In Parts One and Two I addressed the favored status of the ratings agencies in affecting all manner of financial instruments and investment decisions. But now, as an outgrowth of Dodd-Frank, the agencies’ impact appears to be on the wane. The new OCC regulations are figuratively airbrushing the ratings agencies out of the financial landscape. My third post on the agencies addresses the final insult, as the private sector snubs them.
The shenanigans that Moody’s and Standard and Poor’s pulled in the two years leading up to their massive ratings downgrades of 3Q 2007, have come home to roost. At the same time that Dodd-Frank has smacked them down, it appears Wall Street is also now beginning to ignore them. [In fact, one might wonder if legislative comeuppance was even necessary, inasmuch as the agencies are now receiving less and less attention from the very industry upon which their existence relies. In short, it appears that we are witnessing a sort of Darwinian result, akin to what happened to the dinosaurs, who simply got too big for their own good. – PCQ]
In a June 23, 2012 article by David Fry for Seeking Alpha, entitled “Banks Rally on Downgrades”, and subtitled “Moody’s Gets No Respect” – next to a picture of Rodney Dangerfield, he writes:
“It would appear the rating agencies are either “leading from behind” or just don’t have much respect these days after they botched the mortgage crisis. [1] The 15 bank downgrades by Moody’s Thursday evening didn’t seem to bother anyone.” [2]
Bloomberg echoed a similar sentiment in its May 29, 2012 article entitled “Moody’s Fading Relevance Exposed in Nordic Downgrades”[3]:
- “The response to the Moody’s Investors Service downgrade of the biggest Nordic banks was rising bond and share prices.” (Underscore added.)
- “The reaction is the latest sign that investors are paying less attention to the views of rating companies and relying more on their own analysis to determine whether to buy or sell.”
- “’We can see for ourselves just how strong the Swedish banks are so we don’t place much weight on what rating agencies tell us,” Nicklas Granath, a partner at Stockholm-based asset manager Norron AB, who helps manage about $200 million, said in an interview. ‘More and more the market is likely to take the same approach.’”
And in an interesting post on a blog site entitled “Arbitrage the World” dealing with the financial services industry, the author spells it out in spades – the agencies’ recent downgrades appear to be their effort to make up for the incestuous relationship they carried on with the Big Banks during 2005 – 2007:
“When I see ratings agencies in the news lately because of a downgrade, I can only think of one thing: public relations. They want the public to see them as tough on their ratings when in reality, their ratings were very lax leading up to the sub-prime crisis when they were competing with each other for the investment banker’s business. In this case, they rubber stamped a lot of collateralized debt obligations (CDOs) and mortgage backed securities (MBS) even though as we later found out, they were pretty much worthless in the wake of foreclosures that followed. Investors of that debt were relying on the ratings from these agencies and when they found out the hard way that these ratings were in fact not reflective of the true default risk, they lost trust in the ratings and the companies that rated that debt.”
The Cheyne Gang. But the bad news doesn’t end in the court of public opinion. Bloomberg reports in a July 2, 2012 article entitled “Morgan Stanley Got S&P To Inflate Ratings, Investors Say” that Moody’s and Standard & Poor’s face claims that they knowingly gave inflated ratings to $23 billion worth of notes backed by subprime mortgages. This information recently came to light following the unsealing of internal documents and emails from Moody’s and Standard & Poor’s, who are defending against a major lawsuit brought in 2008 by Abu Dhabi Commercial Bank, which is based in the United Arab Emirates. [4]
According to the Bloomberg article: “The case focuses on notes issued by Cheyne Finance Plc, a so-called structured-investment vehicle that collapsed in 2007. SIVs issued short-term debt to fund purchases of higher-yielding long-term notes and failed when credit dried up amid the financial crisis, sparked by investments in mortgage-backed securities. The Cheyne SIV declared bankruptcy in August 2007 when borrowers defaulted on the mortgages that secured the notes, according to the 2009 ruling. Holders of the notes that were initially rated AAA got back little of their investment and some other securities turned out to be worthless….”
Keeping in mind that there are always two sides to a story, the plaintiffs’ version of events, if true, seem particularly incriminating for the agencies:
“As Morgan Stanley bankers were designing the Cheyne notes, they asked Moody’s to use the same volatility assumptions for subprime-backed mortgage securities as for those that had prime home loans as collateral, the investors allege in yesterday’s filing. The ratings company agreed, the investors claim. [Underscore added.] *** “We in fact built everything,” Dorothee Fuhrmann, an executive for New York-based Morgan Stanley, said according to the documents, allegedly referring to the risk-analysis methods applied to the Cheyne ratings.
Uh – did I get that right? Morgan Stanley built the risk models for the securitized investment vehicles Moody’s was to use, and then asked Moody’s to pretend that the investment bank’s subprime SIVs were no more risky than the mortgages given to prime borrowers? “Puppet, meet Puppet Master.”
Quote of the Week. Upon learning that an S&P employee had given the Cheyne securities a “BBB” rating rather than the more valuable ”A” rating,[5] a banker emailed the employee’s boss complaining that the rating was “very inappropriate.” Then, the head of the S&P group that rated the Cheyne securities, emailed that it “…would be a “good idea” to figure out how to change its methodology to be more competitive….” And responding to the upgraded ratings change, the S&P exec pondered: “I’m a bit unclear if it is a big change or a ‘wee itty bitty no-one’s going to notice’ change!” [Truth is stranger than fiction. You just can’t make this stuff up! – PCQ]
Well, Jack, someone did notice – right after the subprime mortgages began failing. Big surprise.
Conclusion. Surely, the ratings agencies must hear the drumbeat and feel the heat. They had known for years that banks such as Countrywide were making loans with little or no underwriting, to borrowers with little or no ability to repay. And as the defaults continued to mount, they concluded they could ignore reality no more. But before coming clean, they made a final push to issue as many sham ratings as possible before their performing their public pirouette in July 2007. According to the Levin Report:
“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.”
Let me repeat that: “…quickly pushed these ratings through to avoid losing revenues before the mass downgrades began.” [I don’t know which is more remarkable: Pushing through bogus ratings, or actually thinking that the timing wouldn’t give them away. These folks must be the dumbest guys in the room. – PCQ]
Justice takes many forms and much time. But eventually right prevails over wrong. Unfortunately it may not be in time to help all those who lost their retirement savings when they bought into funds that were believed to be investment grade securities.
I will not miss the ratings industry as it currently exists. Its days are numbered. If it survives at all, it will be with a new business model that somehow guarantees absolute independence from those they evaluate. The jury is still out. But unless they are perceived as totally independent in the mind of the public, the ratings agencies are going to become marginalized out of existence. Just like the dinosaurs.
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[1] The phrase “botched the mortgage crisis” is a woefully inadequate description of what the agencies did. I submit that “were enablers to the Big Banks as they caused the subprime mortgage crisis” is a more apt description of what happened.
[2] The author is referring to the recent agency downgrades that came out approximately four years too late. In short, the basis for the downgrades had been known for some time, and the result was that this information – not Moody’s recent action, had already been built into investor pricing decisions much earlier. This is what the Seeking Alpha article [quoted above] meant by “leading from behind.”
[3] “Nordic Downgrades” refers to those affecting several major banks in Sweden and Norway.
[4] The case is entitled “Abu Dhabi Commercial Bank v. Morgan Stanley,” No. 08-7508, in U.S. District Court, Southern District of New York (Manhattan).
[5][5] According to their website, an “A” rating means a “(s)trong capacity to meet financial commitments, but somewhat susceptible to adverse economic conditions and changes in circumstances.” A “BBB” rating means “Adequate capacity to meet financial commitments, but more subject to adverse economic conditions.” For comparison purposes, the next level below “BBB” is “BBB-“ which is the lowest investment grade.
