How Moody’s sold ratings, and sold out investors

[Naveed Yaseen]

WASHINGTON: As the housing market collapsed in late 2007, Moody’s Investors Service, whose investment ratings were widely trusted, responded by purging analysts and executives who warned of trouble and promoting those who helped Wall Street plunge the country into its worst financial crisis since the Great Depression, McClatchy newspapers reported on Sunday.

A McClatchy investigation has found that Moody’s punished executives who questioned why the company was risking its reputation by putting its profits ahead of providing trustworthy ratings for investment offerings.

Instead, Moody’s promoted executives who headed its ‘structured finance’ division, which assisted Wall Street in packaging loans into securities for sale to investors. It also stacked its compliance department with the people who awarded the highest ratings to pools of mortgages that soon were downgraded to junk. Such products have another name now: “toxic assets.”

As Congress tackles the broadest proposed overhaul of financial regulation since the 1930s, however, lawmakers still aren’t fully aware of what went wrong at the bond rating agencies, and so they may fail to address misaligned incentives such as granting stock options to mid-level employees, which can be an incentive to issue positive ratings rather than honest ones.

The Securities and Exchange Commission issued a blistering report on how profit motives had undermined the integrity of ratings at Moody’s and its main competitors, Fitch Ratings and Standard & Poor’s , in July 2008 , but the full extent of Moody’s internal strife never has been publicly revealed.

Moody’s, which rates McClatchy’s debt and assigns it quite low value, disputes every allegation against it. “Moody’s has rigorous standards in place to protect the integrity of ratings from commercial considerations,” said Michael Adler , Moody’s vice president for corporate communications, in an e-mail response to McClatchy.

Insiders, however, say that wasn’t true before the financial meltdown. “The story at Moody’s doesn’t start in 2007; it starts in 2000,” said Mark Froeba, a Harvard-educated lawyer and senior vice president who joined Moody’s structured finance group in 1997.

“This was a systematic and aggressive strategy to replace a culture that was very conservative, an accuracy-and-quality oriented (culture), a getting-the-rating-right kind of culture, with a culture that was supposed to be ‘business-friendly’, but was consistently less likely to assign a rating that was tougher than our competitors,” Froeba said.

After Froeba and others raised concerns that the methodology Moody’s was using to rate investment offerings allowed the firm’s profit interests to trump honest ratings, he and nine other outspoken critics in his group were “downsized” in December 2007.

“As a matter of policy, Moody’s does not comment on personnel matters, but no employee has ever been let go for trying to strengthen our compliance function,” Adler said.Moody’s was spun off from Dun & Bradstreet in 2000, and the first company shares began trading on October 31 that year at $12.57. Executives set out to erase a conservative corporate culture.

To promote competition, in the 1970s ratings agencies were allowed to switch from having investors pay for ratings to having the issuers of debt pay for them. That led the ratings agencies to compete for business by currying favour with investment banks that would pay handsomely for the ratings they wanted.

Wall Street paid as much as $1 million for some ratings, and ratings agency profits soared. This new revenue stream swamped earnings from ordinary ratings.

“In 2001, Moody’s had revenues of $800.7 million; in 2005, they were up to $1.73 billion; and in 2006, $2.037 billion. The exploding profits were fees from packaging, and for granting the top-class AAA ratings, which were supposed to mean they were as safe as US government securities,” said Lawrence McDonald in his recent book, ‘A Colossal Failure of Common Sense’.

He’s a former vice president at now defunct Lehman Brothers, one of the highflying investment banks that helped create the global crisis.

From late 2006 through early last year, however, the housing market unraveled, poisoning first mortgage finance, then global finance. More than 60 per cent of the bonds backed by mortgages have had their ratings downgraded.

“How on earth could a bond issue be AAA one day and junk the next unless something spectacularly stupid has taken place? But maybe it was something spectacularly dishonest, like taking that colossal amount of fees in return for doing what Lehman and the rest wanted,” McDonald wrote.

Ratings agencies thrived on the profits that came from giving the investment banks what they wanted, and investors worldwide gorged themselves on bonds backed by US car loans, credit card debt, student loans and, especially, mortgages.

Before granting AAA ratings to bonds that pension funds, university endowments and other institutional investors trusted, the ratings agencies didn’t bother to scrutinise the loans that were being pooled into the bonds. Instead, they relied on malleable mathematical models that proved worthless.

“Everyone else goes out and does factual verification or due diligence. The credit rating agencies state that they are just assuming the facts that they are given,” said John Coffee, a finance expert at Columbia University. “This system will not get fixed until someone credible does the necessary due diligence.”

Nobody cared about due diligence so long as the money kept pouring in during the housing boom. Moody’s stock peaked in February 2007 at more than $72 a share.

Billionaire investor Warren Buffett’s firm Berkshire Hathaway owned 15 per cent of Moody’s stock by the end of 2001, company reports show. That stake, largely still intact, meant that the Oracle from Omaha reaped huge financial rewards while Moody’s overlooked the glaring problems in pools of subprime mortgages. A Berkshire spokeswoman had no comment.

One Moody’s executive who soared through the ranks during the boom years was Brian Clarkson, the guru of structured finance. He was promoted to company president just as the bottom fell out of the housing market.

Several former Moody’s executives said he made subordinates fear they’d be fired if they didn’t issue ratings that matched competitors’ and helped preserve Moody’s market share.

Froeba said his Moody’s team manager would tell his team that he, the manager, would be fired if Moody’s lost a single deal. “If your manager is saying that at meetings, what is he trying to tell you?” Froeba asked.

In the 1990s, Sylvain Raynes helped pioneer the ratings of so-called exotic assets. He worked for Clarkson. “In my days, I was pressured to do nothing, to not do my job,” said Raynes, who left Moody’s in 1997. “I saw in two instances, two deals and a rental car deal, manipulation of the rating process to the detriment of investors.”

When Moody’s went public in 2000, mid-level executives were given stock options. That gave them an incentive to consider not just the accuracy of their ratings, but the effect they’d have on Moody’s, and their own, bottom lines.

“It didn’t force you into a corrupt decision, but none of us thought we were going to make money working there, and suddenly you look at a statement online and it’s (worth) hundreds and hundreds of thousands (of dollars). And it’s beyond your wildest dreams working there that you could make that kind of money,” said one former mid-level manager, who requested anonymity to protect his current Wall Street job.

Moody’s spokesman Adler insisted that compensation of Moody’s analysts and senior managers “is not linked to the financial performance of their business unit.” Clarkson couldn’t be reached to comment.

Clarkson’s own net worth was tied up in Moody’s market share. By the time he was pushed out in May 2008, his compensation approached $3 million a year.

Clarkson rose to the top in August 2007, just as the subprime crisis was claiming its first victims. Soon afterward, a number of analysts and compliance officials who’d raised concerns about the soundness of the ratings process were purged and replaced with people from structured finance.

“The CEO is from a structured finance background, most of the people in the leadership were from a structured finance background, and it was putting their people in the right places,” said Eric Kolchinsky, a managing director in Moody’s structured finance division from January 2007 to November 2007, when he was purged, he said, for questioning some of the ratings.

“If they were serious about compliance, they wouldn’t have done that, because it isn’t about having friends in the right places, but doing the right job.”

Another mid-level Moody’s executive, speaking on the condition of anonymity for fear of retribution, recalls being horrified by the purge.

“It is just something unthinkable, putting business people in the compliance department. It’s not acceptable. I was very upset, frustrated,” the executive said. “I think they corrupted the compliance department.”

One of the new top executives was Michael Kanef , who was experienced in assembling pools of residential mortgage-backed securities, but not in compliance, the division that was supposed to protect investors.

“What signal does it send when you put someone who ran the group that assigned some of the worst ratings in Moody’s history in charge of preventing it from happening again,” Froeba said of Kanef.

Clarkson and Kanef, who remain at Moody’s, were named in a class-action lawsuit alleging that Moody’s misled investors about its independence from companies that paid it for ratings.

Kanef went after Scott McCleskey, the vice president of compliance at Moody’s from the spring of 2006 until September 2008, and the man that Moody’s said was the one to see for all compliance matters.

“It’s speculation, but I think Scott was trying to get people to follow some rules and people weren’t ready to accept that there should be rules,” Kolchinsky said.

McCleskey testified before the House of Representatives Oversight and Government Reform Committee on September 30 and described how he was pushed out on the heels of the people he’d hired.

“One hour after my departure, it was announced that I would be replaced by an individual from the structured finance department who had no compliance experience and who, to my recollection, had been responsible previously for rating mortgage-backed securities,” McCleskey testified.

His replacement, David Teicher, had no compliance background. SEC documents describe him as a former team director for mortgage-backed securities from 2006 to 2008.

McCleskey had raised concerns about the integrity of the ratings process, and Moody’s had excluded him from meetings in January 2008 with the Securities and Exchange Commission about the eroding quality of pools of subprime loans that Moody’s had blessed with top ratings.

SEC officials, however, didn’t bother to seek out McCleskey, even though he was the “designated compliance officer” in company filings with the agency. The SEC maintains that its officials met with Kanef because he was McCleskey’s superior.

SEC spokesman Erik Hotmire said that officials met with Kanef because “we ask to interview whomever we determine is appropriate.”

Another former Moody’s executive, requesting anonymity for fear of legal action by the company, said the agency might’ve understood what was going wrong better if it had talked to the hands-on compliance officials.

“If they had known he’d (Kanef) come from structured finance, the conflict of having him in that position should have been evident from the start,” the former executive said.

Others who worked at Moody’s at the time described a culture of willful ignorance in which executives knew how far lending standards had fallen and that they were giving top ratings to risky products.

“I could see it coming at the tail end of 2006, but it was too late. You knew it was just insane,” said one former Moody’s manager. “They certainly weren’t going to do anything to mess with the revenue machine.”

Moody’s wasn’t alone in ignoring the mounting problems. It wasn’t even first among competitors. The financial industry newsletter Asset-Backed Alert found that Standard & Poor’s participated in 1,962 deals in 2006 involving pools of loans, while Moody’s did 1,697. In 2005, Standard & Poor’s did 1,754 deals to Moody’s 1,120. Fitch was well behind both.

“S&P is deeply disappointed in the performance of its ratings on certain securities tied to the US residential real estate market. As far back as April of 2005, S&P warned investors about increased risks in the residential mortgage market,” said Edward Sweeney, a company spokesman.

S&P revised the criteria and demanded greater buffers against default risks before rating pools of mortgages, he said.

Still, S&P continued to give top ratings to products that analysts from all three ratings agencies knew were of increasingly poor quality. To guard against defaults, they threw more bad loans into the loan pools, telling investors they were reducing risk.

The ratings agencies were under no legal obligation since technically their job is only to give an opinion, protected as free speech, in the form of ratings.

“As an analyst, I wouldn’t have known there was a compliance function. There was an attitude of carelessness, or careless ignorance of the law. I think it is a result of the mentality that what we do is just an opinion, and so the law doesn’t apply to us,” Kolchinsky said.

Experts such as Columbia University’s Coffee think that Congress must impose some legal liability on credit rating agencies. Otherwise, they’ll remain “just one more conflicted gatekeeper,” and the process of pooling loans, essential to the flow of credit, will remain paralysed and economic recovery restrained.

“If (credit) remains paralysed, small banks cannot finance the housing demand. They have to take them (investment banks) and these mortgages and move them to a global audience,” said Coffee. “That can’t happen unless the world trusts the gatekeeper.”

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