Reckless Credit Rating Agencies

By David Arthur Walters Last edited: Saturday, July 25, 2009 Posted: Saturday, July 25, 2009

Take heart, Big Business, Barrack Obama's 'Change' is virtually synonymous with John McCain's 'Reform'

The cat has been out of the bag for some time now. An enormous number of people who were qualified for mortgage loans should not have been qualified in the first place, but were qualified anyway because the interest in making easy money and palming off the risk on someone else far outweighed the willingness to diligently inquire into peoples creditworthiness. Diligence was no longer due from the loan originators or anyone else for that matter. The buyers of the securities did not do due diligence, they relied on credit ratings instead. The credit rating agencies did not bother to scrutinize a representative sample of the loan files. Sure, they reasoned, there will always be some bad apples in the barrel, but the diversification doctrine of modern portfolio theory secures us as long as there are a lot of apples in the barrel, therefore we can rate the barrel itself highly. Hence an increasing number of them went bad until even good apples suffered the rot greed and corruption always spreads. Now we hear about proposals to reform the credit rating agencies, but we do not see a requirement to do due diligence, for that is always someone elses job. Big businesses allied with big government must always have someone else to shift the blame to.
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Barrack Obamas Change is virtually synonymous with John McCains Reform, a mere tweaking of the business-as-usual engine tighten a screw here and there, renew the oil, grease some palms. Besides, we might not want to put to much pressure on major credit rating agencies because they might downgrade not only our companies but our entire nation to boot. If there were not such a demand for mortgage backed securities rated investment grade, the Jones would not have been qualified for a loan in the first place. The bundle of securities including their mortgage, or rather the bond backed by that bundle, was originally rated investment grade by a respectable credit rating agency, but it became toxic junk worth a quarter on the dollars or perhaps less due to the self-fulfilling prophecies of pessimism toxic assets are called legacy assets when the government wants to save them from the dump. Maybe the security is worth more, but nobody could say for sure how many victims like the Joneses may be involved in that bundle of mortgages or in the whole kit and caboodle of mortgage obligations out there. As the financial crisis took its terrible toll on the economy, even the Smiths and the Does, whose credit is even better than the Joneses, started losing their jobs and defaulting on their mortgages. Investment-minded homeowners and speculators, instead of patiently waiting for a full recovery, are walking away from obligations that exceed the market value of the underlying assets. Notwithstanding old-fashioned scruples about keeping ones word, maybe it is best to bail out now
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and buy back in after the decline has run its course. Only God knows how bad a disaster will get and how long recovery will take. Alas that people thought real estate was bound by natural law to continue its recent rise despite long, flat historical periods. Alas that retired folks or people near retirement cannot wait for their equity and bond portfolios to recover in the long run. It seems that credit raters and economists are like the rest of us inasmuch as they run with the herd and expect more of the same: when things are looking up for a while, they think they will continue to go up, and the crowd will naturally ignore pessimists. Almost everybody was inflating the bubble one way or another. Oh, we might have had our doubts, but who wants to sleep under the overpass or in a doorway? It is better to get in or close to the winners circle, is it not? Much of the market is based on expectations and wishes instead of reality, so woe unto those who do not get out in time, and blessed be those who made billions shorting the bubble although they are cursed for popping it. Surely George Soros is writing a book on this profound reflexivity episode as we speak. Someone should have done some due diligence and provided negative feedback along the loop to forestall the chain reaction blowing up in our faces. The bursting of the credit bubble ruined and is still ruining the credit of formerly creditworthy investors who once considered themselves invulnerable because they relied upon the evaluation of the mortgage back securities by credit rating agencies
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who deliberately overrated the subprime mortgages investment grade in their eagerness to line the pockets of their executives and fatten the wallets of shareholders such as Warren Buffet with easy money Mr. Buffet for some reason has not yet preached on the subject of his enormous investment in a credit rating agency. The certified credit rating agencies or NRSROS (nationally recognized statistical rating organizations), with the help of Congress, the Securities and Exchange Commission, and courts that equated their ratings with protected journalistic opinions, had built quite a money machine for themselves. How would you like to buy a stellar credit rating for yourself? It would be quite nice if we could all provide some positive information about ourselves, buy a good credit rating from the credit bureaus, and then go shopping until a colossal default. There is no doubt about it at this point, that the purveyors of the mortgage backed securities who bought the ratings paid the credit rating agencies to help them structure the bundles of securities so they would appear to be investment-grade instead of toxic assets. And what babbling towers those structures were, with their pools and cascading waterfalls and tranches or floors buttressed by flying bonds. But since twelve honest men could not be found on the street to admit that they did not believe or know what they were talking about, the towers came tumbling down, and all the kings men could not put them back together again, so they must be dumped on the commons to save the aristocracy. What was highly rated is now rated rubble. Can investors in the
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mortgage-backed securities make a good court case against the rating agencies? Did they not violate the securities law? After all, the securities could not have been sold to many institutional investors without the ratings. Go ahead, buy yourself a Triple-A rating, and dont worry that you will be charged for bribery, although an NRSROS is almost a government agency. Whosoever wants to offload their mortgage loan risk onto others can simply promise to pay the credit rating agency handsomely, and provide it with information that it will run through its black box, which will crank out a high rating according to its quantum modeling program. For that rating and its updates a million or more dollars in fees will be collected for securities with large nominal values. Alas that the black box will not save us from disasters, although, if recovered, it may give us information that will help us to prevent a similar occurrence. If there is anything to the doctrine of original sin, the sin of being born a self-interested individual, then everyone is at fault no matter how unwittingly. The future is unpredictable because history is a mistake. Computer modeling of risk cannot save us from all the contingencies. The highly improbable is still possible and occurs when we least expect it, when habit has lulled us into a false sense of security. It is almost as vain to rely upon the things of this world as it is to expect a place in heaven for the immortal soul: everything along with the best insurance company in the world is bound to fail one day. Nevertheless, prudence provides a

modicum of safety until disaster unexpectedly strikes. Due diligence is essential to our survival. In the old days, or so the story goes, the agencies charged investors who subscribed to its ratings, but after the fax machine was invented certain investors got a copy of the proprietary rating book and freely circulated it, so the agencies started doing business with the issuers of securities instead of with the investors. Thanks to the government, the members of the certified credit rating agency partner monopoly1[1] functioned as virtual government agencies, with the exception that they are not accountable to Congress except to respond to its concerns so it may make some tepid recommendations to the SEC, which will continue to serve the interests of Wall Street. And, certified rating agencies, creatures of government to whom governance is delegated, make a profit on each evaluation, while government agencies do not directly charge for their services but rely instead on the distribution of general tax revenues. All the rating agencies had to do was feed their money machine with data provided by their clients. Credit analysts did not have to give it much thought since the machine did their thinking for them. Fortunately, businessmen used to be generally honest because honesty paid, so the ratings provided
1[1] "Partner monopoly" is a term used by U.S. Department of Justice personnel. A partner monopoly differs from an oligopoly in the sense that the two firms share the market whereby the gain in revenues by one firm does not reduce the revenues of the second firm. Since two ratings are normally needed for the issuance of bonds, the gains of Moody's do not come at the expense of S&P and vice versa.

usually stood up to snuff. There will be exceptions but they will be soon forgotten. The reputation of the credit rating agency may be temporarily tarnished by big defaults, but reputation will be only slightly sullied, for everyone knows that nothing is perfect, and that a small percentage of investment grade securities are bound to be defaulted on during normal times. Besides, the top three rating agencies are immune from liability for their mistakes, and they enjoy a virtual monopoly on their business, a business that has a broad impact on the economy due to the legal significance afforded to its product by the Federal Reserve and the SEC. Furthermore, at least 8 federal statutes, 47 federal regulations, and over 100 state laws and regulations reference NRSRO ratings as a benchmarks. The ratings handed out for a fee are a matter of life and death to companies who need official investment grade ratings to flourish, so the rubber-stamp ratings are well worth paying for. Yes, rubber stamps. Academia tends to support the notion that ratings are rubber stamps. In his March 20, 2002 statement before the Senate Governmental Affairs Committee, Jonathan Macey, Professor at Cornell University Law School, said that Academic studies tend to show that information in credit ratings is of marginal value at best because the information contained in the ratings had already been incorporated into share prices. One well known study showed that the ratings provided by rating agencies lagged the information contained in securities prices by a full year.

With the advent of popular asset-back securities, the credit rating agencies went to town on the gravy train. Why, there could never be too many assetbacked securities to rate between the AAA and BBB investment grades in order for them to be marketed by respectable institutions to respectable institutions. If something went wrong, the rater could always make the same claim as the tax preparer, who may say he acted, not as an IRS auditor, but according to the information provided to him by his clients, to which his software applied the labyrinthine Internal Revenue Code. Of course we oversimplify. The tax preparer may have to interpret some of the information provided to him, and she may be moved to ask for more information, in effect practicing law, before posting the position taken in the computer; she can certainly get into hot water for blithely signing off on loose or false interpretations. But to better understand how the money machine works for certified public raters, who short of provably malicious conduct are accountable to no one, it behooves us to quote testimony from the horses mouth; for instance, the Rating Agency Testimony of Michael Kanef, Group Managing Director Moodys Investors Service, Before the United States House of Representatives Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises on September 27, 2007: "Moodys credit ratings are forward-looking opinions that address just one characteristic of fixed income securities the likelihood that debt will be repaid in
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accordance with the terms of the security. They reflect an assessment of both the probability that a debt instrument will default and the amount of loss the debt-holder will incur in the event of default. In assigning our credit opinions, Moodys analysts adhere to published rating methodologies, which we believe promote transparency and consistency on our global ratings. Our ratings are expressed according to a simple system of letters and numbers, on a scale that has 21 categories ranging from Aaa to C. The lowest expected credit loss is at the Aaa level. It is a probabilistic system in which the forecasted probability and magnitude of credit losses rises as the rating level declines. Moodys credit ratings are widely and publicly available at no cost to investors or the general public. We publicly disseminate our ratings through press releases and also make them available on our website.... While Moodys ratings have done a good job predicting the relative credit risk of debt securities and debt issuers, as validated by various performance metrics including published rating accuracy ratios and default studies, they are not statements of fact about past occurrences or guarantees of future performance. Furthermore, ratings are not investment recommendations.... Credit ratings do not address many other factors in the investment decision process, including the price, term, likelihood of prepayment, liquidity risk or relative valuation of particular securities. We have discouraged market participants from using our ratings as indicators of price, as measures of liquidity, or as recommendations to buy or sell securities. Although some market participants may have used our ratings
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for such purposes, they are not designed to address any risk other than credit risk and should not be used for any other purpose.... Our analytical methodologies, which are published and freely available on our website, consider both quantitative and qualitative factors. Specifically, in rating a mortgage-backed securitization, Moodys estimates the amount of cumulative losses that the underlying pool of mortgage loans is expected to incur over the lifetime of the loans (that is, until all the loans in the pool are either paid off, including via refinancing, or default). Because each pool of loans is different, Moodys cumulative loss estimate, or expected loss, will differ from pool to pool. These publications include a wide variety of metrics, including a measure of the accuracy of ratings as predictors of the relative risk of credit losses. In arriving at the cumulative loss estimate, Moodys considers both quantitative and qualitative factors. We analyze between 40 and 60 specific credit characteristics for each loan in a pool, which help us assess potential future performance of the loans under a large number of different projected future economic scenarios. For example, the quantitative data we analyze includes, among other characteristics: credit bureau scores, which provide information about borrowers loan repayment histories; the amount of equity that borrowers have or do not have in their homes; how fully the borrowers documented their income and assets; whether the borrower intends to occupy or rent out the property; and whether the loan is for purchase of a home or for refinancing an existing mortgage loan.
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We also consider the more qualitative factors of the asset pool, past performance of similar loans made by that lender and how good the servicer has been at loan collection, billing, record-keeping and dealing with delinquent loans. We then analyze the structure of the transaction and the level of loss protection allocated to each tranche, or class of bonds issued by the structure. Finally, based on all of this information, a Moodys rating committee determines the credit rating of each tranche. However, it should be noted that the quality of our opinions is directly tied to the quality of the information we receive from the originators and the investment banks. Regardless of the quantity of data we assess, if the data we receive is faulty e.g., as a result of misrepresentation the quality of our rating opinions will be jeopardized. It is important to note that, in the course of rating a transaction, we do not see individual loan files or information identifying borrowers or specific properties. Rather, we receive only the aforementioned credit characteristics provided by the originator or the investment bank. The originators of the loans and underwriters of the securities also make representations and warranties to the trust for the benefit of investors We do not receive any personal information that identifies the borrower or the property.In considering the role of rating agencies in this market, it is important to recognize that we are one of many players with historically well-defined roles in the market. Moody's comes into the residential mortgage securitization process well after a mortgage loan has been made to a homeowner by a lender and identified to be sold. In particular, we do not conduct any due diligence
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on these loans as that role is currently conducted by two separate parties at separate time periods during the loan origination and securitization process: first, the lender or originator of the loan conducts due diligence at the time when it is extending the mortgage loan to the borrower; and second, the investment banker arranging the structured finance vehicle conducts due diligence and ensures that the loans in a particular pool meet underwriting standards. We do not participate in the origination of the loan; we do not receive or review individual loan files for due diligence); and we do not structure the security. Rather, we provide a public opinion (based on both qualitative and quantitative information) that speaks to one aspect of the securitization, specifically the credit risk associated with the securities that are issued by securitization structures. (underlining added) After reflecting on that statement, who would be so foolish as to rely on a credit rating agencys rating if it were not for the fact that government regulations require its seal of approval? Moodys competitor Standard & Poors may claim that it reviews individual loan files to see if someone else has apparently conducted due diligence, but we cannot be so sure of that from the S&P email cited by the House Committee on Oversight and Government Reform. Two former Moodys and S&P officials testified on October 22, 2008, that the lousy performance of credit rating agencies was due to their conflict-of-interest business model. Frank L. Raiter, who had headed S&Ps mortgage rating facility
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for a decade, said that profits were running the show. The Committee referred to S&P email that seemed to indicate a lack of due diligence on S&Ps part. Mr. Raiter had asked his managing director for individual loan data so that he could better assess the creditworthiness of a collateralized debt obligation. The managing director replied: Any request for loan level tapes is totally unreasonable!!! It is your responsibility to provide those credit estimates and your responsibility for devising some method for doing so. Raiter retorted, This is the most amazing memo I have ever received in my business career. However, S&P spokesman Chris Atkins said the incident referred to in the email was in regard to a security that had already been rated by another agency, and that it was S&Ps longstanding practice to review detailed loan data for new residential mortgage backed securities As for the Fitch rating agency, its stance on the subject is reiterated in the December 2006 Committee of European Securities Regulators Report to the European Commission on the compliance of credit rating agencies with the International Organization of Securities Commissions Code: Fitch shall have no obligation to verify or audit any information provided to it from any source or to conduct any investigation or review, or to take any other action, to obtain any information that the issuer has not otherwise provided to Fitch. Naturally, Fitch analyzes only the information known to it, and thus voluntarily complies with this section of the IOSCO code: The CRA should adopt, implement and enforce written procedures to ensure
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that the opinions it disseminates are based on a thorough analysis of all information known to the CRA that is relevant to its analysis according to the CRA's published rating methodology. A mere-opinion disclaimer should not absolve the agencies from liability. If judges were making the impartial and just law they should be making, they would not bestow a press shield on these fee-biased, one-source prejudiced reporters! Surely the rating agencies must somehow be held accountable for the ratings that presumably drove the asset-backed securities and the underlying housing market to such dizzying heights sophisticated investors disclaim personal responsibility, saying the securities were so complicated that they had to rely on the ratings. We said presumably drove the market, as if the ratings made the market instead of the market making the ratings. But the agencies in ambiguous statements say their forward-looking ratings assess creditworthiness based on historical information on the nature of the particular securities involved, and that they are in no way responsible for general market turns that might diminish the value of securities or even render them worthless. Even if they could somehow be held liable under the Securities Act for their opinions, Section 11 of the Act provides an affirmative defense to all defendants to the extent they can prove that all or any portion of the damages resulted from something other than a decrease in the value of the security from an alleged misrepresentation or omission. Therefore, to the extent the parties can show that the decrease in value of the mortgage-backed securities was caused
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by deteriorating market conditions, as opposed to an inappropriate credit rating, the plaintiffs damages would be reduced. Alas that the structured investment bundles rated were rather novel, did not have much of a history at all, and that was the fly in the modeling ointment, the glitch in the modeling program. Indeed, the main risk associated with the rated securities seems to be the rating itself. According to a report entitled The Role of Ratings in Structured Finance: Issues and Implications (Jan. 2005) from the Committee on the Global Financial System of the Bank for International Settlements, Model risk is not confined to structured finance. However, given the lack of historical default data and the analytical challenges in assessing credit risk exposures (e.g. treatment of correlation, recoveries and time variation), it is likely to be a more important issue in the credit risk than in the market risk world. This applies, in particular, for structured finance instruments, as in the case of correlation assumptions discussed above. As a result, model-based risk assessments can be a long way from true values and, to the extent that investors rely on ratings for their structured finance investments, the model risk linked to the agencies rating methodologies will be among the principal risks these investors are exposed to. It is a pervasive practice for the rating agencies to keep the cost of due diligence down to make easy money. We recall their role in the notorious Enron fiasco, as outlined in the October 8, 2002 Report of the Staff to the Senate Committee on Governmental
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Affairs entitled Financial Oversight of Enron: The SEC and Private-Sector Watchdogs: Ratings have taken on great significance in the market, with investors trusting that a good credit rating reflects the results of a careful, unbiased and accurate assessment by the credit rating agencies of the rated company. But as with so many other market players, Enron caused this legendary reliability to be called into question. It was not until just four days before Enron declared bankruptcy that the three major credit rating agencies lowered their ratings of the company to below the mark of a safe investment, the investment grade rating. Based on a number of interviews conducted by Committee staff with officials from Moodys, S&P, and Fitch, Committee staff has concluded the agencies did not perform a thorough analysis of Enrons public filings; did not pay appropriate attention to allegations of financial fraud; and repeatedly took company officials at their word, without asking probing, specific questions despite indications that the company had misled the rating agencies in the past. While the credit rating agencies did not completely ignore problems at Enron when those problems became very apparent, their monitoring and review of the companys finances fell far below the careful efforts one would have expected from organizations whose ratings hold so much importance.... the Committee staff has concluded that the credit rating agencies approach to Enron fell short of what the public had a right to expect, having placed its trust in these firms to assess corporate creditworthiness for the purposes of federal and
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state standards. It is difficult not to wonder whether lack of accountability the agencies practical immunity to lawsuits and non-existent regulatory oversight is a major problem. The credit rating agencies are aware of how much their decisions can affect the fortunes of the companies they rate (and therefore the fortunes of the companies investors). Nevertheless, based on the testimony of the credit analysts at the March 20 hearing and the remarks of the analysts in interviews with Committee staff, Committee staff concluded that the credit analysts do not view themselves as accountable for their actions. When asked if he thought the credit rating agencies had done a good job, former SEC Chief Accountant Lynn Turner testified that his own initial review of Enrons financial statements raised more questions than they answered, and that anyone doing a similar review should have been given pause by their opacity. One of the more glaring concerns Committee staff developed based on their interviews of the credit rating agencies was that the analysts who worked on Enron appear to have been less than thorough in their review of Enrons filings, even though they said that they rely primarily on public filings for information in determining credit ratings. Not only did they apparently fail to scrutinize Enrons public filings (indeed, they failed even to read all the major filings), the credit analysts in general appear to have taken the company officials at their word, simply assuming that they were telling the truth. As Ronald Barone of S&P testified at the March 20 hearing, we do rely on what senior management tells us. It is in their best interest to tell us and be forthright and not convey a different message,
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because if we convey a message to the market that is different that what the market perceives over the long term, then the credibility of Standard & Poors and then ultimately the credibility of the company is at risk.. . . . And so it is in their best interest to tell us the truth, and we rely on that. Senator Thompson called this reasoning a chicken-and-egg deal, pointing out that corporate executives might instead view it in their best interests to minimize bad news and stretch the truth. Indeed! Now one might think, in view of the scandalous gravity of the Enron failure, and the fact that the credit rating agencies practically ignored negative information, that the Committee would have recommended that the Congress enact a reform that would hold credit rating agencies and their analysts definitely liable for the failure to provide adequate due diligence, but instead the buck was passed to the SEC, a virtual fasces of major vested interests, run by revolving-door caesars, whose double-axe is seldom wielded against those interests. What teeth it does have rarely bites the worst offenders, and never those who have the power to corrupt the political system and legalize their offenses. Instead of facing firing squads, they are admired and emulated in our free country. After fully discussing the immunity of NRSROs from liability under the law that gives them a rating monopoly, some ideas were passed along by the Committee, such as conducting investigations of future meltdowns to see if the ratings were adequate under some standard to be determined by the usual
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regulatory suspects who rely upon them: Committee staff recommends that the SEC, in consultation with other agencies that use the NRSRO designation in their regulations particularly banking agencies set conditions on the NRSRO designation through additional regulation. Those conditions should include imposing a set of standards and considerations that the rating agencies must use in deriving their ratings, such as accounting issues. In addition, the SEC should also require a level of training for analysts working for credit rating agencies, including training as to the information contained in the periodic filings with the SEC and other government agencies that oversee companies in the particular sector each analyst is assigned to as well as training in basic forensic accounting. The SEC should monitor the compliance with these requirements, and in the event of a future corporate meltdown such as Enron, the SEC should investigate to ensure that the ratings were derived in accordance with those standards. If the public and the government is to rely on the ratings of these agencies, and give them legal force, then it must ensure that they are the product of diligent and effective analysis. Meaningful SEC oversight is the best way to ensure such an outcome. Flash forward to the next major meltdown, and consider the June 11, 2008 opening statement by SEC Chairman Christopher Cox at the Open Meeting on Rules for Credit Rating: All of the proposed rules that we are considering are born of the subprime mortgage crisis and the resulting credit crunch.... At bottom in the subprime mess, of course, were the
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high-risk mortgages typified by lax loan underwriting, unverified borrower information, and even, in many cases, clear signs of fraud in the loan files. Yet the SEC, which as a corporatist entity naturally puts the interest of business-as-usual ahead of good government, did not mandate in its revised rules that due diligence oversight be conducted. At least the agencies will now have to disclose the steps they take to verify information. And they must issue statistics on their upgrades and downgrades. Most importantly, they are prohibited from rating securities they help to create. The limited rule changes severely disappointed sincere reformers and were of course approved of in advance by the accredited rating agencies that the government favors and purportedly regulates. Incidentally, one of the favorite proposals for credit agency reform besides tempering the conflict of interest is to promote competition that would break up the duopoly then more confirms could compete to give securities high ratings. Again and again the clear signs of imprudent conduct go unnoticed or are deliberately ignored, and yet again we are feeling the effects of yet another colossal instance of GIGO garbage in, garbage out. The black box retrieved from the wreckage was no big secret although only rocket scientists understand how it really works. It was presumably not the credit model but the market that caused the crash. However, before taking off one might expect the overarching flight engineer to see if his instruments were really reading underlying reality.
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With so much at stake, at least a random inspection of a certain percentage of the actual loan files might be made by the mechanics, and the information therein investigated for its veracity. Someone might even go out to the house and say howdy to the purchasers and find out what kind of characters they are. But that would slow things down and take a bite out of the million or more dollars for the rating. It is far more profitable to trust the mortgage originators, over half of whom were not even regulated in the first place, as the raters knew very well. If more loans go bad because of loose qualification standards, the default percentage may simply be updated when the model is tweaked. As for the frame of the high-flying machine, it is obvious from the complaints and regulatory reform efforts that the rating agencies and the regulators colluded in the conflicting-interest task. It now seems likely that the new administration, staffed by leaders who helped engineer the current crash, will adjust some loose screws, and that business-as-usual will continue apace, for that is all they know how to do. The next crash will then be the Mother of all crashes.

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