Affordable Housing Institute : US

How much opportunity should an issuer have to work with a rating agency to achieve a target result?

 

[For background on the rating agencies, see my five-part post from last August, A Symbiote’s Life is Not a Happy One, Part 1, Part 2, Part 3, Part 4, and Part 5.]

 

 

Mel: You mean to tell me that you argued your way from a C+ to an A-?
Cher: Totally based on my powers of persuasion, you proud?
Mel: Honey, I couldn’t be happier than if they were based on real grades.

– Cher Horowitz (Emma Woodhouse), Clueless, to her father the litigator

 

“Honey, I couldn’t be happier than if they were based on real grades.”

 

That’s the question posed by an interesting and thorough Wall Street Journal article on how the rating agencies evolved toward more responsive symbiosis with those whom they were rating (and who were paying their fees):

 

RATING GAME
As Housing Boomed,
Moody’s Opened Up

 

At issue is whether the rating agency, in pursuit of greater market share and higher fees, consciously or subconsciously lowered its vigilance, like a university luring students with the promise of easy grade-inflated high marks.  Given the massive collapse of previous ratings rounds, where thousands of issues were marked down in one day like contaminated goods, it’s a rebuttable presumption. 

 

Moody’s acknowledges it sometimes got things wrong in judging mortgage bonds, but says these were honest mistakes and not the result of efforts to garner market share. It says it has maintained its rigor and objectivity in a rating process that is still adversarial toward big investment banks.

 

While we would ordinarily view charges against an issuer with a skeptical eye, here the scale of the error is so great I think the burden of proof is reversed; it’s up to the rating agencies, in particular Moody’s, to demonstrate that being palsy-walsy with their clients was merely good relationship management, not becoming a rater of easy virtue.

 

“It may be virtue, but it ain’t easy”

 

Bond-rating agency Moody’s Investors Service used to be an ivory tower of finance. Analysts were discouraged from having a drink with a client.  Phone calls from bankers went unanswered if they rang during intense, almost academic debates about credit ratings.

 

John Bohn, Moody’s president from 1989 to 1996, says he used to tell recruits that Moody’s was a “special business” where “you can’t go out for beers” with friends who worked for investment banks.

 

A rating agency is not a university, not a pure research institution.  It is a business – a paid referee – and it has a business model.  It needs revenue, which means it needs clients, which means it needs to schmooze them:

 

Mr. Clarkson’s view is that “it’s important to socialize.” The onetime mountain climber and recreational weightlifter met with investment-bank officials and gave speeches at industry conferences peppered with movie quotes and references to television shows like “Survivor.”

 

Oh God, popular culture references!   Is nothing sacred?

 

Ratings are sacred if nothing else!

 

Next we’ll hear he’s blogging, and – worst crime of all! – making fun of the Wall Street Journal!

 

My goodness, making fun of institutions!

 

Anyhow, while a rating agency referees the games, it’s also paid by the players.

 

Firms like Moody’s are hired by companies, governments and other organizations that seek to sell bonds. The firms rate bonds based on the likelihood they’ll default — and, in Moody’s case, also based on how much of their principal bondholders are likely to get back.

 

Top-rated triple-A bonds rarely miss payments, and even if they do, investors can expect to get nearly all of their money back. Bonds rated B and C are more likely to lose money for their owners. To compensate for the added risk, they pay higher interest rates. Bond buyers depend heavily on the ratings, and conservative investors often buy only triple-A bonds.

 

Bond issuers, knowing that a higher rating means they pay a lower interest rate, have an incentive to shop around among rating agencies. And they have clout as they shop: They’re the ones paying the bill.

 

It competes with other rating agencies – Standard and Poor’s, and Fitch being the two biggest – so one can imagine a collaborative relationship between Moodys’ desire to expand its rating business and the issuers’ desire to achieve higher ratings:

 

A decade ago, as the housing market was just beginning to take off, Moody’s was a small player in analyzing complex securities based on home mortgages. Then, Moody’s joined Wall Street and many investors in partaking of the punch bowl.

 

Some people just can’t handle the ratings, can they?

 

How was this indulgence manifested?

 

1.   A firm once known for a bookish culture began to focus on the market share that affected its own revenue and profit.

2.   The rating firm became willing, on occasion, to switch analysts if clients complained.

3.   An executive overseeing mortgage ratings went skydiving with a client.

 

“Don’t worry, I have total confidence in your rating!”

 

Of the three big rating agencies, Moody’s underwent the deepest cultural change amid the housing boom.

 

Responsible-spokesman-rebuttal note: of these three offenses, the first is sound business, the third’s no worse than doing any other social activity with a client – maybe stupider, but that’s the skydiving part, not the client part J — and the second could have multiple explanations. 

 

At the heart of the firm’s gradual transformation into a player in the mortgage game was Brian Clarkson, 51 years old, who joined the company as an analyst in 1991 and became president last August. Mr. Clarkson maintains that his focus on making Moody’s friendlier to Wall Street was what the company needed early this decade. “We’re in a service business,” he says. “I don’t apologize for that.”

 

I’m not apologizing for being in a service business, or for my hair, either

 

By the height of the mortgage-securities frenzy in 2006, Moody’s had pulled even with its largest competitor, rating nine out of every 10 dollars raised in these instruments. It gave many of the bonds its coveted triple-A rating.

 

That’s not a 90% share, because many issuers would get ratings from multiple agencies.  It’s impressive growth, but if the issues were rated by multiple agencies, wouldn’t that be a comfort? 

 

(The same bond often gets a rating from two different firms.)

 

The same rating from multiple agencies?  Call me skeptical.

 

Profits at the 99-year-old firm, which John Moody started to rate railroad bonds, rose 375% in six years. The share price quintupled.

 

That’s a statistic.  Color me less skeptical. 

 

When Mr. Clarkson first joined Moody’s, the agency was known as a place where analysts often didn’t even promptly pick up their phones, much less talk extensively to companies whose bonds they were rating.

 

The first (in)action is rude, the second is foolish.  You have to talk to the issuer, if only to learn things or get context. 

 

A magazine story [in Treasury and Risk Management – Ed.] in the mid ’90s attempted to answer the question “Why Everyone Hates Moody’s.”

 

“You don’t return my phone calls, and you give me lousy ratings.  That’s two.”

 

Moody’s toughness gave issuers reason to go elsewhere, and back in the mid-1990s, Fitch and S&P were both rating more mortgage bonds than Moody’s, in large part because their standards were considered easier.

 

That year, Mr. Clarkson took over the group at Moody’s that analyzed such securities. The firm added new analysts and overhauled its ratings approach, allowing for higher ratings in the area. Within a year, Moody’s moved ahead of both Fitch and S&P in the sector. Rivals said Moody’s had cut its standards. Mr. Clarkson was quoted as calling this “sour grapes.” He says now that the change in the ratings approach was the right call.

 

Hey, we didn’t want to rate those, anyway

 

In 1999 Mr. Clarkson took over the part of the firm’s “structured finance” business that oversaw bonds and complex securities based on home mortgages. Moody’s rated just 14% of high-quality “prime” bonds in that area in the year before he took over, compared with 51% that Fitch rated and 89% that S&P rated, as calculated by the publication Asset-Backed Alert.

  

By 2001, Moody’s was an independent company. It had long been tucked inside financial publisher Dun & Bradstreet Corp., but D&B spun it off as a new public company in 2000. Just before it did so, Warren Buffett saw the growth and profitability of Moody’s business and had his Berkshire Hathaway Inc. raise its stake in D&B. Berkshire is now Moody’s biggest shareholder, with a 19% interest.

 

Is my 19% holding good enough to bid here?

 

In some areas, Moody’s continued to make it hard to get a high rating, with the result that it didn’t do much business in those areas; these areas included the riskier part of home-mortgage bonds and products known as net-interest margin securities.

 

Hindsight, being a part of memory, is prone to selective reorienting of cause, effect, coincidence, and significance.  Nobody ever errs in the post-mortem.

 

If I hadn’t made those stupid mistakes, I wouldn’t have lost

 

Yet at the same time, there’s no question that Mr. Clarkson presided over not merely a vast expansion of Moody’s business, but also a vast systemic understatement of risk.  Did one cause the other?  Just how did Mr. Clarkson overhaul a once-dusty institution?

 

“Don’t ask me, I have enough trouble trying to overhaul an antiquated bank-regulatory system!”

 

[Continued tomorrow in Part 2.]

Send post as PDF to