How the Ratings Agencies Lost the Will to Say 'No'

subprime mortgages housing bubble
subprime mortgages housing bubble

Friday's congressional hearing on the role of the ratings agencies in the financial crisis featured three panels: The first, filled with ex-employees of Standard & Poors (MHP) and Moody's (MCO), told a dark, detailed tale of how the ratings agencies produced inflated ratings.

The other panels featured current managers and executives explaining how the agencies did their best and how the dramatic ratings downgrades reflected the bursting of the real estate bubble and market decline generally, not something deeply flawed in the ratings themselves.

Rather than claim management deliberately required inflated ratings, the ex-employees suggested that massive underfunding and understaffing of the ratings departments coupled with a shift to a customer-satisfaction culture -- customer being defined as the banks issuing the securities, not the market at large -- inexorably led to inflated ratings. The most specific charge was made by Eric Kolchinsky, who said he believed Moody's committed securities fraud in connection with a 2009 deal named Nine Grade Funding II by issuing a rating that it knew wasn't true, because it knew the ratings on underlying assets -- ratings that played into Nine Grade's -- were inaccurately high.

Highlights from the ex-employee panel follow. All quotes from the oral and written testimony come from the documents and webcast available on the committee's website.

From "Independent Arbiter of Risk" to "Captive Facilitator of Risk Transfer"

The most detailed and devastating testimony came from Richard Michalek, a former attorney and vice president at Moody's Investors Service, a subsidiary of Moody's. Michalek joined the Moody's Structured Derivative Products Group in June 1999 and left when his position was eliminated in December 2007. His duties included legal analysis on the structure and documentation of complex structured-finance transactions and participating in rating committees (ratings are determined by a committee of analysts rather than a single analyst).

In his oral testimony (at about 66 minutes into the webcast), Michalek charged that as Moody's became more profitable and the structured-finance department accounted for more of that profit, the department lost the ability to say no to issuers. Indeed, management's attitude was "must say yes," Michalek said. Market share concerns were deeply corrosive to ratings integrity, he explained, noting:

"The threat of losing business to competitor rating agencies, even if not realized, absolutely tilted the balance away from the independent arbiter of risk towards captive facilitator of risk transfer."

In his written testimony, Michalek bears more detailed witness to the culture shift at Moody's and its consequences. When he started at Moody's, the firm was "conservative" and the derivatives group "intellectual." New hires were experienced and then heavily mentored on the job. To ensure sufficient analysis, every deal was assigned a lawyer and a "quant." The lawyer ensured the deal documentation was sufficient and correct, and the quant did the math. All that changed after Moody's was spun off by Dun & Bradstreet in 2000 and deal volume exploded in 2003.

"I'll Be Gone, You'll Be Gone"

After the spin-off, Brian Clarkson took over the structured-finance department, including the derivatives group, and systematically set about changing the culture in it, according to Michalek. One quick change: Collateralized debt obligation (CDO) deals in London and Paris (as opposed to those managed by Michalek) had only a quant now responsible for both the math and the legal documents, backed up by one "thinly stretched" lawyer who assisted several deals simultaneously. Michalek believed that lawyer was "primarily focused on keeping the deals moving and chose very carefully what (if any) issues to raise." In the face of exploding deal volume, that's not a staffing level that lends itself to careful review and analysis of deal documents.

Michalek wryly noted that one banker, "who was running out of patience with my insistence on a detailed review of the documentation," told him that if problems cropped up after the deal closed, so what? "It was just another case of 'IBGYBG' -- 'I'll be gone, you'll be gone.'"

Michalek believes that Clarkson's primary goal was to make the analysts and lawyers more "accommodative to the needs of our 'customers,' i.e., the investment banks." As a first step, Clarkson met with the customers to understand their views of Moody's, to listen to their "concerns and wish lists." Then Clarkson met with each lawyer for a "discussion." In Michalek's discussion, he was told he was one of the "more 'difficult' analysts who had a reputation for making too many comments on the deal documentation." Worse, Clarkson then made a slightly veiled threat to encourage Michalek to ease up on the investment banks.

Clarkson told Michalek that he'd fired a different person, despite liking him, because the customers had complained of his "extreme conservatism, rigidity and insensitivity to client perspective." After firing him, Clarkson "quickly received 'dozens' of calls from clients thanking him for finally addressing the problem." Clarkson then asked Michalek why he shouldn't fire him, too.

The Slide Down the Slippery Slope

Deals involved 40 to 60 documents and would never be completed if each document had to be written from scratch each time. Instead, deals would start with documentation from a prior deal and then they'd get edited as appropriate. Each set of forms reflected a different negotiation: Some were more favorable to investors, some to issuers, etc. As deal volume spiked and Moody's focused on making the investment bankers happy, Michalek charges, the forms became more and more pro-issuer. This shift is probably what he means when he talks about the ratings agencies becoming "captive facilitators of risk transfer."

In particular, Michalek noted that one attorney, whom he didn't name but referred to as "lawyer X," essentially let the banks control the documents' language, and he said those deals became the ones the banks would push to use as forms for the next round. To reassure himself that his stubbornness about reviewing and editing the documents on deals he oversaw added value, Michalek analyzed the performance of his deals versus lawyer X's and found his performed much better. However, Michalek noted that other factors might have controlled that outcome, such as "luck, or the adverse selection of [lawyer X] by those banks who were most aggressive in their structures and their negotiation of documentation."

Although Michalek says several banks tried to get the most bank-friendly forms, he called out Goldman Sachs (GS) in particular: Goldman Sachs consistently chose "the most 'risk-seller-friendly'" forms, and that Goldman was "the only bank I knew of that employed someone whose primary job was -- to put it politely -- arbitrage the rating agencies. . . . Goldman was very prompt when informing us that 'S&P doesn't require that.'"

Incentives Sped Up the Slippery Slide

Critical testimony was delivered by Eric Kolchinsky, who during the majority of 2007 was the managing director in charge of the business line that rated subprime-backed CDOs at Moody's. "The incentives in the marketplace for ratings agency services favored, and still favor, short-term profit over credit quality, and quantity over quality," explained Kolchinsky. "At Moody's, the source of this conflict was the quest for market share. . . . It was an unspoken understanding that loss of market share would cause a manager to lose his or her job."

Kolchinsky didn't think that senior management ever ordered analysts to lower their standards ,but he noted that it was an "easy way for a managing director to regain market share." Recognizing the pressures, Kolchinsky doesn't accuse the managers of deliberately lowering credit standards. Rather, he explained that lower standards happened organically, as managers rationalized changes in methodology and avoided asking tough questions.

Kolchinsky explained that in early September 2007, he was told that the then-current ratings on the 2006 vintage of subprime bonds were wrong, did not reflect the best opinion of the ratings agency and were about to be downgraded severely. Kolchinsky had CDO deals in the pipeline that would have ratings tied to those bonds, so that if those bonds' ratings were wrong, the new CDO ratings would also be wrong.

Kolchinsky "believed that to assign new ratings based on assumptions which I knew to be wrong would constitute securities fraud." Kolchinsky was able to get management to adjust the CDO ratings model to avoid what he perceived to be fraud. However, Kolchinsky charged that "a nearly identical situation" occurred in January of 2009 "in connection with a transaction called Nine Grade Funding II," and in that situation management didn't address the concerns he raised. Instead, they suspended him.