December 7, 2008
Debt Watchdogs: Tamed or Caught Napping?
John Moody in 1956. He made his name by publishing
opinions on risks facing investors.
“These errors make us look either incompetent at credit analysis or like
we sold our soul to the devil for revenue, or a little bit of both.”
Moody’s managing director responding anonymously to an internal
management survey, September 2007.
housing mania was in full swing in 2005 when analysts at
Moody’s Investors Service, the nation’s oldest and most prestigious
credit-rating agency, were pressured to go back to the drawing board.
Moody’s, which judges the
quality of debt that corporations and banks issue to raise money, had just
graded a pool of securities underwritten by
Countrywide Financial, the nation’s largest mortgage lender. But
Countrywide complained that the assessment was too tough.
The next day, Moody’s
changed its rating, even though no new and significant information had come
to light, according to two people briefed on the change who requested
anonymity to preserve their professional relationships.
Moody’s had assigned high
grades to many securities containing Countrywide mortgages. Those securities
and mortgages, issued during the lending spree of recent years, later soured
— leaving investors with large losses and homeowners and communities
struggling with foreclosures.
That was not the only time
Moody’s softened its stance on Countrywide securities. It elevated ratings
several times after Countrywide complained, the people briefed on the matter
Since the subprime mortgage
troubles exploded into a full-blown
financial crisis last year, the three top credit-rating agencies —
Standard & Poor’s and
Fitch Ratings — have faced a firestorm of criticism about whether their
rosy ratings of mortgage securities generated billions of dollars in losses
to investors who relied on them.
The agencies are supposed to
help investors evaluate the risk of what they are buying. But some former
employees and many investors say the agencies, which were paid far more to
rate complicated mortgage-related securities than to assess more traditional
debt, either underestimated the risk of mortgage debt or simply overlooked
its danger so they could rake in large profits during the housing boom.
A Moody’s spokesman, Anthony
Mirenda, said the company would not change ratings without substantive
reasons. “As a matter of policy, Moody’s is obligated to reconvene a rating
committee if there is new information put forth by an issuer that could have
a material impact on a security’s creditworthiness,” he said, “and our
policies prohibit changes to ratings for anything other than credit
He added that “Moody’s knows
of no instances in which a reconvened rating committee resulted in improper
changes to ratings on Countrywide securities.”
Bank of America, which took over Countrywide earlier this year, said it
could not verify details of prior management’s interactions with Moody’s.
Members of Congress have
grilled the agencies, asking their executives to answer accusations of
incompetence and to say whether they assigned glowing ratings to keep
clients happy and expand their business.
State and federal officials
are also making inquiries. Moody’s recently disclosed in its regulatory
filings that it had received subpoenas from state attorneys general and
other authorities pertaining to its role in the credit crisis.
Moody’s said it was
cooperating with the investigations.
“Moody’s credit ratings play
an important but limited role in the financial markets — to offer reasoned,
independent, forward-looking opinions about relative credit risk, based on
rigorous analysis and published methodologies,” Mr. Mirenda said. The
company denies that it went easy on ratings to generate income.
That the credit-rating
agencies missed immense problems in the mortgage-related securities they
blessed is undeniable. Moody’s declined to say how many classes of the
securities it has downgraded. But the number is in the thousands and the
original value in the hundreds of billions of dollars.
When Moody’s began lowering
the ratings of a wave of debt in July 2007, many investors were incredulous.
“If you can’t figure out the
loss ahead of the fact, what’s the use of using your ratings?” asked an
executive with Fortis Investments, a money management firm, in a July 2007
e-mail message to Moody’s. “You have legitimized these things, leading
people into dangerous risk.”
Whether such risks were
truly undetectable, or were ignored by Moody’s and the other agencies, is at
the core of what regulators, legislators, investigators and investors are
trying to determine.
Moody’s current woes, former
executives say, were set in motion a decade or so ago when top management
started pushing the company to be more profit-oriented and friendly to
issuers of debt. Along the way, the firm, whose objectivity once derived
from the fact that its revenue came from investors who bought Moody’s
research and analysis, ended up working closely with the companies it rated,
and being paid by them.
And in 2000, when Moody’s
issued stock to the public for the first time, executives hungry to churn
out quarterly profit growth had another incentive to redirect the firm’s
focus from low-margin ratings of relatively simple bonds to highly lucrative
assessments of much more complex debt securities.
As it rode the mortgage
wave, Moody’s came to enjoy profit margins that were higher than those of
the mightiest of Fortune 500 companies, including Exxon and
“Moody’s was like a good
watchdog that had regarded the financial markets as its turf and barked and
growled when anybody it didn’t know came near it,” said Thomas J. McGuire, a
former director of corporate development at the company who left in 1996.
“But in the ’90s, that watchdog got muzzled and gelded. It was told to turn
into a lapdog.”
A Lucrative Niche
A key reason for the soaring
housing market was a process known as securitization. The machinery, devised
by Wall Street, packaged individual mortgages into ever larger and more
complex bundles. This allowed banks to sell their loans to investors,
thereby reducing the banks’ risk and allowing them to lend more to aspiring
Wall Street made handsome
profits bundling and selling the loans, and investors stepped up to buy the
packaged debt, often because rating agencies like Moody’s had graded it as
safe enough for the investors’ portfolios.
The agencies divided the
securities into slices known as tranches and analyzed each based on its
risk. The securities deemed safest received the rating Moody’s called Aaa.
Consider a residential
mortgage pool put together in summer 2006 by
Goldman Sachs. Called GSAMP 2006-S5, it held $338 million of second
mortgages to subprime, or riskier, borrowers.
The safest slice of the
security held $165 million in loans. When it was issued on Aug. 17, 2006,
Moody’s and S.& P. rated it triple-A. Just eight months later, Moody’s
alerted investors that it might downgrade the top-rated tranche. Sure
enough, it dropped the rating to Baa, the lowest investment-grade level, on
Aug. 16, 2007.
Then, on Dec. 4, 2007,
Moody’s downgraded the tranche to a “junk” rating. On April 15 of this year,
Moody’s downgraded the tranche yet again; today, it no longer trades. The
combination of downgrades and defaults hammered the securities.
Reversals like this have
enraged investors. Internal e-mail messages disclosed by Congress in
October, for example, recounted a July 2007 conversation Moody’s had with an
irate customer at Pimco, a major money management firm.
“He feels that Moody’s has a
powerful control over Wall Street but is frustrated that Moody’s doesn’t
stand up to Wall Street,” the e-mail stated. “They are disappointed that in
this case Moody’s has ‘toed the line. Someone up there just wasn’t on top of
it,’ he said.” For decades after its founding in 1909, Moody’s was an
independent and respected arbiter of credit quality. Today, the company’s
1,200 analysts rate debts of 100 nations, 12,000 corporate issuers, 29,000
public issuers like cities and 96,000 complex securities known as
“structured finance.” It is a franchise that generated revenue of $1.35
billion and earnings of $370 million in the first three quarters of this
Edmund Vogelius, a Moody’s
vice president, explained the company’s business model in a 1957 article in
Christian Science Monitor.
“We obviously cannot ask
payment for rating a bond,” he wrote. “To do so would attach a price to the
process, and we could not escape the charge, which would undoubtedly come,
that our ratings are for sale.”
In the early 1970s, Moody’s
and other rating agencies began charging issuers for opinions. The numbers
of securities — and their complexity — had increased and the agencies could
no longer finance their operations on revenue from investors who bought
In 1975, the Securities and
Exchange Commission secured the rating agencies’ positions by allowing banks
to base their capital requirements on the ratings of securities they held.
The upside of this was that it theoretically created an elegant
self-policing mechanism: any firm that ran afoul of the agencies also would
run afoul of investors. The heavier hand of direct government regulation
could be scaled back.
But for Mr. McGuire, the
former director of corporate development at Moody’s, there were also dangers
in relying on ratings as a form of regulation because the agencies would be
able to sell ratings even if they failed investors.
“Rating agencies are staffed
by ordinary people with families to support and bills to meet and mortgages
to pay,” he said in a speech to the S.E.C. in 1995. “Government regulators
are inadvertently subjecting those people to improper pressure, and share
accountability for any scandals which may result.”
Fortunes Tied to Issuers
As the agencies exerted
growing sway, they became the arbiters that issuers loved to hate. Yet
instead of viewing that ire as a reflection of their independence, Moody’s
executives decided that it signaled a need to become more friendly to
issuers of debt, according to Jerome S. Fons, a former managing director for
credit quality at Moody’s.
“In my view, the focus of
Moody’s shifted from protecting investors to being a marketing-driven
organization,” he said in testimony before Congress last month.
“Management’s focus increasingly turned to maximizing revenues. Stock
options and other incentives raised the possibility of large payoffs.”
early proponent of the profit push was John Rutherfurd Jr., who joined
Moody’s in 1985. In 1998, he became chief executive; a news release that
year praised him for helping the company’s bottom line.
According to people who
worked with him at Moody’s, Mr. Rutherfurd was very focused on profit. They
recall a conversation about 10 years ago in which he said he wanted every
Moody’s analyst to produce at least $1 million in revenue each year. This
encouraged Moody’s to generate as many ratings per analyst as possible.
In an interview, Mr.
Rutherfurd said that he might have discussed such a goal but that he did not
recall it specifically.
“Moody’s has to be all the
time both a standards business and a service business,” he said. “I wasn’t
in Moody’s in the old days, so to speak, but I think I always understood
both elements of what we had to do.”
By the time Moody’s became a
public company in 2000, structured finance had become its top source of
revenue. Employees in this unit rated bundles of assets like credit card
receivables, car loans and residential mortgages. Later they rated
collateralized debt obligations, or C.D.O.’s, yet another combination of
various bundles of debt.
Moody’s could receive
between $200,000 and $250,000 to rate a $350 million mortgage pool, for
example, while rating a municipal bond of a similar size might have
generated just $50,000 in fees, according to people familiar with Moody’s
A standard of profitability
at many companies is its operating margin, which measures how much of its
revenue is left over after it pays most expenses. While operating margins at
Moody’s were always enviable — in 2000 they stood at 48 percent — they
climbed even higher as revenue from structured finance rose. From 2000 to
2007, company documents show, operating margins averaged 53 percent.
Even thriving companies like
Exxon and Microsoft had margins of 17 and 36 percent respectively in 2007.
But Moody’s and its counterparts were not founded to be profit machines.
“The mistaken notion that
Moody’s was a company like any other, that was very fundamental,” said
Sylvain Raynes, a former Moody’s analyst who is co-founder of R&R
Consulting, a firm that helps investors gauge debt risks. “It is not just a
profit-maximization entity like Exxon or Microsoft. Moody’s has a duty to
the American public. People trusted it.”
Moody’s soaring fortunes
were tied to the housing boom. When the Federal Reserve Board cut interest
rates to 1 percent in 2003, Moody’s structured-finance revenue stood at $474
million, more than twice the amount generated just three years earlier.
As low interest rates fed
the housing surge, Moody’s structured-finance business continued to rack up
impressive gains. In 2005, structured finance generated $715 million, or 41
percent, of Moody’s total revenue.
In both 2005 and 2006,
almost all of the unit’s growth came from mortgage-related securities, the
company said, rather than other forms of debt like credit card receivables
or auto loans. By the first quarter of 2007, structured finance accounted
for 53 percent of Moody’s revenue.
The man overseeing Moody’s
structured-finance unit in the midst of the mania was Brian M. Clarkson, 52.
He had joined Moody’s as an analyst in 1991 and rose through the
organization until he became president in 2007. He resigned last May; he
declined to comment for this article.
As mortgage securities grew
more complex, investors leaned more heavily on the agencies’ ratings. There
was little transparency around the composition and characteristics of the
loans held in the pools, and the securitization process grew so complicated
that it required sophisticated systems to assess the risks embedded in each
Even though the standards at
many lenders declined precipitously during the boom, rating agencies did not
take that into account. The agencies maintained that it was not their
responsibility to assess the quality of each and every mortgage loan tossed
into a pool.
Anger From Investors
By early 2007, it was
becoming more and more obvious that the subprime mortgage boom was ending.
Yet Moody’s did not start downgrading mortgage-related securities until that
summer. In July and August, the firm cut the ratings on almost 1,000
securities valued at almost $25 billion.
“These loans are defaulting
at a rate materially higher than original expectations,” Moody’s said.
Investors sharply criticized Moody’s over the tardiness of the response,
internal documents made public in Congressional hearings show.
Two e-mail messages in July
2007 recount conversations Moody’s had with executives at Vanguard,
BlackRock and Fortis, three huge money management firms. While Fortis
offered some of the harshest assessments, none of the firms were pleased.
The Vanguard executive, the
messages show, was frustrated that Moody’s was willing to “allow issuers to
get away with murder.” As a result, the Moody’s messages say, Vanguard
“finds itself ‘less and less relying on the opinions of rating agencies.’ ”
BlackRock, meanwhile, said that Moody’s “relied too much on manufactured
data that is weak” when rating residential mortgage securities.
Two months later, Moody’s
executives held a meeting for their managing directors to talk about the
crisis. The tone of the meeting, according to a transcript released by
Congress, was defiant.
Moody’s had become a
“punching bag,” said one of its executives, an easy target for investors
eager to deflect responsibility for escalating mortgage losses.
“One of the questions
everybody asks is, ‘Why does everybody hate us so much?’ ” Mr. Clarkson said
during the meeting. “The theory that I’ve come up with lately is the fact
that it’s perfect. It’s perfect to be able to blame us for everything.”
During the meeting, Moody’s
executives predicted that the current crisis of confidence would pass, just
as investor outrage over the company’s failure to detect trouble at
Enron and Worldcom had several years earlier.
Other employees at the
meeting were not so sure. When asked by top management if the meeting
addressed the topics of greatest concern, one managing director whose
anonymous comments were part of the documents given to Congress said there
had been “really no discussion of why the structured group refused to change
their ratings in the face of overwhelming evidence they were wrong.”
And two months later,
Christopher Mahoney, former vice chairman of Moody’s and the person who led
its credit policy committee, wrote in an e-mail message to Raymond W.
McDaniel, the firm’s chief executive, that although mistakes had been made
in subprime mortgage loss estimates, “more importantly I think sector wide
risk management rules should have done more to alert investors of problems.”
A version of this article
appeared in print on December 7, 2008, on page A1 of the New York edition.