn't a few bad apples; it was the barrel.

And here's why that's troublesome in this case. Nearly three years after the financial system caved in, no one seems to know exactly what to do with the credit agencies. The ratings system, while more closely watched, remains opaque. Pay can still be exchanged or play.

Meanwhile, the reform legislation under debate in Washington does nothing to change the status quo. Not that it's too late. Lawmakers could still tack on amendments when the bill hits the Senate floor or goes into conference for reconciliation with the House measure.

The best change would be to end the practice of companies paying directly the credit agencies for a rating. The process also must become more transparent. Investors need to know who paid for a credit rating, how much and whether the rater provided any other services as part of the deal. It's also critical to determine if an issuer or investment bank "shopped" for a given rating.

Trouble is, congressional support for such proposals is uncertain. The ratings agencies successfully lobbied against including similar provisions in the House bill passed in December. With a majority of lawmakers, and President Obama, eager to clinch the deal on financial reform, I don't expect any wholesale changes to the Senate legislation.

I'd be shocked if we aren't having the same discussion in years to come.

Images from Flickr and C-Span

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