Fraud at the Credit Rating Agencies

By: David Dayen

If we had a media that highlighted events in proportion to their importance to the nation, Carl Levin’s Permanent Subcommittee on Investigations would be plastered across every channel in the nation, including MTV. He has done some spectacular work on the financial crisis in a series of hearings, essentially morphing into the Pecora Commission, the 1930s-era panel which teased out the origins of the Great Depression and devised the recommendations that made banking and finance stable for 50 years and more.

Yesterday, Levin’s committee hosted an incredible hearing on the credit rating agencies, the “independent” analysts who assess various types of securities. During the financial crisis, the rating agencies, who are owned and funded by the very banks who create the securities they rate, simply gave up any pretense of independent assessment, rubber-stamping toxic assets as triple-A and safe, neglecting the very real dangers for investors and creating a false sense of security.

“Investors trusted credit rating agencies to issue accurate and impartial credit ratings, but that trust was broken in the recent financial crisis,” said Levin. “A conveyor belt of high risk securities, backed by toxic mortgages, got AAA ratings that turned out not to be worth the paper they were printed on. The agencies issued those AAA ratings using inadequate data and outmoded models. When they finally fixed their models, they failed for a year — while delinquencies were climbing — to re-evaluate the existing securities. Then, in July 2007, the credit rating agencies instituted a mass downgrade of hundreds of mortgage backed securities, sent shockwaves through the economy, and the financial crisis was on. By first instilling unwarranted confidence in high risk securities and then failing to downgrade them in a responsible manner, the credit rating agencies share blame for the massive economic damage that followed.”

Fund managers needed top ratings to move their investments; in many cases, the entities with which they were doing deals, like pension funds or banks or insurance companies, were legally bound to have a safe AAA rating on the security. So they would basically pitch the rating agencies to give their products the seal of approval. Furthermore, the major raters – Moody’s, Standard and Poor’s and Fitch – competed with one another for business, and downgrading securities didn’t lead to repeat customers. And, the rating agencies didn’t have the resources or the methodology to really investigate things like the housing bubble. So for a variety of reasons, the rating agencies listened to the banksters and buckled under the pressure.

Levin’s committee produced 18 pages of emails (see below) from the rating agencies that shows some of the most obvious evidence of culpability that you’ll ever get. Let me just quote from a few of them:

“Version 6.0 [a new version of the S&P ratings model] could’ve been released months ago and resources assigned elsewhere if we didn’t have to massage the subprime and Alt-A numbers to preserve market share… We have known for some time, based on pool level data and LEVELS 6.0 testing that – Subprime: B and BB levels need to be raised; Alt A: B, BB and BBB levels need to be raised (we have had a disproportionate number of downgrades).” -Email from S&P employee, 3/23/2005

“We have spent significant amount of resource on this deal and it will be difficult for us to continue with this process if we do not bave an agreement on the fee issue.” “We are okay with the revised fee schedule for this transaction. We are agreeing to this under the assumption that this will not be a precedent for any future deals and that you will work with us further on this transaction to try to get to some middle ground with respect to the ratings.” -Email exchange between Moody’s and Merrill Lynch, 6112107, Subject., “Re: Rating application for Belden Point COO.”

“Lehman is proposing an alternative way of calculating haircuts which I think has some merit Independent models are provided by several banks …. I must recognize that we do not have the knowledge nor the time to develop our own models.”
–Email from Moody’s employee, 12/05/2006

You will get sick reading through these documents. They show that the rating agencies knew about the imminent collapse of the housing market through financial fraud and subprime loans as far back as 2004. And they did nothing about it, and were lured into a game of chicken with the other rating agencies, where they all made money by not blinking and downgrading the securities tied to the loans. The revenue of the rating agencies doubled in this time, from 2002-2007. They essentially were being bribed.

In testimony yesterday, the CEOs of the rating agencies plead ignorance:

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.

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 […]

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.

But if the head honchos didn’t know, their lieutenants did. Gripping testimony yesterday came from Eric Kolchinsky, a managing director at Moody’s who pushed to change the methodology on pending deals that included downgraded bonds. He was told no.

“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.

This is basically securities fraud, and yet the SEC is statutorily barred from even conducting oversight on the rating agencies. The Financial Crisis Inquiry Commission had to issue a subpoena to Moody’s to get documents released.

The financial reform bill from Chris Dodd creates an Office of Rating Agencies inside the SEC, and gives the ability to sue them for negligence. Rating agencies would need to disclose their methodologies and incorporate third-party information. But it does not truly remove the fundamental conflict of interest, where rating agencies compete for the business of those who issue securities, creating the internal pressure to rate those securities positively. Until then, we will see the same fraud in the rating agencies, in the pursuit of profits, that we see throughout Wall Street.


Fraud – Credit Rating Agencies Competitive Pressures Affecting Ratings