As we watch the US housing and capital markets struggle to find their equilibrium, there’s no question we are experiencing a worldwide phenomenon – and even allowing for the parochial lenses through which Americans receive news of other people’s markets, I think it’s clear that however much disturbance we are facing in the US markets, many other nations are about to fare worse, as illustrated by a recent article from The Economist:

STUDENTS of politics (and more than a few politicians) know only too well the old dictum about lies that are repeated often enough becoming truth. Those foolish enough to believe it should take a look at the sorry tale of Northern Rock, a troubled mortgage lender that failed last September when it ran out of cash.

The US has the world’s most complex – some might say, ‘overgrown’ — housing ecosystem, and it is replete with creatures absent from other nations, starting with:

Something not seen in America since 1932: the run on Northern Rock

1.  Deposit insurance.  Ever since 1933, Northern Rock couldn’t happen in the US, not because we’re cleverer about avoiding bank failures (we’re not), but rather because we have deposit insurance.  In the US, all deposit-taking institutions must be backed up by the FDIC – the Federal Deposit Insurance Corporation – and its now-absorbed sibling, the FSLIC. 

For almost a year afterwards Alistair Darling, the chancellor of the exchequer, repeated, mantra-like, that this was a sound bank brought low by events from afar, and that taxpayers would get back every one of the billions of pounds they lent it. On August 5th Mr Darling was mugged by reality when Northern Rock came to him, cap in hand, again.

They want more money?

This time the bank wanted help in shoring up its balance-sheet, which is crumbling thanks to a mortgage book that looks worse by the day. The government, which is still owed some £21 billion ($41 billion) by the hapless bank, has agreed to convert as much as £3 billion of the debt (as well as some £400m in preference shares) into ordinary shares.  This urgent need for capital should make those who still think taxpayers will get all their money back think twice. So should those who dare to hope that Britain’s banks have seen the worst of the credit crisis.

While reports over here are sketchy and I’ve had no time to study them, I’m very confident that the Bank of England did the right thing, at least strategically, in covering Northern Rock’s deposits.  However, lacking an established regulatory structure – remember, catastrophe is a precondition to fundamental reform – the Bank has to make up the rules as it goes along.  As we saw in Banking on Value and Anatomy of a Coup, this is high-stakes poker, and very complex:

Northern Rock needed more government help because the cushion of capital it holds against bad loans deflated alarmingly in the first half of the year, leaving it dangerously undercapitalised. In the first six months it posted a net loss of £565.5m; without the extra money, similar losses in the second half would have brought it within a hair’s breadth of running out of regulatory capital. This injection has bought it time. But there is little hope that it can stem its losses, most of which arise from bad loans in its mortgage book. And the bank has mainly itself to blame for it.

The thinness of Northern Rock’s capitalization highlights another feature of the US:

Thinly capitalized?  Moi?

2.  The Government-Sponsored Enterprises (GSEs).  The US has a dozen of these – in addition to Fannie Mae and Freddie Mac, about whom I’ve written extensively before, there are the twelve Federal Home Loan Banks.  All of these are Federally-backed sources of continuing liquidity, and while the GSEs may expose us to extensive systemic risk, the last twelve months have made a good case for them

For much of this decade it expanded rapidly. All the way up to, and then beyond, the peak of the housing market last summer it helped customers pile on debt, lending buyers who could not scrape together a deposit up to 125% of the value of a property.

You’ll end me 25% more than I’m worth?

Those numbers are – well, they’re insane.  Nobody in his or her right mind lends over 100% of a property’s value, without any hard equity as mind-concentrating security.  Small wonder they’re rotting at a rapid rate:

Such loans account for about a quarter of Northern Rock’s mortgage book and they are going bad fast. Arrears on them have trebled in the past year (from 0.7% to 2.1%) and are now almost double the industry average for all mortgages.

Our managing director sees nothing Rotten about our portfolio

Northern Rock, as an unregulated and unobserved lender, obviously bought its market share by offering the most generous lending terms – and even now appears to be flailing desperately:

Some of the increase in arrears is an illusion caused by a shrinking mortgage book. In order to repay the government its loan (and to avoid falling foul of European rules prohibiting companies that get state aid from competing unfairly), the bank is encouraging existing customers to take their business elsewhere. Its very best ones are doing just that. But those who have already missed payments or who flunk credit tests at other banks are being left behind at Northern Rock.

There, children, is a quintessential example of ‘adverse selection.’

Selected by others

Northern Rock is also unwittingly making an even better case for an under-appreciated part of the US ecosystem:

3. The state housing finance agencies.  The nation’s state-level housing finance agencies are independent governmentally-controlled lending bodies that serve multiple roles: they provide long-term mortgage financing, they channel Federal resources (such as tax-exempt bonding authority and Low Income Housing Tax Credits), and they have a mission orientation.  As I previously said, they’re the subprime lender that worked:

Amid all the stories about the subprime sector’s troubles, a remarkable finding — a whole group of subprime lenders whose loans have done well — has gone largely and curiously unnoticed.

I’m modest about my accomplishments

Who are these heroes? As presented in this Standard and Poor’s report — the housing finance agencies:

Housing finance agencies (HFAs) also serve borrowers who would be candidates for subprime loans: low- to moderate-income and first-time homebuyers. However, Standard & Poor’s Ratings Services has found that HFAs face little risk from defaults on their loans.

When the nation’s largest subprime lender can go insolvent almost overnight (meltdown in a mere six weeks), the HFAs’ stability is thus truly remarkable:

We do not expect to see any impact from subprime lending on the ratings of HFA single family indentures – several series of bonds with the same collateral; or their issuer credit ratings (Issuer Credit Ratings), which measure the entities’ general creditworthiness.

In term of pursuing the bankability and homeownership frontiers, HFAs are well capitalized, publicly accountable, and publicly supported.  That makes them the right pioneers for this territory.

Heading for homeownership

If England had a set of mission-oriented regional lenders, the space that Northern Rock foolhardily occupied would have been filled by entities with both political legitimacy and greater financial resources.

All banks are now afflicted by a slowing economy and falling house prices, which are driving up arrears and repossessions. On August 7th Barclays joined the queue of banks bearing bad news, with pre-tax profits down 33% and predictions of tough times ahead.  One sign of desperation is that the government may scrap transaction taxes on home sales in a bid to breathe life into the market.

Never mind that England’s high transfer taxes (they’re called ’stamp duty’ and over here, them’s fightin’ words) add a gratuitous drag on the home-buying economy and tax one subgroup (homeowners) for burdens that ought to be borne by the nation as a whole.

When in doubt, blame the Indians

The thinking behind waiving stamp duty indirectly highlights the fourth element of the US housing ecosystem that will continue to cushion our downside:

4.  A permanent professional rental sector.  For all that it has done, the subprime phenomenon lifted US homeownership rates no more than three points, from 67% to just under 70%.  The remaining 30% of households, as my AHI advisor and Harvard’s Joint Center for Housing Studies chair Nic Retsinas repeatedly points out, are renters. 

A steep rise in bad debts could not come at a worse time for British banks. They are only now getting their heads back above water after raising capital from investors to rebuild balance-sheets battered by write-offs on exotic bonds and derivatives backed by iffy American mortgages. There is a real risk that they will be faced with a fresh wave of write-downs, this time home-grown, and be forced to ask shareholders again for cash—lots of it.

When homes are foreclosed, they do not disappear; they either go vacant or they turn into rentals.  As I’ve written about, busted condos can become rental reversions.  In a country with an established professional rental sector, price downturns are opportunities to thicken the stock of permanent professional rental apartments.  The financial markets take the hit – investors lose their money – but the properties remain occupied, and eventually they recover.

Professional rental, in other words, is a systemic shock absorber. 

You want some rental in your housing undercarriage

The UK doesn’t have it.  To begin with, the homeownership rate is well above 80%.  REITs are very new, and have focused on more glamorous property types (shopping centers, office buildings).  Most apartments are buy-to-let properties held by small landlords.

A few months ago only the most pessimistic analysts were musing about the impact on banks of a 1990s-style recession. Then, predictions that banks’ loan losses might approach £20 billion were seen as fanciful. Now gloom is a growth industry, and such dire estimates are commonplace. Some reckon that losses may be far higher: consumers are more heavily indebted going into this recession than they were before the last one, and inflation is lower, which means that nominal house prices may fall further. More cash calls from banks seem certain.

There are times when nothing but cash will do

If the UK had a professional rental market, there would be buyers – at large discounts, to be sure, but capital sources nevertheless.  (We’ve seen this already in the US.)  And that invites the fifth difference:

5.  Mission Entrepreneurial Entities, in the form of CDC’s and non-profit owners.  I’ve written about MEE’s before:

Unfortunately for them – and for cities around the world – bad nomenclature (NGO v CDC v HA) has obscured fundamental similarities, preventing information exchange.  Regardless of what they are called, all these entities are mission entrepreneurial enterprises:

Mission.  They got into the field to make positive change.

Entrepreneur.  They achieve their results via entrepreneurship, as actors in the space, not government, taking risks, persuading established institutions to do things (approve proposals, provide capital).

Enterprise.  However little they pay their staff, they must cover their expenses and make cash profits, else they cannot continue pursuing their mission outcomes.

Faithful AHI blog readers know that because of my background – thirty-plus years working in affordable housing, but always on the private side, and always in an entrepreneurial environment – I’m predisposed to see their value everywhere.  Still, when I see change being made – in the UK, the US, or increasingly in the global south – the change is coming from the MEEs. 

They’re the ones doing transactions.

They’re the ones turning resources into properties and developments.

They’re the ones organizing slum dwellers into political and economic forces.

They’re the ones whose activity changes the political environment.

MEEs are the change agents. 

In housing-finance ecosystemic terms, they’re the critters.

We’re driving the pace of change!

Just as ecosystems don’t work without animals, whether acting as the plants’ reproductive system or converting DNA into more DNA (”A hen is only an egg’s device for making another egg” – Samuel Butler), without the critters, the ecosystem doesn’t work.

The ecosystem works in Erewhon

The UK has some MEEs, as I’ve noted before:

In the UK, which has essentially no for-profit permanent professional rental sector, the non-profit Housing Associations (HAs) have grown up with the field to themselves.  With that head start, many of them have become large, diversified, and highly professional, to the point where the whole sector is seen as thoroughly market-competitive.  More than any other group, UK Housing Associations see themselves as MEEs.   

If the UK’s Housing Associations don’t step up, and fast, the situations going to get really nasty:

Whether shareholders will be willing to dig deep a second time is far less clear.

That’s Economist-speak for ‘not bloody likely.’

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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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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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[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.]

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