[edited to include Krugman op-ed and for typos]
Senator Levin's Senate Permanent Subcommittee on Investigations held hearings Friday on "Wall Street and the Financial Crisis: the role of credit rating agencies", third in the series of hearings on the "causes and consequences" of the financial crisis. The website provides statements of Levin and Coburn as well as those of the various speakers at the hearing.
What shows through all of these hearings is the way financial institutions lost sight of any responsibility to the public interest in their effort to earn quick profits that would translate into big bonuses. Risky lending strategies promised quicker short term gains, so why not? selling complex securitization products offloaded the risky loans to clients, so why not? trading for the bank's own benefit made more money (especially when you could short naive customers) than merely serving as a staid, prudent middleman in normal business deals, so why not?
That mentality carried over to bankers' relationship with the credit rating agencies and to the way the credit rating agency did their deals, especially as more complex products were structured that were less comprehensible to even sophisticated investors. Pressure from bankers for the "right" rating approach made a difference to the rating agencies' bottom lines, and that pressure generally got what it wanted. As a result, the securitization "gig" led to huge profits from the too-ready flow of securitization dollars for banks and rating agencies. See, e.g., Levin Exhibit 1g showing doubling of the top three credit rating agencies' revenues from $3 billion to over $6 billion from 2002 to 2007, a period when about $2 trillion in mortgage-backed securities were issued (36% backed by subprime mortgages).
This has significant repercussions for the financial crisis, since the easy availability of triple-A credit ratings meant the continuing flow of easy credit through the hyped-up securitization markets. But it is also meaningful for tax analysis.
Back when I worked on mortgage securitizations (in the somewhat less heady pre-2001 days), we tax analysts also relied on credit rating agencies in making our analysis of whether a particular security would be treated as debt for federal income tax purposes. A high credit rating signifies, we thought, that the credit rating agency has done its internal modeling on the underlying assets and concluded that there is unlikely to be a default and that the cash flows on the underlying assets in the securitization are sufficient to service the debt, so that interest and principal payments can be treated as relatively certain to be paid. Lawyers giving tax advice, in other words, were also relying a great deal on credit rating agency "opinions" to give their own opinions that a security should be treated as debt rather than an equity investment. That in turn opened the security for investment by pension funds or others who would only invest in relatively "safe" debt and insured the issuer that there would be an interest deduction, rather than a nondeductible dividend or other payment on equity.
As a result, pressure from investment bankers who set up and sell securities to get the "right" credit rating may not only lead to deception of investors in terms of the riskiness of the loan but also to mistreatment of the security as debt for tax purposes.
And if investment bankers sometimes bullied junior associates to get the "right" tax opinion (which I personally experienced), one cannot doubt that they sometimes (perhaps even more frequently) bullied credit rating agency personnel to get the "right" credit rating.
But the credit rating agency problems did not just stem from this inherent conflict of interest (that investment bankers who were putting together deals were paying them to come up with a rating that would help sell the deals). They also were hoist on their own "proprietary modeling" petard. Models are only as good as historical information can make them--they cannot easily deal well with the rapid pace of financial innovations, and human judgment is especially important for new products. But the ratings agencies tended to go in the other direction--worries about market share tended to support delays in revamping models to deal with financial innovations or to enable "massaging" numbers that would otherwise lead to lower ratings and declining market share.
Here are just a few of the important statements made at the hearing:
Raiter, 1995-2005 S&P head of residential mortgage rating group:
The rating agencies were granted preferred status by the SEC and then other regulators incorporated ratings into their investment and capital rules, but nobody provided regulatory oversight or standards to ensure the quality of ratings.
Senior management ...was focused on revenue, profit and ultimately share price. Management wanted increased revenues and profit while analysts wanted more staff, data and IT support which increased expenses and obviously reduced profit.
Michelek, structured derivative products group at Moody's 1999-2007, describes how a culture that started as somewhat staid, relaxed and intellectual transformed to a please-the-clients (investment bankers" culture with Sumo wrestling in fat suits at retreats under the new head, Brian Carlson.
Structured finance...raised the profile and magnified the importance of the rating agencies. Almost by definition, structured finance products beget new structured finance products, with ever increasing degrees of complexity....
The incentives for the 'fee-based' structuring investment bank were clear; get the deal closed, and if there's a problem later on, it was just another case of "IBGYBG"-"I'll be gone, you'll be gone." ...
[The derivatives group in New York started out with a practice of using two analysts for each deal--a "quant" who would check the modeling and a lawyer who would review the documentation. But as the decade wore on, this shifted.] This shift away from two analysts per deal was, in my opinion, reflective of both the desperately under-resourced status of the Group, and the predominance of the concern for cost control (despite internally reported profit margins that were nothing short of extraordinary). ... (later comment on this issue at page 12) Nevertheless, it was hardly reassuring that soon after the initiation of rating CDOs in the London and Paris offices, complex structured finance transactions (including cash and synthetic CDOs) were being rated by only one analyst, referring all legal questions to a single (thinly stretched) lawyer based in London.
We did not 're-underwrite' any of the assets proposed for inclusion in the issuer's portfolio. Errors in the ratings assigned to the underlying assets ... by definition compound into magnified errors in the derivative product. ... "Systematic" errors--where whole cohorts or classes of assets would be found to represent more risk than was identified by the original underwriting and the rating ...understandably created very significant problems for the rating of derivative products. ...
Goldman Sachs ..were the only bank I knew of that employed someone whose primary job was--to put it politely--arbitrage the rating agencies. It was not difficult to know where Moody's stood in terms of the relative conservatism of our modeling assumptions and drafting requests; Goldman was very prompt when informing us that "S&P doesn't require that." ...
With every increase in issuance there was a concordant increase to the number and size of the structuring departments at banks. And with every such increase, there was automatic need for increasing deal flow to service that new investment in staff. ...
To be effective, [any new legislation] will do well to recognize that meaningful ratings represent a public good, and as such some part of the function of a publicly 'approved' Credit Rating Agency should acknowledge and accept the responsibility--and liability--for providing that public good.
Cifuentes, Industrial Engineering, University of Chile and former Moody's Senior Vice President
[T]he ratings agencies exacerbated the magnitude of this [financial] crisis by making three significant negative contributions: 1) They misjudged the quality of these loans..., 2) They misjudged the risk associated [with] the securitization (re-packaging) of such loans..., and 3) They misjudged the risk associated [with] the re-securitizations, that is, re-packaging of debt issued by previous securitizations... All in all, the combined effect of these three unfortunate actions was that a colossal number of securities perviously known as 'investment grade' which, until recently, was a synonym of 'low probability of defaulting.' have either defaulted or been downgraded. ...
One can only guess what could have happened if the rating agencies had monitored the subprime market with the same level of care that they seemed to have employed to monitor their market share.
Susan Barnes, currently a managing director at S&P's, provides a discussion of securitization that essentially claims that S&P has always done appropriate review based on the information provided by issuers. She provides a chronology of S&P's public statements about the deterioration of the securitization market and downgrades to RMBS deals.
Consistent with our commitment to transparency we repeatedly informed the market of our view that the credit quality of subprime loans was deteriorating and putting negative pressure on RMBS backed by those loans. And, consistent with our commitment to analytical rigor, we revised our models, took action when we believed action was appropriate, and continue to look for ways to make our analytics as strong as they can be. ...
[T]he years 2005 and 2006 were characterized by an inreasing flow of publications and information from S&P...regarding the deterioration of the subprime mortgage market and the ahistorical performance of rated securities. Beginning in late 2006, these observations resulted in the earliest and most severe rating actions that S&P has taken in this area.
McDaniel, chair and CEO of Moody's, and Yoshizawa, senior Managing Director, Moody's Investors Service, similarly claim to have highlighted the trend of escalating housing prices and loosening mortgage underwriting processes, though Moody's "like many others, did not anticipate the unprecedented confluence of forces that drove the unusually poor performance of subprime mortgages."
[P]otential conflicts exist regardless of who pays [for ratings--investors or issuers]. The key is how well the rating agencies manage the potential conflicts. We believe that Moody's manages the potential conflicts in our business model to a global best practice standard, and we have implemented a series of changes over the past year to further strengthen these standards. ...
Moody's comes into the residential mortgage securitization process well after a mortgage loan has been made...and has been identified to be sold and pooled into a residential mortgage-backed security by an originator and/or an investment bank. We do not participate in the origination of the loan; we do not receive or review individual loan files; we do not conduct due diligence; 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. ...
Beale here: What is perhaps most striking about these statements is the way the current rating agency personnel absolve themselves of responsibility by asserting that due diligence is not a part of their duties, and by avoiding discussion of the drive for market share and profits as a rating determinant. Is it really possible for an analyst to do a decent job of forecasting ability of a securitization to make payments without actually looking at the underlying assets, rather than some spreadsheet of information drawn up by the issuer? Can a rating agency determination that is provided to a customer to help that customer achieve the sales objectives it has set for the deal possibly be "independent" when the customer determines whether or not to use the rating agency and the fee paid is negotiated at the same time that discussions about the rating determination are ongoing?
Krugman concludes that the Subcommittee's "work on the financial crisis is increasingly looking like the 21st-century version of the Pecora hearings, which helped usher in New Deal-era financial regulation." See Krugman, Berating the Raters, NY Times, Apr. 25, 2010. But Krugman's key point is that the "deeply corrupt system" revealed by emails by rating agency employees is "a system that financial reform, as currently proposed, wouldn't fix." Instead, "the ratings agencies skewed their assessments to please their clients [and that] helped the financial system take on far more risk than it could safely handle."
What possible refinements to the rating process for securitizations should be made--to the extent we think that securitizations are reasonable parts of the financial system of providing credit (an assumption that should itself be questioned in considering how to restructure the financial system)? Krugman notes that the current bill before the Senate mainly makes it easier to sue for "knowing or reckless failure to do the right thing" whereas what is needed is "a fundamental change in the raters' incentives."
What kinds of things might be considered?
- More transparency is needed--should all conversations and correspondence between issuer and rating agency be summarized as an exhibit that is part of the deal documents? should rating agencies be required to provide a document summarizing the investigations they have conducted and their reasons for the rating provided as part of the deal documents?
- More analysis is needed--should every rating assignment require at least two analyst-participants whose final opinions must be included in the deal documents?
- Less attention to market share is needed--should there be some kind of random assignment of rating agency reviewer to securitization deals, to remove the drive for market share from the equation (and if so, should there be a standard fee for ratings of complex structured products based on time spent by analysts rather than on type of deal)?
- More concern for the public interest is needed--should rating agencies be liable to investors when their "opinions" reflect a much more optimistic flavor than their internal documents and other analyses of relevant information show? should their opinions be regulated like tax opinions by practitioners before the IRS under Circular 230--e.g., with specified requirements for disclosures and certifications of amount of certainty depending on the category of opinion (AAA requires a certification of more due diligence than BBB, etc.)?