All The Devils Are Here: Unmasking the Men Who Bankrupted the World (24 page)

What caused Moody’s to change were three things. The first was the inexorable rise of structured finance, and the concomitant rise of Moody’s structured products business. The second was the 2000 spin-off, which
resulted in many Moody’s executives getting stock options and gave them a new appreciation for generating revenues and profits. And the final factor was the promotion of a former lawyer named Brian Clarkson within structured finance.

A Detroit native who had graduated from Ferris State University in Michigan and then practiced law at a tony New York firm, Clarkson joined Moody’s as an executive in 1991, without ever having worked as a credit analyst. One of his early tasks was to rate mortgage-backed securities issued by Guardian, the subprime mortgage originator founded by the Jedinaks in California. The bonds, needless to say, eventually blew up, but if there was a lesson in that, it was lost on Clarkson and his bosses. By 1995, he had become the co-head of the asset-backed finance group.

Clarkson went off like a bomb inside Moody’s. He developed a reputation for being nasty to those who couldn’t fight back and for never forgetting a slight. “At my level, any watercooler discussion of his management style included the words ‘fear and intimidation,’ ” a former Moody’s lawyer, Rich Michalek, later told the Senate Permanent Subcommittee on Investigations. Mark Froeba, another ex-Moody’s lawyer, told investigators that the company’s top executives “recognized in Brian the character of someone who could do uncomfortable things with ease, and they exploited his character to advance their agenda.” That agenda was using structured finance to boost revenues, market share, and—above all—Moody’s stock price.

Clarkson had no problem with this agenda. “We’re in a service business,” he once told the
Wall Street Journal
. “I don’t apologize for that.” But what exactly did that mean for a company that rated bonds? It wasn’t just a case of answering the phones on the first ring. Under Clarkson, former analysts say, it also meant caring about whether the issuers—meaning the small group of investment banks who mattered—were happy with the ratings they got.

Clarkson’s co-head of the asset-backed group was longtime Moody’s analyst Mark Adelson. Adelson was, in some ways, the opposite of Clarkson—a careful, cautious, somewhat skeptical analyst. He had been involved in structured finance seemingly forever; as a young lawyer in the 1980s, Adelson had worked on several of the early deals put together by Lew Ranieri and Larry Fink. Perhaps because of his long experience, he was always less willing to accept uncritically many of the arguments made for mortgage-backed securities. When underwriters began reducing their credit enhancements, claiming that the securities had proven themselves with their good performance, Adelson didn’t buy it. The fact that an asset class like housing had performed
well in the past said nothing about how the same asset class was going to perform in the future, he believed. For a very long time, Moody’s backed Adelson, for which he would always be grateful. But his skepticism was out of sync with both the market and the new Moody’s. “My view wasn’t the most widely held one at Moody’s,” he says now. “You spend a lot of time doing soul-searching when you’re looking one way and everyone else is looking the other way.” As Clarkson was rapidly promoted, Adelson was eventually moved out of asset-backed securities. In 2001, he quit.

There had long been tension between the corporate bond side of Moody’s and the structured finance side; Clarkson’s ascension signaled that structured finance had won. More than that, the
culture
of the structured finance side had won. Bond analysts, even in the good old days, regularly faced pressure to issue favorable ratings, but Moody’s had always backed them when they resisted. Not anymore. Soon after Clarkson took charge, Moody’s began making a point of informing its analysts of the company’s market share in various structured products, according to a lawsuit filed in 2010 against Moody’s by the state of Connecticut. If Moody’s missed out on a deal, the credit analyst involved would be asked to explain why. (“Please … advise the reason for any rating discrepancy vis-à-vis our competitors,” read one e-mail.) Michalek, who had a reputation as a stickler, said that Goldman Sachs once requested that he not be assigned to its deals. Gary Witt, the Moody’s executive who took the call from Goldman, later testified that he was told that not complying with its request “would result in a phone call to one of my superiors.”

“When I started there, I don’t think Moody’s managers knew what their market share was,” says one former employee. “By the peak of subprime, there were regular e-mails every time Moody’s didn’t get a deal.” Another former managing director says that Clarkson used to tell people, “We’re in business and we have to pay attention to market share. If you ignore market share, I’ll fire you.”

“When I joined Moody’s in late 1997,” Mark Froeba told investigators, “an analyst’s worst fear was that he would contribute to the assignment of a rating that was wrong, damage Moody’s reputation for getting the answer right and lose his job as a result. When I left Moody’s, an analyst’s worst fear was that he would do something that would allow him to be singled out for jeopardizing Moody’s market share, for impairing Moody’s revenue or for damaging Moody’s relationships with its clients, and lose his job as a result.” (In prepared testimony for the Financial Crisis Inquiry Commission,
Clarkson denied that “Moody’s sacrificed ratings quality in an effort to grow market share.”)

Examples:

• In August 1996, after Commercial Mortgage Alert noted that Moody’s share of commercial mortgage-backed securities was just 14 percent—largely because it was being tougher in certain areas than S&P or Fitch—Clarkson responded by saying, “It’s the right time to take a second look.” Moody’s market share soon rose to 32 percent.

• In 2000, Moody’s had 35 percent of the mortgage-backed securities market, according to Asset Backed Alert. By the first half of 2001, it had jumped to 59 percent. Rivals claimed Moody’s had lowered its standards, but Clarkson attributed Moody’s rise to a “reshuffling” of its analysts. Several former Moody’s executives say that analysts weren’t “reshuffled.” They were fired. (Clarkson said that complaints by rivals that Moody’s had lowered its standards were “sour grapes.”)

• Another example: Moody’s was initially more conservative on securitizations in cases where, in addition to the first lien, there was a second-lien mortgage. But that was a problem because S&P had a different, looser standard: it concluded in 2001 that as long as second-lien loans were attached to no more than 20 percent of the mortgages in the pool, it would treat the entire pool as if it didn’t have additional risk. “The other agencies took the same position shortly thereafter,” Richard Bitner, a former subprime lender, later told the Financial Crisis Inquiry Commission. He added, “The rating agencies effectively gave birth to the subprime piggyback mortgage.” Those were subprime mortgages in which the homeowner avoided putting up any cash and got two loans—one for the mortgage itself and another for the down payment.

The great advantage issuers had in seeking triple-A ratings is that they rarely needed all three agencies to be involved in any one deal. Investors liked having two agencies rate a deal, but nobody cared about having all three involved. So issuers could play the agencies off each other. They didn’t really care which rating agencies bestowed the rating. All that mattered was the rating itself. “The triple-A was the brand, not Moody’s,” says a former Moody’s structured finance managing director.

Like everyone else utilizing risk models, the rating agencies used the mathematics of probability theory to arrive at their ratings. A given mortgage-backed deal might contain as many as ten thousand mortgages. As every investor is taught, diversification spreads risk, so one question was, how diversified were the mortgages? If they all came from California, they were less diversified than if some were from California, some from Idaho, and some from Connecticut. The working assumption was if home prices dropped in California, they would remain stable, and even keep rising, in other parts of the country. The Wall Street term for spreading risk this way—and there are more complex variants—is correlation. Correlation is essentially a way of describing, in numerical terms, the likelihood that if one security defaults, others would default in tandem. Zero correlation means that one default would have no effect on anything else in the security; 100 percent correlation means that if one defaults, everything else would, too. The closer the mortgage-backed security came to zero correlation, the greater the percentage of tranches that could be labeled triple-A. Underwriters often added credit enhancements to boost the percentage of triple-A tranches.

One obvious flaw of this approach is that nowhere in the process was anyone required to conduct real-world due diligence about the underlying mortgages. As the SEC later noted, “There is no requirement that a rating agency verify the information contained in RMBS loan portfolios presented to it for rating.” (RMBS stands for residential mortgage-backed security.) A second problem is that the rating agency models were built on a series of assumptions. One assumption was that if housing prices declined, the declines would not be severe. Another was that the housing market in California was indeed uncorrelated with the housing market in Connecticut. And then there was the fact that assumptions could be changed. If the bankers didn’t like the outcome of the analysis, maybe a little rejiggering might be in order.

For instance, UBS banker Robert Morelli, upon hearing that S&P might be revising its RMBS ratings, sent an e-mail to an S&P analyst. “Heard your ratings could be 5 notches back of moddys [sic] equivalent,” he wrote. “Gonna kill your resi biz. May force us to do moodyfitch only …” Internally, the rating agencies had a term for this: ratings shopping. Even Clarkson acknowledged that it took place. “There is a lot of rating shopping that goes on,” he told the
Wall Street Journal
. Of course, he saw nothing wrong with it. “People shop deals all the time,” he shrugged.

Ratings shopping was a classic example of why Alan Greenspan’s theory of market discipline didn’t work in the real world. The market competition between the rating agencies, which Greenspan assumed would make
companies better, actually made them worse. “The only way to get market share was to be easier,” says Jerome Fons, a longtime Moody’s managing director. “It was a race to the bottom.” A former structured finance executive at Moody’s says, “No rating agency could say, ‘We’re going to change and be more conservative.’ You wouldn’t be in business for long if you did that. We all understood that.”

“It turns out ratings quality has surprisingly few friends,” Moody’s chief executive, Raymond McDaniel, told his board in 2007. “Ideally, competition would be primarily on the basis of ratings quality, with a second component of price and a third component of service. Unfortunately, of the three competitive factors, ratings quality is proving the least powerful.” He added, “In some sectors, it actually penalizes quality by awarding ratings mandates based on the lowest credit enhancement needed for the highest rating.”

Just as LTCM exposed the dangers of derivatives in 1998, there also came an early moment when the failings of the rating agencies were exposed for all to see. The moment was December 2, 2001, the day Enron filed for bankruptcy. Although Enron had been faking a portion of its profits for years—and though it had been in precipitous decline since October, when the outlines of its fraudulent practices were first revealed—the rating agencies didn’t downgrade the company’s debt until four days before its collapse. Investors in both Enron’s stock and its bonds lost millions. The Enron bankruptcy—quickly followed by similar debacles at WorldCom, Tyco, and a handful of other companies—became a huge, ongoing news story. And the fact that the rating agencies had failed to sniff out any of them was a big part of the scandal narrative.

Government investigators put together thick reports about the failings of the agencies. The rating agencies were excoriated in congressional hearings. Senator Joseph Lieberman said they were “dismally lax” in their coverage of Enron. At one hearing, the S&P analyst who had covered Enron confessed that he hadn’t even read some of the company’s financial filings. There was a strong sense that something was going to be done to reform the rating agencies.

Perhaps to appease Washington—and fend off regulation—Moody’s agreed to adopt a code of conduct. Among other things, the code stated that “the determination of a credit rating will be influenced only by factors relevant to the credit assessment.” It also stated that “The credit rating Moody’s assigns … will not be affected by the existence of, or potential for, a business relationship between Moody’s and the issuer.”

In its lawsuit, the state of Connecticut alleged that shortly after Moody’s unveiled its code of conduct, two experienced compliance officers were fired and replaced by employees from the structured finance department. The head of the department later complained, “My guidance was routinely ignored if that guidance meant making less money.” Investigators also allege that during a dinner party after a board meeting, the president of Moody’s walked by the head of compliance and said, quite loudly, “Hey … how much revenue did Compliance bring in this year?”

In other words, nothing changed. Not a single analyst at either Moody’s or S&P lost his job as a result of missing the Enron fraud. Management stayed the same. Moody’s stock price, after a brief tumble, began rising again. The ratings remained embedded in all the rules and regulations. The conflict-ridden business model didn’t change. “Enron taught them how small the consequences of a bad reputation were,” says one former analyst.