Affordable Housing Institute : US

[Continued from yesterday's Part 1.]

 

Yesterday we tackled a tough subject — 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.]

 

 

The issue matters greatly because, as I’ve previously written:

 

How we got here: the supermarket of products and ratings

 

Once upon a time, a supermarket (let’s call it “Wall Street”) sold food (investments) in bewildering profusion and choice.  Debt, equity, structured finance, original, derivative — everything was there, on the shelves and the glowing monitors, all neatly categorized, rated, and priced.  Quality assurance was done by the three global rating agencies, and was widely regarded as thorough, disinterested, and accurate. 

 

Guaranteed to have no nutrients and nothing but chemicals!

 

With increasing volume, shoppers increasingly picked goods not by ingredients but by quality label – ratings.  AAA commanded one yield, AA slightly higher yield, and so on down creditworthiness through the B’s and thence into junk.  Regardless what food was in the can, all AAA’s were equal in the market’s eyes.  And the goods had a long shelf life: once an AAA, always an AAA. 

 

Otto, you can’t put subprime derivatives in a Triple-A can!!

 

You thought you were safe buying and selling paper assets easily and securely, based on their labels (ratings) and prices.  Unfortunately, turmoil in the credit markets has exposed that labels are unreliable and prices are way too low.  Now there is no one to take the goods you don’t want off your hands.

 

What now?
 

What now includes, among other things, lots of lawsuits, such as investors suing rating agencies.

 

Daddy’s a litigator. Those are the scariest kind of lawyer. Even Lucy, our maid, is terrified of him. And daddy’s so good he gets $500 an hour to fight with people. But he fights with me for free because I’m his daughter.

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

 

“You rating agencies, I might fight with for free.”

 

The plaintiffs’ lawyers undoubtedly read eagerly an interesting and thorough Wall Street Journal article on the rating agencies‘ move to be more friendly:

 

“Look, fake those smiles like you mean it!”

 

Moody’s top home-mortgage analyst at the time, Mark Adelson, took a cautious approach that resulted in fewer triple-A ratings.  Mr. Clarkson shook things up, firing or reassigning about two dozen analysts and hiring new ones who started giving higher grades under a new methodology. Mr. Adelson left for an investment bank. In 2001, Moody’s market coverage was up to 64%.

Mr. Adelson says “the world thought differently than I did” about mortgage bonds in 1998 and 1999. He isn’t critical of Mr. Clarkson’s management. Mr. Clarkson “is what Moody’s needs,” Mr. Adelson says. “He’s very smart, capable and driven.”

 

It’s hard for the journalist to get much traction if the top mortgage analyst, now with a competitor, goes out of his way to praise his ex-boss.

 

“If we keep digging, we’re sure to find a story.”

 

“Brian [Clarkson] created a dialogue between Moody’s and the Street that was good,” says Paul Stevenson, a former Moody’s executive who now works at BMO Financial Group. But “the most recent problem,” he says, “is that the rating process became a negotiation.”

 

Negotiation is such a crass word.  Call it instead a ‘hypothetical question,’ and it’s a variant of those annoying Verizon Can you hear me now? commercials. 

 

The issuer starts with a position and asks, Am I AA now?  If the answer’s Yes, the issuer dilutes the deal terms; if No, the issuer improves them a tad.  Either way, the issuer then asks, Am I AA now?

 

The rating agencies love this; each rehearsal rating is another rating fee, and with no liability.  No wonder revenues and profits can skyrocket.  But this pantomime dance erodes the value of ratings in two ways:

 

1.   Like the digits on your temperature sign, the numbers truncate reality.  Stepping forward and back turns ratings that should mean ‘average’ into ‘the skinniest possible.’

2.   If the ratings formula is weak — if it has flaws – the issuers will find them. 

 

Our principles go back to our roots, and those haven’t changed

 

It also potentially erodes consumer confidence.  Would you feel the same about ratings if you knew that the rater and the ratee were cozily swapping hypotheticals until they found juuust the right mixture?

 

Consider a Bank of America mortgage deal in early 2001.  [In other words, the Journal has to go seven years back to find its example – Ed.]  As in most such deals, the vast majority of the securities based on the pool of mortgages would be rated triple-A. The question was how big a chunk would be rated lower — paying a higher interest rate and bearing the brunt of any defaults that occurred.

 

The slicing of a larger issue into tranches is a perfect example of the technical and ethical challenge facing Moody’s.  Who can say precisely where the line should be drawn? 

 

“There was never an explicit directive to subordinate rating quality to market share,” says Mark Froeba, a former Moody’s analyst who recently started a bond valuation company that may compete with rating firms. “There was, rather, a palpable erosion of institutional support for rating analysis that threatened market share.” An example would be raising too many legal issues on deals, slowing them down unnecessarily.

 

If you have one party leaning on you the entire time, breathing down your neck as it were, it takes some real integrity to pick your ground and stand upon it.

 

Have you come up with the answer I want yet?

 

Mr. Clarkson says the goal was maintaining consistency about the issues Moody’s raised on deals. “I have no problem losing deals for the right reasons,” he says. “We don’t change methodology to garner market share.”

 

That is absolutely the statement you want to hear.  You’d also like to see it demonstrable, even with the benefit of selectively adverse hindsight.

 

A rating committee at Moody’s voted to require that the issuer put about 4.25% of the deal’s value in the lower-rated section, to provide extra [Gratuitous word here – Ed.] protection for buyers of the top-rated section. But after [A] Bank of America complained and said it might go with a different rating firm, [B] Moody’s reduced the size of the lower-rated chunk slightly — saving the issuer some interest costs — according to people with knowledge of the matter.

 

That’s a sequence of what I call Zoroastrian logic – A happened, and later B happened, therefore B was caused by A.  I sacrificed a goat, and the eclipse passed, therefore my sacrifice brought about the eclipse’s end.  Said that way, it’s ridiculous.  Now reread the previous Journal sentence – is that a causal link?  Maybe, maybe not.

 

Maybe there’s a link …

And maybe there’s not

 

Linda Stesney, a Moody’s managing director who was then co-head of mortgage-backed securities, says she doesn’t recall the deal.

 

Why should she?  It was seven years ago.

 

She says Moody’s reconsidered its view on deals when issuers presented new information affecting credit quality.

 

Good for her.  Any good analyst will acknowledge that new information should lead to a new opinion, and possibly a shifting of the stake in the ground.  Anything else would be mule-headed and unprofessional. 

 

She adds that Moody’s mortgage ratings at the time held up well.

 

In short, the Journal’s done itself no service with this example, since (x) the deal didn’t go bad, (y) the reasons for the change are facially plausible, and (z) there’s no evidence of impropriety in the decision process.

 

Some supporters say that while Mr. Clarkson cared about market share, he cared more about the quality of Moody’s ratings. Bill May, a Moody’s managing director, recalls Mr. Clarkson warning him in 2002 about the things that could get a managing director fired.  He says inaccurate ratings topped the list, followed by “arrogant or rude” behavior toward market participants.

 

Nothing whatsoever about either that list or the hierarchy.

 

On occasion, Moody’s agreed to switch analysts on deals after bankers complained.  

 

If you think hearing from issuers is bad, try getting a blast from Hank Steinbrenner!

 

In my former life, I was once or twice taken off a particular syndication matter.  Syndication is negotiation, after all, and sometimes two parties clash or get stuck. 

 

Sometimes you take one for the team

 

Among banks that requested that a different analyst look at their deals were Credit Suisse Group, UBS AG and Goldman Sachs Group Inc., according to a person familiar with the matter. The banks declined to comment. Mr. May says analysts were switched on “rare” occasions to accommodate such a request.

 

Again, if ‘rare’ is the answer, that’s a good one.  Evidence one way or another would be nice.

 

When Moody’s sought to rate more deals for GMAC’s residential-finance unit in the late 1990s, Moody’s officials traveled to the company’s Minneapolis offices several times.

 

Good God!  Visiting clients?!?

 

Some analysts say they occasionally would attend the dinners that celebrated the launch of a new CDO Moody’s had just rated.

 

Eating with clients???

 

Moody’s says it has rules to prevent conflicts, including a $50 limit on gifts, and that building better relationships with Wall Street officials was part of its effort to be more transparent in its rating methodologies.

 

After all this utterly unimpressive guilt-by-innuendo, the Journal settles down to the less emotional but more persuasive evidence – statistics. 

 

What do you need the numbers to show?

 

[Concluded tomorrow in Part 3.]

 

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