Rating Subprime Investment Grade Made `Joke' of Credit Experts

Dec. 20 -- As storm clouds gathered over New York on July 10, Standard & Poor's started a 10 a.m. conference call to discuss why the credit rating company was about to take its most dramatic action in more than two years.

S&P analysts said they might cut ratings on $12 billion of the world's worst-performing subprime mortgage bonds, some of them less than a year after they had been given investment-grade designations. Not since 2005, when it downgraded Ford Motor Co. and General Motors Corp., had S&P generated so much attention.

S&P Chief Economist David Wyss, 63, and Managing Director Thomas Warrack, 45, made a 20-minute presentation and then opened the line for questions from investors and analysts.

``I'd like to understand why now, when you could have made this move many, many months ago,'' said Steven Eisman, 45, who manages the $1.5 billion FrontPoint Financial Services hedge fund for Morgan Stanley in Greenwich, Connecticut. ``The paper just deteriorates every single month.''

Warrack and Managing Director Susan Barnes, 42, explained S&P's view of the time needed to accurately judge the performance of securities. Eisman cut them off. ``You need to have a better answer,'' he said.

As the five-year real estate boom approached its peak in 2005, Wall Street marketed a new type of security backed by high-interest subprime mortgages issued to the least credit- worthy homebuyers. Blessed by the biggest credit rating companies as safe investments, these instruments offered higher returns than government bonds with the same ratings.

`God-Like Status'

Investment banks including Bear Stearns Cos., Deutsche Bank AG and Lehman Brothers Holdings Inc. sold $1.2 trillion of these securities in 2005 and 2006, said Brian Bethune, director of financial economics for Global Insight Inc. in Waltham, Massachusetts.

None of this could have happened without the participation of Wall Street's three biggest arbiters of credit -- Moody's Investors Service, S&P and Fitch Ratings. About 80 percent of the securities carried AAA ratings, the same designation given to U.S. Treasury bonds.

This implied the investments couldn't fail, says Sylvain Raynes, 50, a former Moody's analyst who now is a principal at R&R Consulting, a structured securities valuation firm in New York.

``The rating agencies had an almost God-like status in the eyes of some investors,'' Raynes says. ``Now, that trust is gone. It's been replaced with a feeling of betrayal.''

Guidance to Issuers

The companies' ratings underpinned Wall Street's expansion of the global market for securities based on high-risk subprime loans. Driven by the innovations of a group of Wall Street bankers, the subprime securities markets expanded quickly in 2005 and 2006, reaching into every corner of the world's investment community and winding up in the portfolios of banks and public investment pools from Europe to Asia.

Many institutional investors' own rules, in addition to state or national laws, bar them from buying securities that don't carry investment-grade ratings.

Issuers got guidance from rating companies on how to shape their subprime securities to win the ratings, says Joshua Rosner, managing director of the New York-based research firm Graham Fisher & Co. Investment banks used software distributed by the ratings companies to show them how to meet the requirements, then paid the companies to have the securities rated, he says.

Reaching `Desired Rating'

``The idea that the rating agencies are impartial in the world of structured finance is a joke,'' Rosner says. ``The issuers use the publicly available model to structure a pool and then sit down with the rating agencies to fine-tune it until they reach the desired rating.''

Distributing the criteria and discussing them with issuers is a matter of transparency, says Claire Robinson, Moody's senior managing director of asset finance and public finance.

``We do not structure transactions,'' Robinson says. ``We do not provide consulting services in terms of assembling transactions or choosing assets or pools or anything of that nature. We comment on credit quality.''

Moody's raised ``credit enhancement'' requirements for bonds in 2006 as analysts noted the deterioration of lending standards, she says. The practice requires additional collateral or insurance to protect investors who purchase the higher-rated levels, or tranches, of a security.

Rating Sadek's Loans

One $720 million loan pool created by Tokyo-based Nomura Holdings Inc. was rated Baa3, an investment-grade rating, by Moody's when issued in 2006. Now, it's rated Caa1, seven levels deep into junk-bond territory, and priced at 32 percent of the original value after 29 percent of the mortgages defaulted.

Almost 40 percent of the loans in the pool were originated by Costa Mesa, California-based Quick Loan Funding, run by Daniel Sadek, a broker who started the subprime company in 2002 with the motto: ``You can't wait. We won't let you.''

It wasn't the first misstep by Moody's, founded in 1900 by former Wall Street errand runner John Moody. Nor was it a first for Standard & Poor's, started in 1860 by Henry Poor, a Maine farm boy turned journalist known for citing ``the investor's right to know.''

The raters faced vitriol and lawsuits in 2001 when they were slow to downgrade Enron Corp. and WorldCom Inc. as accounting discrepancies emerged. In Enron's case a downgrade would have put the Houston-based energy company into default because of so-called rating triggers on its bonds. The rating companies were also criticized in 1994 for keeping bonds sold by Orange County, California, at investment grade even as the county filed the nation's largest municipal bankruptcy.

`Cultural Shift'

Colorado's Jefferson County School District sued Moody's in 1995 claiming the company issued a negative rating after the district refused to hire Moody's to evaluate its bonds. While the suit was dismissed in 1996, the dispute set off a three-year antitrust investigation by the Department of Justice that ended in 1999 with no action.

The probe led to the ouster of Thomas McGuire, Moody's chief of corporate ratings, and started a ``cultural shift,'' as Moody's prepared to go public, says Ann Rutledge, an analyst who left in 1999 after four years. In early 2000 the board of Dun & Bradstreet Corp., Moody's parent, voted to split into separate publicly traded companies. Employees were required to take a six-week class on ``issuer relationships'' with listening exercises, Rutledge says.

Customer Service

``There used to be a strong sense that we weren't a touchy, feely company,'' says Rutledge, who is now a principal at R&R Consulting, along with her husband, Raynes, a fellow Moody's alum. ``Our attitude used to be: We're not here to be your friend. We're here to look at credit quality. But that began to change.''

Initiatives such as the listening exercises were part of the company's emphasis on customer service, says Warren Kornfeld, managing director of Moody's.

``We care very deeply what people think,'' Kornfeld says. ``We want to have a dialogue with investors, and we want to have a dialogue with issuers. Our value to the market is our accessibility.''

The lure of profits as the housing market began a run of five record-breaking years in 2000 fueled the change, says Graham Fisher's Rosner.

``They went from looking at companies that already existed to having a role in structuring securities,'' Rosner says.

Regulator Sounds Warning

S&P, a unit of New York-based McGraw-Hill Cos., issued ratings for about 98 percent of all new subprime mortgage bonds created last year, according to the industry newsletter Inside B&C Lending. Moody's, whose parent is New York-based Moody's Corp., provided ratings on 97 percent, while Fitch assessed 51 percent.

Fitch, owned by Paris-based Fimalac SA, declined to comment, according to spokesman James Jockle.

One regulatory voice was issuing warnings. In a June 2006 speech at a Mortgage Bankers Association conference in Half Moon Bay, California, Susan Bies, the Federal Reserve governor in charge of regulation, urged the bankers to tighten credit standards for adjustable subprime mortgages. Bies said borrowers might default because of ``payment shock'' when interest rates rose.

``The recent easing of traditional underwriting controls and the sale of non-traditional products to subprime borrowers may contribute to losses on these products,'' Bies said.

Lowering Standards

The bankers didn't listen. The Fed's survey of senior loan officers issued the following month showed that 10 percent of U.S. lenders had lowered standards to qualify customers for mortgages.

In September 2006, Congress passed the Credit Rating Agency Reform Act, after hearings and investigations that began in the wake of the Enron meltdown. The measure gave authority to the Securities and Exchange Commission to designate, regulate and investigate rating companies.

The law also prohibits notching, the threat of unsolicited bad ratings unless an agency is hired to assess a security. It also requires the rating companies to disclose any potential conflicts of interest.

On Sept. 26, SEC Chairman Christopher Cox told the Senate Committee on Banking, Housing and Urban Affairs that his agency was investigating whether the rating companies were ``unduly influenced'' by asset-backed issuers and underwriters who paid for ratings.

`Tainted' by `Conflict'

The same day Cox testified in Washington, Teamsters Local 282 Pension Trust Fund sued Moody's in U.S. District Court in New York alleging that the company's ratings misled investors and caused losses on bonds backed by subprime mortgages. The suit defied conventional belief that rating opinions are protected by the free-speech provisions of the First Amendment to the U.S. Constitution.

``This goes beyond the realm of protected opinion,'' says Ira Press, the Kirby McInerney LLP attorney in New York representing the pension fund. ``There's evidence that in some cases the ratings were something other than pure opinion. They were tainted by an economic conflict of interest.''

Anthony Mirenda, a spokesman for Moody's, says the Teamsters' suit ``is entirely without merit, and we expect it to be dismissed expeditiously.''

Less Transparency

In October, Connecticut Attorney General Richard Blumenthal issued subpoenas to Moody's, S&P and Fitch Ratings as part of a fair-trade investigation into practices including alleged notching. All the companies have said they are cooperating with the investigation.

``The essential conflict is they are being paid by the people that they rate, they are working with the people they rate,'' says Arthur Levitt, former Securities & Exchange Commission chairman, a Bloomberg LP board member and a senior adviser to the Carlyle Group, a Washington-based hedge fund.

One remedy suggested by New York Democratic Senator Charles Schumer and others would be to have investors, not bond issuers, pay for credit assessments.

Paul Coughlin, S&P's executive managing director, says that would reduce transparency by giving some investors information others don't have. In the current arrangement, rating actions are announced via press releases and reports posted on the company's Web site.

``With the issuer-pay model the information is widely known and freely available,'' Coughlin says in an interview. ``The other option is to do it by a subscription-pay model, which reduces transparency in the marketplace.''

S&P's president, Kathleen Corbet, resigned in August after lawmakers and investors criticized the company for failing to judge the risks of subprime securities.

Jose Sepulveda's Pension

In coming months, subprime losses will reach into almost every home in the U.S. as pension funds reveal setbacks, the former Moody's analyst Raynes says. Some funds won't show the extent of their subprime losses until they issue reports for the current fiscal year, some as late as September 2008.

``The smallest investor, not Wall Street, is the one who will pay the ultimate price because he trusted the fund managers who blindly followed the rating agencies,'' Raynes says.

Jose Sepulveda, 57, worked 34 years as a reading teacher and elementary school principal in southern Texas towns along the banks of the Rio Grande, the border between the U.S. and Mexico. Now retired in Weslaco, Texas, he says he thought he was as far as he could be from the mortgage crisis roiling markets in New York, London and Tokyo.

He wasn't far enough. The Austin-based Teacher Retirement System of Texas, the manager of Sepulveda's retirement money, holds $6 billion of securities backed by assets that include subprime mortgages, most of it rated AAA, according to a report on the fund's Web site.

``How could anyone think that investments backed by subprime loans were safe?'' Sepulveda says.