Credit Rating Agencies – The Shills in the Crowd

Shill – “…a person who helps a person or organization without disclosing that he or she has a close relationship with that person or organization. “Shill” typically refers to someone who purposely gives onlookers the impression that he or she is an enthusiastic independent customer of a seller (or marketer of ideas) that he or she is secretly working for.” Wikipedia

Introduction. The Fall of 2007 seems like a long time ago.  While most people do not mark the season with anything other than falling leaves and back-to-school activities, the third quarter of 2007 was a watershed moment.  It represented a period of massive investment downgrades by the credit rating agencies, and marks the tipping point for the financial crisis that was to follow.

Until Q3, 2007, the credit ratings companies had been issuing high grade ratings to investments that, we now know, did not deserve them. Without these ratings, investment banks could not have bought and packaged millions of home loans to sell as securities to large investors.  Without investment banks buying their loans, lending banks would not have tossed their underwriting standards out the window.  Without banks originating millions of bad loans to purchase homes, real estate values would not have ballooned to stratospheric levels.  In short, the rating agencies were enablers of the entire securitization process that set in motion the rise and fall of the American real estate industry.

What are the “rating agencies” anyway, and how did they get so much power?  How is it that they had the ability to make and break markets, when their entire business model was based upon a huge conflict of interest?  And why is anyone giving them any credence today, when they were, together with the big investment banks, the shills in the crowd, giving inflated ratings to junk, so investors would buy them?  Lastly, how have they escaped liability for their misdeeds? Or have they?

The Senate Subcommittee Investigation. Among all of the papers, reports, articles, panels, and investigations into the causes of the financial crisis, the very best source is the U. S. Senate’s Permanent Subcommittee on Investigations Report titled: “WALL STREET AND THE FINANCIAL CRISIS: Anatomy of a Financial Collapse” (hereinafter, “the Report”)  It lays the entire financial industry out on the autopsy table, and performs a complete post mortem exam, paying particular attention to the pathology leading to the cause of death.

Seventy-five pages of the 639-page Report are devoted to the ratings agencies.  Here’s a summary of the Committee’s indictment:

• Historically, the Securities and Exchange Commission’s (SEC) regulations required the use of credit ratings by Nationally Recognized Statistical Rating Organizations (“NRSRO”).
• Until recently, there were only three NRSROs: Moody’s, S&P, and Fitch Rating Ltd.  By some accounts, these three firms issue about 98% of all credit ratings and collect 90% of the industry’s rating revenue.  By 2008, just as the financial crisis was bubbling over, the SEC had granted NRSRO status to ten credit rating agencies.
• Prior to the stock market crash of 1929 crash, credit rating agencies made money by charging subscription fees to investors of financial instruments.  This method of payment was known as the “subscriber-pays” model.  Following the 1929 crash, the credit rating agencies fell out of favor because: “Investors were no longer very interested in purchasing ratings, particularly given the agencies’ poor track record in anticipating the sharp drop in bond values beginning in late 1929. The rating business remained stagnant for decades.”
• In 1970, the credit rating agencies changed to an “issuer-pays” model and have used it since. In this model, the party seeking to issue a financial instrument, such as a bond or security, pays the credit rating agency to analyze the credit risk and assign a credit rating to the financial instrument.  [This is like Consumer Reports getting paid by the manufactures of the products it evaluates. No conflict there! – PCQ]
• “The conflict of interest inherent in an issuer-pay setup is clear:  rating agencies are incentivized to offer the highest ratings, as opposed to offering the most accurate ratings, in order to attract business.  It is much like a person trying to sell a home and hiring a third-party appraiser to make sure it is worth the price.  Only, with the credit rating agencies, it is the seller who hires the appraiser on behalf of the buyer – the result is a misalignment of interests.  This system, currently permitted by the SEC, underlies the “issuers-pay” model.”
• “Credit ratings use a scale of letter grades, from AAA to C, with AAA ratings designating the safest investments and the other grades designating investments at greater risk of default.   Investments with AAA ratings have historically had low default rates.  For example, S&P reported that its cumulative RMBS [Residential Mortgage Backed Securities – PCQ] default rate by original rating class (through September 15, 2007) was 0.04% for AAA initial ratings and 1.09% for BBB.  Financial instruments bearing AAA through BBB- ratings are generally called “investment grade,” while those with ratings below BBB- (or Baa3) are referred to as “below investment grade” or sometimes as “junk” investments.  Financial instruments that default receive a D rating from S&P, but no rating at all by Moody’s.”
• Over the last ten years, Wall Street firms devised increasingly complex financial instruments for sale to investors. These included the Residential Mortgage Backed Securities (“RMBS”) and Collateralized Debt Obligations (“CDOs”).”  Because of their complexity, investors relied heavily on the credit rating agencies to determine whether they could or should buy the products.
• Ignoring the obvious conflict of interest, for a fee, Wall Street firms helped the investment banks design these complex instruments in order to obtain the best ratings. It was these instruments that were packaged and sold as securities to pension funds, insurance companies, university endowments, municipalities, and hedge funds.
• “Here’s how one federal bank regulatory handbook put it: ‘The rating agencies perform a critical role in structured finance – evaluating the credit quality of the transactions. Such agencies are considered credible because they possess the expertise to evaluate various underlying asset types, and because they do not have a financial interest in a security’s cost or yield.  Ratings are important because investors generally accept ratings by the major public rating agencies in lieu of conducting a due diligence investigation of the underlying assets and the servicer.’”
• Wall Street investment banks began to blend high risk assets, such as subprime mortgage backed securities carrying a high rate of return, with safer assets carrying investment grade AAA ratings.  This alchemy, aided and abetted by the ratings bureaus, made these securities appear especially attractive as “safe” investments.  [This is the “lipstick on a pig” approach to securities packaging and sales. – PCQ]
• During this same period, with loan underwriting that was virtually nonexistent, Americans were clamoring for home loans.  This drove up prices and risk, as more people obtained loans that should not have.  At this time, the National Association of Realtors®’ housing affordability index  – which measures what a typical family can afford for a home loan – showed that housing had become less affordable than at any point in the previous 20 years.
• Ratings became big money during the mortgage pooling and securitization craze:  Moody’s gross revenues from ratings more than tripled in five years, from over $61 million in 2002, to over $260 million in 2006.  In 2002, S&P’s gross revenue for RMBS and mortgage related CDO ratings was over $64 million and increased to over $265 million in 2006.
• “In the years leading up to the financial crisis, Moody’s and S&P together issued investment grade ratings for tens of thousands of RMBS and CDO securities, earning substantial sums for issuing these ratings.  In mid-2007, however, both credit rating agencies suddenly reversed course and began downgrading hundreds, then thousands of RMBS and CDO ratings. These mass downgrades shocked the financial markets, contributed to the collapse of the subprime RMBS and CDO secondary markets, triggered sales of assets that had lost investment grade status, and damaged holdings of financial firms worldwide.  Perhaps more than any other single event, the sudden mass downgrades of RMBS and CDO ratings were the immediate trigger for the financial crisis.” [Underscore mine. PCQ]

The Mass Downgrades. Why did they happen?

• “During the first half of 2007, despite the news of failing subprime lenders and increasing subprime mortgage defaults, Moody’s and S&P continued to issue AAA credit ratings for a large number of RMBS and CDO securities.  In the first week of July 2007 alone, S&P issued over 1,500 new RMBS ratings, a number that almost equaled the average number of RMBS ratings it issued in each of the preceding three months.   From July 5 to July 11, 2007, Moody’s issued approximately 675 new RMBS ratings, nearly double its weekly average in the prior month. The timing of this surge of new ratings on the eve of the mass downgrades is troubling, and raises serious questions about whether S&P and Moody’s quickly pushed these ratings through to avoid losing revenues before the mass downgrades began.”  [Underscore mine. – PCQ]
• Then, in mid-July 2007, S&P and Moody’s began the first of several mass rating downgrades. “On July 10, S&P placed on credit watch, the ratings of 612 subprime RMBS with an original value of $7.35 billion, and two days later downgraded 498 of these securities.  On July 10, Moody’s downgraded 399 subprime RMBS with an original value of $5.2 billion.”
• By the end of July, S&P had downgraded more than 1,000 RMBS and almost 100 CDO securities.
• “The downgrades created significant turmoil in the securitization markets, as investors were required to sell off RMBS and CDO securities that had lost their investment grade status, RMBS and CDO securities in the investment portfolios of financial firms lost much of their value, and new securitizations were unable to find investors.  The subprime RMBS secondary market initially froze and then collapsed, leaving financial firms around the world holding suddenly unmarketable subprime RMBS securities that were plummeting in value.” [Thus, without a private market to buy these securitized packages of risky residential loans, the lending banks couldn’t – or wouldn’t -loan more money, since they had nowhere to off-load the paper. Thus, the residential housing market froze up, prices had already begun to fall and toxic loans began to default in record numbers. But refinancing was out of the question because of falling values.  And this loss in value made it difficult to sell homes, as well. – PCQ]
• “Neither Moody’s nor S&P produced any meaningful contemporaneous documentation explaining their decisions to issue mass downgrades in July 2007, disclosing how the mass downgrades by the two companies happened to occur two days apart, or analyzing the possible impact of their actions on the financial markets.  When Moody’s CEO, Raymond McDaniel, was asked about the July downgrades, he indicated that he could not recall any aspect of the decision- making process.   He told the Subcommittee that he was merely informed that the downgrades would occur, but was not personally involved in the decision.”  [This is known as the “Sargent Schultz Defense”. – PCQ]
• “In late 2007, both credit rating agencies began downgrading the securities; by 2008, they began downgrading the AAA rated securities, and by August 2009 S&P had downgraded all its tranches [i.e. slices of the pooled investments which consisted of various combinations of rated securities, from high to low. – PCQ] to noninvestment grade or junk status.”
• One particularly glaring example of the speed with which downgrades occurred following their being issued with AAA ratings was the Delphinus CDO:  According to the Report, “…Moody’s gave AAA ratings to seven of its tranches and S&P to six tranches in July and August 2007, respectively, but began downgrading its securities by the end of the year, and by the end of 2008, had fully downgraded its AAA rated securities to junk status. *** Analysts have determined that, by 2010, over 90% of subprime RMBS securities issued in 2006 and 2007 and originally rated AAA had been downgraded to junk status by Moody’s and S&P.

What Do The Ratings Agencies Have Do Say For Themselves? It is true that the ratings agencies acknowledged the risks early on.

• “Both S&P and Moody’s published a number of articles indicating the potential for deterioration in RMBS performance.   For example, in September 2005, S&P published a report entitled, “Who Will Be Left Holding the Bag?” The report contained this strong warning: ‘It’s a question that comes to mind whenever one price increase after another – say, for ridiculously expensive homes – leaves each succeeding buyer out on the end of a longer and longer limb:  When the limb finally breaks, who’s going to get hurt?  In the red-hot U.S. housing market, that’s no longer a theoretical riddle.  Investors are starting to ask which real estate vehicles carry the most risk – and if mortgage defaults surge, who will end up suffering the most.’”
• But it is also true that these agencies failed to heed their own warnings – and the warnings of others – such as the federal government.  In 2004, the FDIC issued a statement of concern about more and more high-risk loan delinquencies:  “[I]t is unlikely that home prices are poised to plunge nationwide, even when mortgage rates rise.  The greater risk to insured institutions is the potential for increased credit delinquencies and losses among highly leveraged, subprime, and ARM [adjustable rate mortgage- PCQ] borrowers.  The high-risk segments of mortgage lending may drive overall mortgage loss rates higher if home prices decline or interest rates rise.”
• The Report goes into detail covering the incestuous relationship [likened to a “Stockholm Syndrome” by one insider] between the captive rating agencies and their captors, the big investment banks. Factors such as the drive for market share between Moody’s and S&P; rocketing share prices, increased executive bonuses, and other forces, all permitted the agencies to become shills for the sponsors of the bonds being marketed.

“We’re just rendering our ‘opinions’ – You have to do your own due diligence.” So far, the ratings agencies have been able to dodge civil liability claims from institutional investors that relied upon the “investment grade” ratings that were handed out like party favors.

In May, 2011, the U.S. Court of Appeals for the Second Circuit issued a unanimous 3-judge ruling that the rating agencies were only issuing an “opinion” and under their commercial Free Speech rights, could do so without liability.  For the Wall Street Journal story, link here. This opinion, along with several others in the Federal District Courts, tended to affirm the “opinion” argument.  Indeed, this is consistent with Moody’s own Terms of Use, below:

“Moody’s obtains all information furnished on the Site from sources believed by it to be accurate and reliable. You expressly agree that (a) the credit ratings and other opinions provided via the Site are, and will be construed solely as, statements of opinion of the relative future credit risk (as defined below) of entities, credit commitments, or debt or debt-like securities and not statements of current or historical fact as to credit worthiness, investment or financial advice, recommendations regarding credit decisions or decisions to purchase, hold or sell any securities, endorsements of the accuracy of any of the data or conclusions, or attempts to independently assess or vouch for the financial condition of any company; (b) the credit ratings and other credit opinions provided via the Site do not address any other risk, including but not limited to liquidity risk, market value risk or price volatility; (c) the credit ratings and other opinions provided via the Site do not take into account your personal objectives, financial situations or needs; (d) each rating or other opinion will be weighed, if at all, solely as one factor in any investment or credit decision made by or on behalf of you; and (e) you will accordingly make your own study and evaluation of each credit decision or security, and of each issuer and guarantor of, and each provider of credit support for, each security or credit that you may consider purchasing, holding, selling, or providing. Further, you expressly agree that any tools or information made available on the Site are not a substitute for the exercise of independent judgment and expertise. You should always seek the assistance of a professional for advice on investments, tax, the law, or other professional matters. For purposes of this paragraph, Moody’s defines “credit risk” as the risk that an entity may not meet its contractual, financial obligations as they come due and any estimated financial loss in the event of default.” [Text in bold mine. PCQ]

So, riddle me this:  If (a) these ratings agencies, which publically tout their skill and expertise at doing what they do, cannot be relied upon in the ratings they issue, and (b) investors should “seek the assistance of a professional for advice on investments,” where are they supposed to go?  Aren’t the rating agencies supposed to be the smartest guys in the room?  Isn’t this their business?

In his definitive book on the causes of the financial crisis, The Big Short,” author Michael Lewis writes: “Everyone could evaluate a U.S Treasury Bond; hardly anyone could understand a subprime mortgage-backed CDO.  There was a natural role of an independent arbiter on these opaque piles of risky loans. ‘…it became clear to me that this entire huge industry was just trusting in the ratings,” Eisman said.  ‘Everyone believed in the ratings, so they didn’t have to think about it.'”

Clearly, the ratings agencies are issuing “opinions” that they know will be relied upon by others to make investment decisions.  But when the “opinions” have been bought and paid for by the companies benefited by them, the process takes on a the appearance of shills in the crowd, hyping investments so others will buy them.

Are The Agencies Off The Hook Today For Their Misdeeds Of The Past? Only time will tell.  But there is one misdeed that may come back to haunt one or more of them.  It appears that S&P may have been up to some mischief involving the Delphinus CDO [referenced above and discussed in the Report]. As reported in the Wall Street Journal on September 27, 2011, the Securities and Exchange Commission has initiated an investigation of S&P [Yes, the very same agency that recently downgraded the United States’ credit rating….PCQ] for assigning its highest triple-A investment rating to the $1.6B CDO deal based on “dummy,” or hypothetical, assets.  Delphinus collapsed in spectacular fashion within six months.  Apparently, using dummy assets is not uncommon for credit-rating firms.  They do this in order to determine a final rating for the investment when the tranches are not yet fully sold out.  [It still sounds fishy to me, since the rating is thus “hypothetical” and based upon a best-case scenario. – PCQ] However, in S&P’s rating of Delphinus, the “dummy” assets were replaced with lower quality assets but S&P still maintained the original triple-A rating.  In the vernacular, this appears to be the quintessential “bait and switch.”

The Wall Street Journal article noted that since Moody’s and Fitch had also used “dummy” assets in the Delphinus CDO, “(i)t isn’t clear why S&P received a Wells notice [SEC notice of intent to bring enforcement action. – PCQ] while Moody’s and Fitch didn’t.”  Perhaps it’s because Moody’s and Fitch didn’t downgrade the country’s credit rating….

Conclusion. There is little question that the big three rating agencies have suffered significant reputational damage as a result of the financial crisis, which, due to their reckless upgrades and then massive downgrades, were perhaps the single-most significant cause of the financial crisis.  However, it has successfully avoided any serious financial consequences.  The next move is up to the SEC, Congress, and the Court of Public Opinion.