Affordable Housing Institute : US

[Continued from the previous Part 1 and Part 2.]

 

For the previous two days, we’ve been delving into whether, as implied by a Wall Street Journal article on the rating agencies, Moody’s got so cozy with the issuers it was rating, and who were paying its fees, that it succumbed to grade inflation.

 

 [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.]

 

“Inflated?  I came by all this growth naturally!”

 

There’s no question that nourished by these rating fees, Moody’s grew plump:

 

We may have been plump but we keep our eye on the ball

 

Mr. Clarkson’s structured-finance group grew to account for about 43% of Moody’s revenue in 2006, up from 28% in 1998. By 2006, the firm had more revenue from structured finance — $881 million — than its entire revenue had been in 2001.

 

For the few non-numerates among my readers, that’s gigundo.  In five years, Mr. Clarkson built a business from zero to bigger than his original firm had been at the time.  This is like you and me growing a new head late in our middle age.

 

“Hey, that’s totally possible … isn’t it?”

 

That much money torques an organization. It can’t help but torque the organization.

 

We’ve stayed true to our course

 

Employees, though paid a fraction of what they could earn on Wall Street, sometimes grew wealthy from Moody’s surging share price and their stock options.

 

Money, particularly sudden money, also changes people.  You start to believe you’re worth what you’re being paid.

 

According to a regulatory filing, Mr. Clarkson’s compensation totaled $3.8 million in 2006. The firm’s chief executive, Raymond McDaniel, earned $8.2 million that year, more than twice what his predecessor made in 2000. Moody’s says the rise in their compensation reflected growth in the overall business, not just the mortgage area, and that much of the rise came from the increasing value of stock options that had been granted years before.

 

Uh-huh.

 

By early 2007, some Moody’s analysts were growing worried about the market for securities backed by subprime mortgages. But Mr. McDaniel told a group of investors in May 2007: “The good-news story for us” includes “very strong growth coming out of our largest business, which is the structured-finance business.  It is both large and a significant growth engine for the company.”

 

At this point, my credulity-meter hit overload. 

 

Don’t make an ass of my credulity

 

May, 2007 – yes, the spread-widening was three months in the future, but New Century had filed for bankruptcy a month earlier, some perspicacious bloggers were already warning of problems, and some of Wall Street’s largest houses were putting out the trash.  Caution was called for.

 

Despite some analysts’ concerns, Moody’s rated about 94% of the $190 billion in mortgage-related and other structured-finance CDOs issued in 2007, the second busiest year ever.

 

Noted above: rating 94% doesn’t mean 94% market share, but it does mean you’re rating just about everything, making the importance of holding the line against rating inflation more critical than ever.

 

Many of those CDOs have since been downgraded, some from triple-A to levels that suggest investors will have significant losses. Moody’s says some bonds it rated were backed by fraudulent loans.

 

Moody’s is doing itself no favors with these answers.  To be sure, fraud is something beyond the rater’s control, but as a defense it’s the willowiest reed?  Moody’s downgraded several thousand issues; they couldn’t possibly be all or even any meaningful fraction due to fraud.

 

It also notes that it wasn’t alone in being surprised by the depth of the housing decline. “We were preparing for a rainstorm and it was a tsunami,” Mr. Clarkson says.

 

This is not caused by a little rain

 

Is anyone else bothered that the first phenomenon is meteorological and the second is geological?  In other words, that the latter is not a larger-scale version of the former, but something completely different?

 

Those two things are completely different

 

Since becoming Moody’s president in August, he is spending up to half of some weeks dealing with regulators. “They want the same things we do,” he says.

 

Well, actually, no.  They want the things you’re supposed to want, but they don’t have a hundred-million-dollar conflict of interest.

 

Some options that Moody’s is considering to improve its process — such as adding new labels to structured-finance ratings to convey the products’ unique attributes and risks — were earlier raised by regulators.

 

I’d have a great deal more tolerance of new warning labels if the old ones hadn’t just been revealed as dubious.  This smacks of optical damage control, not a serious effort at change.

 

Mr. Clarkson says analysts have kept their “adversarial” approach, but adds, “One of the things we have to do going forward is be more skeptical.”

 

‘Skeptical’ isn’t something to be ‘more or less.’  You’re supposed to be properly skeptical at all times.

 

What’s the verdict?

 

What’s the verdict, Paul?

 

In Scotland, so I have read, in between Guilt and Not Guilty is a wonderful verdict, Unproven.   The Journal has not proven its case against Moody’s; indeed, its cited evidence is at best circumstantial, at worst Zoroastrian.

 

But.

 

Investors who rely on Moody’s ratings have lost billions in value they probably would not have lost had the ratings been more sound.  Hence Moody’s no longer has the presumption of innocence.  We have, in the classical detective-novel fashion, got all three elements of culpability:

 

Means.  Moody’s certainly had the ability to float ratings upward.

Motive.  Moody’s got rich on the friendly ratings.

Opportunity.  Moody’s had penetrated the entire space (94% of all issues).

 

Does that add up to guilt?  To quote Chief Gillespie from In the Heat of the Night:

 

“I have got the motive which is money and the body which is dead!”

 

“I have got the motive which is money and the body which is dead!”

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