Fraud and Greed of Trusted Rating Agencies Helped Spread the Credit Crisis

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By, Shah Gilani
Contributing Editor
Money Morning

Underlying the credit crisis gripping the U.S. and world Trigger Event Strategist Website - Shah Gilanieconomies is a crisis of confidence. Blame has been laid at the feet of the U.S. Federal Reserve, and an investment bankers’ brew of toxic financial products. Ultimately, however, it was the supposedly trustworthy rating agencies that got everyone to drink the poisoned Kool-Aid.

The sheer fraud and greed of rating agency analysts and executives is staggering. That no one has gone to jail, and none of the agencies have been shut down is a travesty of justice on an infinitely larger scale than Bernie Madoff’s Ponzi scheme. Until depositors, bankers and investors regain confidence in the quality of ratings we rely upon to measure financial stability and creditworthiness, the tremors that underlie the credit crisis will drag on indefinitely.

Letter and number ratings – such as AAA, Aa1, BBB and Caa1 – are financial shorthand for the due diligence supposedly done by rating agencies after they’ve examined an issuer or a security’s financial structure, and evaluated the likelihood of its being able to pay interest and principal at maturity. Investors rely on the objectivity and fiduciary responsibility of the rating agencies to publish fair, accurate and uncompromised assessments.

By law, certain investors must rely on the ratings of a handful of Securities and Exchange Commission designated “Nationally Recognized Statistical Rating Organizations” (NRSROs). For example, most state insurance regulators require that only assets rated in the top four ratings categories by NRSROs are eligible investments. Similarly, money market funds can only invest in securities with the highest NRSRO ratings. In fact, innumerable institutions – public and private, and domestic and international – mandate asset quality levels predicated on the major rating agencies’ due diligence.

Standard & Poor’s Ratings Services, Moody’s Investors Service (MCO) and Fitch Ratings Inc. are all SEC-designated NRSROs. They are the largest, best-known and most-profitable ratings firms in the tiny, $5 billion-a-year universe of ratings firms. S&P is a part of The McGraw-Hill Cos. Inc. (MHP), while Fitch is a subsidiary of France’s Fimalac SA.

Moody’s was spun out of financial publisher Dun & Bradstreet Corp. (DNB) as a public company in 2000. Warren Buffett’s Berkshire Hathaway Inc. (BRK.A, BRK.B), apparently having spotted a diamond in the rough, bought into D&B before the divestiture, and ended up with a hefty 19% stake in Moody’s after the spin-off was completed.

The problem with the business of rating the issuers of securities, and rating the securities they issue – such as mortgage-backed securities and collateralized mortgage-backed obligations – is that the rating agencies are paid by the issuers to rate them. Objectivity aside, ratings firms are in business not to rate but to make money for themselves by rating issuers and their securities. It’s like all the contestants in the Miss World pageant paying the judges with country funds … who’s not going to be judged beautiful? 

What was even more problematic in the scheme of the ratings business model was that analysts didn’t understand how to analyze and rate the very complex cash flow structures of these new collateralized mortgage-backed securities. Not wanting to lose business to their competitors, who were all in the same boat, they used the same rating model structures that they used to rate corporate bonds, though the two different securities had nothing in common.

It was like asking your local car mechanic to certify your Citation V jet – just before you take off for a transatlantic flight to London. God help you if there’s a problem.

And there were problems. Lots of them. According to a Feb. 15 “Review & Outlook” piece in The Wall Street Journal, Joseph Mason, professor of finance at Drexel University, studied collateralized debt obligations rated “Baa” by Moody’s and determined that they were 10 times more likely to default than equivalently rated corporate bonds. The article went on to say that an S&P spokesperson, when asked if they actually examined the underlying mortgages in the pools, answered: “We are not auditors; we are not accounting firms.”

While S&P – and to a lesser degree, Fitch – were just playing the game, Moody’s actually ran away with the ball. An eye-popping and brilliant April 11 Journal article by Aaron Lucchetti exposed the unseemly underbelly of Moody’s greed. What stood out the most in the article was Moody’s willingness – under the direction of Brian Clarkson, who joined the firm in 1991 and became president and chief operating officer – to bend over backwards to accommodate issuers of mortgage-backed and structured finance paper. Clarkson was willing to switch analysts if clients complained, which several did, including Credit Suisse Group AG (ADR: CS), UBS AG (UBS), and Goldman Sachs Group Inc. (GS).

Under Clarkson, Moody’s expanded and grabbed a huge piece of the deal-ratings-market pie. By 2006, the company was rating $9 out of every $10 raised in mortgage securities. For all of that year, the firm’s structured finance group generated more than $881 million in revenue, about 43% of Moody’s revenue. And in 2007 it was estimated that the firm rated 94% of the approximately $190 billion in mortgage and structured-finance CDOs floated during the year.

But there was some concern, including some from insiders. Former Moody’s analyst Mark Froeba told The Journal that “there was never an explicit directive to subordinate rating quality to market share. There was, rather, a palpable erosion of institutional support for rating analysis that threatened market share.” In the same article, former Moody’s executive Paul Stevenson was quoted as saying that “the most recent problem is that the rating process became a negotiation.”

Clarkson, the Moody’s president and COO, didn’t do too badly negotiating his compensation, either. In 2006 he made $3.8 million, while the firm’s chief executive officer, Raymond McDaniel, made $8.2 million. Clarkson “retired” under pressure this past May and McDaniel, the CEO, added the title of president to his mantle.

Eventually, the always-late-to-the-dance SEC awoke to the realization that it was supposed to be watching the watchers – the ratings agencies. While hundreds of billions of dollars around the world was invested in Wall Street’s pay-to-play version of Illinois gubernatorial politics, many heartbroken and flat-out-broke investors discovered that what the rating agencies had determined to be “AAA” rated securities were not the princely investment-grade securities those three letters said they were, but were toxic Amazon frogs instead. Of course, that calls for an investigation. And so it was.

A 10-month “examination” by the SEC, concluded in July, uncovered, believe it or not, “poor disclosure practices and procedures guiding the analysis of mortgage-related debt and insufficient attention paid to managing conflicts of interest.” Brilliant!

According to the report, which included as exhibits several e-mail exchanges between analysts at unnamed ratings firms, there was an obvious degree of knowledge and complicity in playing the ratings game. In one exchange, an analyst said that their ratings model didn’t capture “half” of the deal’s risk but that “it could be structured by cows and we would rate it.” And in another even more famous exchange dated Dec. 15, 2006, a manager wrote that the firms continued to create an “even bigger monster – the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.”

Have any heads rolled? No. Have any fines been levied or any firms closed down? No. The SEC apparently went back to sleep, having since been intermittently aroused by the failure of The Bear Stearns Cos., the bankruptcy of Lehman Brothers Holdings Inc. (OTC: LEHMQ), the nationalization of American International Group Inc.(AIG), and a few other minor nap-interrupting events, including the bailout of Citigroup Inc. (C). I’m only sorry that the Commission’s disjointed hibernation should once again be interrupted by the petty crime of a simple Ponzi scheme artist. Well, maybe now they can finally get some rest. For the sake of our future, someone please disband this band of sleeping fools.

Shortly after the July examination was made public, in an acknowledgement that it might be under unwarranted attack, S&P announced that it was considering ways to take volatility and stability into account in its ratings. But, in a simultaneous burst of clarity, S&P suggested that it feared that a more disciplined and functional ratings model would make it harder for issuers to raise capital. Only days later, in fact, S&P went on the offensive, calling SEC proposals to boost disclosure and mitigate internal conflicts of interest too costly for the ratings businesses. Among the proposals that were pushed back was one to require a separate ratings structure and ranking system for structured products.

Fast-forward to Dec. 3, and the unveiling of the SEC’s latest proposed rules changes. While the toothless wonder folded up like a pup tent once again on all substantive changes that would have created a more transparent and honest playing field, it did manage to sneak in some suggestions, including those that said:

  • The rating agencies can’t rate debt they help structure.
  • Analysts can’t participate in fee negotiations.
  • Analysts can’t be given gifts worth more than $25.
  • Analysts must disclose a random 10% sampling of their ratings within six months.
  • The ratings agencies must maintain a history of complaints against analysts.
  • And that the agencies must record when an analyst’s rating for structured debt differs from a quantitative model.

Calling these proposed rules changes baby steps is like calling the Grand Canyon a ditch.

Because Wall Street didn’t like the idea, what got dropped from the proposed changes were rules to create different structures for rating different products. And the most egregious of the dropped rules was a proposal that ratings firms make public all underlying information they use in making their ratings. Which is exactly the transparency needed.

There is an overwhelming heaviness to the credit crisis that bears on our economic future. It is the inordinate weight of established, self-serving power brokers driving dump trucks full of ill-gotten gains over any clarion call for transparency. The underlying currency of capital markets must be clearly and objectively rated instruments, whose value is determined by free markets. Until confidence is restored in the producers, products and the purveyors of financial services, thirsty investors are unlikely to partake of any new punch.

[Editor’s Note: Uncertainty will continue to be the watchword for at least the first part of the New Year. Little wonder, as the global financial crisis continues to whipsaw the U.S. financial markets in a manner that hasn’t been seen since the Great Depression. It’s almost enough to make you surrender. But what if you knew, ahead of time, what marketplace changes to expect? Then you’d be in the driver’s seat – right? You’d know what to anticipate, could craft a profit strategy to follow, and could then just sit back, watching and waiting – and finally profiting from – the very marketplace events you anticipated.
R. Shah Gilani – a retired hedge fund manager and a nationally known expert on the U.S. credit crisis – has predicted five key financial crisis “aftershocks” that he says will create substantial profit opportunities for investors who know just what these aftershocks are, and how to play them. In the Trigger Event Strategist, trigger events,” as gateways to massive profits. To find out all about these five financial-crisis aftershocks, and about the trigger-event profit strategy they feed into, check out our latest report.]

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. John Thich | December 18, 2008

    I hope President Elect Obama has read this article and will do something to correct this problem…

    I am one of the millions who have seen 50% of their life savings go up in smoke…I hope I never run into one of the greedy bums who have been feeding off of the hard work of many…makes one really angry…what has happened to our country, our basic values??

  2. Paul McCloud | December 18, 2008

    Mr. Gilani is pointing out the latest "fox guarding the henhouse" scenario. As usual, his analysis is nothing short of brilliant. It seems that, no matter under which rock you turn, there's another instance of greed by these huge institutions. What I fear is that it will take a total collapse of the financial system before all of the cheating and greed is corrected. Too much of the investing world is simply speculation and greed, which is nothing but gambling. Gambling and speculation spawn lying and falsehood. There is no surprise here that rampant speculation by investors has led to such shady ratings firms because the very nature of speculation has undermined the honesty of the ratings firms. Where is the objectivity necessary to make proper evaluations? Who is going to make the final assessment without being subject to influence of money? The very fabric of our society is being affected by the influence of money, over any consideration of truth and honesty. Especially in the political arena, there is so much influence of money that the interest of the citizens is being ignored while favor is given to those who thrust money into the politician's pockets. Business and politics, being so closely intertwined, are basically in the same position of being controlled by greed. Whatever honesty and openness is left is rapidly disappearing.
    In response to the current economic crisis, we have now elected a president whose solution to this mess is to "spread the wealth" and introduce socialism. There is no surprise here. People are fed up with the current situation. However, the cure will be worse than the disease. Capitalism is not the cause of the problem. It is the lack of openness and honesty in the system. If there is indeed a demise of capitalism, it will be because of this.
    Thank you, Mr. Gilani, for another blockbuster article.

  3. r sisul | December 18, 2008

    Great article. You gave the facts – simply, logically, clearly. Let's not just 'hope' Obama reads this. Cities, states, pensions funds, bnaks, employers, the US itself is in deep yogurt. Let's make SURE our congressmen, prez-elect, governors, state reps, etc read this. Email them. Include the link. Quote part of this article in the email (in case their aides won't take the time to go to the link). If they get 'enough' mail (believe it or not only 100 is considered a lot) about this it will get their attention. We are not helpess! Please ACT.

  4. Peter .M. Sukwa | December 18, 2008

    Iam a Radio journalist at Breeze Fm in Zambia, with keen interest in following the world financial economic crisis and intervantions. i,ve fund your newletter educative and interesting more especially that i have interest in business stories. i hope to continue getting knowledge

  5. Drew | December 18, 2008

    This article is missing half the story. The problem was outdated use or poor use of "mark to market"rules regarding mortgages which were bundled as securities. These rules allowed the regular mortgage to be sold to someone else. When it was sold, the ability to change it evaporated. When housing prices went down, the decreased was marked as a "lost" even though there were assets. These losses became apparent when people renegotiated their mortgages.

  6. Ken Fischer | December 18, 2008

    Mr. Gilani, this article has brought into sharp focus for me an already existing sense of contempt and revulsion for all things referred to as "oversight." Take my own career for example. I worked 26 years in various audit functions of a very large defense contractor. The last 10 of those years (I retired 3 years ago) were spent in the "Government Compliance" department. At some point in that period I became disgusted with my own my infantile naivete when I undertook a particular audit assignment and was nearly fired for having the audacity to put my significant negative "findings" in writing. My boss said, "you know what you've done here … you've pissed on our whole program." I was astonished to suddenly discover that my job was NOT to go out and find things that were wrong but to report back that things were OK.

  7. eiffel pane | December 18, 2008

    OK, the ratings agencies did a lousy job!!!!!! Wow! That is no longer worth an article unless you have a personal interest in short positions in the stocks of these companies.

    It is comical if not naive to assume that the entire world collapsed because of the ratings agencies. What about the fed? too small? What about the politicians and the regulators? No interest? What about the responsibility of the various portfolio managers to do their own analysis before committing huge sums to these toxic assets? And who is responsible for allowing all the financial institutions to lever up as they did? If these institutions had not so used leverage, the crisis certainly would not have been as great.

    So, the question remains: why focus on just the rating agencies while there are so many other culprits? Until the author can respond to this question, he remains just as suspect in my book as the rating agencies themselves!

  8. James Yamaki | December 18, 2008

    You are hitting the heart of the problem: if rating agencies don't know what they are rating in regard to sophisticated securitizations like credit default obligations (CDOs') etc. and the risks they portend, they shouldn't be making any ratings. If they don't know, they should simply say they don't know and don't dish out any ratings at all. Let the buyers assume the risks, whatever they are, without any ratings.

    The rating agencies should be working to get back their crediblity and work within their own capabilities. What are they going to do from now? …same old same? ..for the big "bucks"?

    The system is broken and need to be fixed. Congress should continue investigating the investment market debacle. Another good place to focus would be the rating agencies.

  9. Ken Fischer | December 18, 2008

    To "eiffel pane" (post #7 above):

    First, an administrative aside … please dispense with the trendy and annoying non-use of capitals in your name.

    Now, on topic: Get a grip! The title of Mr Gilani's article today contains the words "ratings agencies HELPED spread…" There is only so much space available in one article. He certainly knows there is plenty of blame to go around and before this current financial debacle is over enough will be written about its causes to fill the world's libraries.

  10. Vicky Smith | December 19, 2008

    I had 6 credit cards and was paying more than the minimum on each-everything was all right with the world. Whoops!!
    the greedy devils raised my interest overnight to double what once was; this really tore the heck out of my budget. Guess what happened next?—The following month my interest had doubled again and I couldn't afford to pay. Now I have ventured into the bowels of credit hell. Hell does indeed exist on earth and not underground! In 3 months, I went from an excellent credit rating to HaHa go away JUST PAY WHAT THEY WANT.

  11. Ken Fischer | December 19, 2008

    To Vicky (#10 above),

    Apparently you have not heard the old saw that "compound interest is the 8th wonder of the world." Its wonderful if your earning it but disastrous if your paying it. You'll get no sympathy from me if you're dumb enough to have SIX credit cards (in the first place) and to be paying barely more than the minimum to boot. The fact that your interest rate has doubled is almost beyond the point. YOU are a microcosm of what is wrong with this country and, in fact, the world … TOO MUCH CREDIT !! If the credit agencies were telling you you had an "excellent credit rating" 3 months ago, shame on them and shame on you for believing it.

  12. Ken Fischer | December 19, 2008

    Again, to Vicky above,

    You might get a better deal from bent-nose Vinnie in Newark but remember, he don't like when people don't pay on time. Himmin da boys run their own credit agency.

  13. eiffel pane | December 20, 2008

    To Ken Fisher

    Hey Ken. Thanks for calling me trendy. Actually trendy had nothing to do with it. More like lazy!

    At any rate, you seem to be taking my comments a little too "PERSONALLY". My point is that the article talks about fraud. That is a very big word and I am not sure that the CRAs will not respond to that legally assuming that they have time to waste on this aticle. The article should have directed blame to all guilty parties. Otherwise, why wrte the article at all.

  14. v ravichandran | December 20, 2008

    The essence of the issue is who pays for the rating. So long as the issuer pays for the rating, there can be no value addition from the Rating Agencies for the investors. The value will come, when the Investors pay for Rating Agencies, then they can call the tune. To make economic sense, Rating Agencies should position their product in such a way that the Investors are able to subscribe to the ratings at a reasonable price. Having regard to the vast body of investors, it will not be an economically unviable proposition.

    Wtih regards

    Ravichandran

  15. Ken Fischer | December 20, 2008

    Sorry, "eiffel" … you're busted. It's not laziness. It is a subtile message to the world that you're WAY TOO BUSY to hold down the shift key and anybody who does has too much time on their hands. This trend began in the business world some years ago amongst the higher echelon of executives and spread downward as even the peons realized how this simple act could make them appear buried in useful activity. Now, even the janitor's email has dispensed with the upper case … who has the time for such pedantic BS?

    Oh, and by the way, my name is spelled Fischer, not Fisher.

  16. JA | December 21, 2008

    It just goes to show you what goes around comes around remeber the tv shows Dallas and Dynasty.These shows were
    a reflection of America,people pretending to be something that
    they were not i.e. AIG,Citibank,Bear Stearns,they told the world they were worth billions when in actuality it was all a myth,just paper companies with no real value,their wealth was not based on creating wealth,but making investors beleive they were making money when they were really losing money.now the world has seen that it is better to manage your own resources then rely on the above mentioned companies to manage I mean mismange for you.

  17. Carlos E. Comesana | December 22, 2008

    Looking at the disorder and losses the financial system provoked to the society as a whole, it is understand that the government has the rights to intervene and nationalize this market until healthy equilibrium is attained. Rating agencies are part of the market and consequently upon the nationalization there is no longer need for their ratings in this respect.

  18. Roger Davis | December 22, 2008

    The first comment above was by John Thich who asked – whatever happened to our values? Well, part of the blame for that change in values can be laid at the feet of some of the nation's judges – in fact our 2nd President John Adams was worried about unelected judges becoming an oligarchy. They have barred the use of Bibles in our public schools and neither the Congress nor many pastors objected. What do you think will happen to a nation which does not fear God? They ran Judge Moore out of office – what is wrong with the precepts of the Ten Commandments?

    Another part of the blame for the shift in values can be attributed to the ACLU. Here is a quote from Roger Baldwin, one of the founders: I am for Socialism, disarmament and ultimately, for the abolishing of the State itself … I seek the social ownership of property, the abolition of the propertied class and sole control of those who produce wealth. Communism is the goal.

    Of course, Communism wants nothing to do with God.

    John Adams: Our constitution was made only for a moral and religious people. It is wholly inadequate to the government of any other. October 11, 1798

    Benjamin Franklin: Only a virtuous people are capable of freedom. As nations become corrupt and vicious, they have more need of masters. April 17, 1787

    I think you get the idea, whether you agree with it or not. Perhaps we should all forget about owning stock and stick to calls and puts if you know what you are doing.

  19. eiffel pane | December 23, 2008

    Mr Fisher

    Seems to me you have quite a bit of disdain for the little people or peons as you like to refer to them. You do not seem to like janitors either! Am I right?

  20. Ken Fischer | December 23, 2008

    "eiffel"

    I have disdain for people of whatever rank who are corrupting written communication. I'll give you a perfect example … scroll up to comment #18 by JA. He or she either does not know or simply does not care when one sentence ends and another begins, has no concept of when a comma is appropriate vs a period, does not enter a space after punctuation marks, sometimes does and sometimes does not use the upper case where appropriate (like you), does not understand the difference between "then" and "than," enters a period at the end of a question rather than a question mark and has misspelled a couple of common words (e.g. remeber). If someone wants to complain of misdeeds or, especially, laxity in the running of financial institutions the least they can do is to not be guilty of the same sin. Namely, by crafting their complaint clearly and accurately. And a final note: if your aim is to push my button by, again, misspelling my last name you should put it in quotes to signal it was your intention, not just stupidity.

  21. eiffel pane | December 23, 2008

    Hey Fisher:

    Pretty pompous stuff!!!!!!! I am keeping a copy of all that nonsensical rambling. Hope you were serious about this being your final note!

  22. Ken Fischer | December 23, 2008

    Mr Pain,

    Final ONLY as to note #23. Otherwise, the battle rages on.

  23. Ken Fischer | December 24, 2008

    Mr "tower"

    You've played the misspelled-last-name card 3 times. What you need is something new such as misspelling my name AND going to a lower case f. That should get my goat.

    I feel like I'm jousting with someone who has no armor and has never ridden a horse.

  24. Bart Bunts | August 5, 2011

    Hi! After i originally commented I clicked the -Notify me when new comments are added- checkbox and now whenever a comment is added I recevie four emails sticking with the same comment. is there any way you can remove me from that service? Thanks!

  25. Yu Brauchla | September 14, 2012

    This may not be the best place to ask this, but I’m searching for the best insurance agency and I can't figure out who is good and who is not. Does anyone have any opinions on this insurance provider? They're based out of Louisville, 20 min from my home, but I haven’t been able to find reviews on them. — Braden Insurance Agency Inc., 3069 Breckenridge Lane, Louisville, KY 40220, (502)454-9191

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