All The Devils Are Here: Unmasking the Men Who Bankrupted the World (25 page)

The dirty little secret was that nobody really wanted to reform the rating agencies. Investment bankers needed to be able to continue gulling, cajoling, and browbeating the agencies into handing out triple-A ratings. Investors wanted to be able to rely on ratings instead of having to do their own research. Regulators found that in devising rules about risk taking, using ratings was the easiest path.

“Most of the big investors—they like ratings to be scapegoats,” says Jerome Fons. “They say, ‘Oh, we do our own analysis,’ but then when things go bad—well, it’s the fault of the credit rating agencies.” Or as Clarkson later ranted to other Moody’s executives during an internal meeting in the fall of 2007, “It’s perfect to be able to blame us for everything…. By blaming us, you don’t have to blame anybody else.”

Of all the securities whose existence depended on their ability to get a triple-A rating, none would become more pervasive—or do more damage—than collateralized debt obligations, or CDOs. CDOs, which had first been invented in the late 1980s but didn’t become wildly popular until the 2000s, were a kind of asset-backed securities on steroids. A CDO is a collection of just about anything that generates yield—bank loans, junk bonds, emerging market debt, you name it. The higher the yield, the better. Just as with a typical mortgage-backed security, the rating agencies would run the CDO’s tranches through their models and declare a large percentage of them triple-A.
There would also be a triple-B or triple-B-minus slice, which was called the mezzanine portion, as well as an unrated equity tranche, which got paid only after everyone else had collected their returns. One astonishing fact is that the CDO managers didn’t always have to disclose what the securities contained because those contents could change. Even more astonishing, investors didn’t seem to care. They would buy CDOs knowing only the broad outline of the loans they contained. So why were they willing to do so
?
Because the way they viewed it, they weren’t so much buying a security.
They were buying a triple-A rating.
That’s why the triple-A was so key.

Like so many of the other financial products bursting onto the scene, CDOs weren’t necessarily a bad idea. Done correctly, they could give investors broad exposure to different kinds of fixed-income assets at whatever level of risk they desired. But CDOs were fraught with risks and conflicts. Debt was being used to buy debt. CDO managers were paid a percentage of the money in the CDO, meaning they had an incentive to find stuff to buy—good, bad, or indifferent. Wall Street firms, who usually worked hand in glove with the managers, could earn hefty fees. According to one hedge fund manager who became a big investor in CDOs, as much as 40 to 50 percent of the cash flow generated by the assets in a CDO went to pay the bankers, the CDO manager, the rating agencies, and others who took out fees.

What’s more, CDOs could also give banks and Wall Street securities firms both the means and the motive to move their worst assets off their balance sheets and into a CDO instead. And since the rating agencies could be counted on to rate a big chunk of the CDO triple-A, nobody would be the wiser.

Is it a surprise to learn that just as the rating agencies had failed to sniff out Enron and WorldCom, they also drastically misjudged the first batch of CDOs? Perhaps not. Sure enough, in 2002 and 2003 the rating agencies were forced to downgrade hundreds of CDOs—in no small part because they contained the bonds of certain companies the agencies had also woefully misjudged. A handful of investors sued the CDO managers and the firms that had underwritten them. But because the CDO issuance was still small, neither the lawsuits nor the losses made headlines. For a short while, CDO volume declined.

And how did Wall Street respond? By devising a new type of CDO, one that would be backed not by corporate loans, but by mortgage-backed securities. The idea, says one person who was prominent in the CDO business,
was that the original rationale for CDOs—loan diversification—had proven to be flawed. But if you bought real estate, he said, “you were golden. You were safe.”

There were a few critical differences between CDOs composed of securitized mortgages and CDOs composed of corporate loans. The former contained not two but three levels of debt. Instead of “merely” using debt to buy the debt of a company, CDOs were using debt to buy the debt from a pool of mortgages, which was itself homeowner’s debt. A second critical difference was that bonds backed by mortgages generally had higher yields than similarly rated corporate bonds. Defenders of mortgage-backed securities tended to explain away this anomaly, once again, by claiming that investors didn’t understand mortgage-backed bonds as well as corporate bonds, and thus demanded a higher yield for what was really a very safe asset. And to be sure, that was one possibility. Another possibility, though, was that the market understood quite well that mortgage-backed securities were riskier than corporate bonds and was compensating by insisting on a higher yield.

Wall Street didn’t really care which explanation was correct. All it cared about was that it had discovered an anomaly it could take advantage of. And, oh, did it ever. Firms bought mortgage-backed bonds with the very highest yields they could find and reassembled them into new CDOs. The original bonds didn’t even have to be triple-A! They could be lower-rated securities that once reassembled into a new CDO would wind up with as much as 70 percent of the tranches rated triple-A. Ratings arbitrage, Wall Street called this practice. A more accurate term would have been ratings laundering.

Soon, CDO managers were buying the lowest investment-grade tranches of mortgage-backed securities they could find and then putting them in new CDOs. Once this started to happen, CDOs became a self-perpetuating machine, like cells that won’t stop dividing. From the very beginnings of the mortgage-backed securities business, marketers had always had to work hard to find enough investors to buy the lower-rated tranches. The triple-As were easy to sell because investors around the globe that were legally confined to conservative investments, or didn’t want to hold the capital against a higherrisk investment, embraced their higher yield relative to their super-safe rating. The triple-B and -B-minus tranches were a harder sell, with a much smaller universe of potential investors. But once the CDO machinery
itself
became the buyer of the triple-Bs, there were suddenly no limits to how big the business could get. CDOs could absorb an infinite supply of triple-B-rated bonds
and then repackage them into triple-A securities. Which everybody could then buy—banks and pension funds included. It really
was
alchemy, though of a deeply perverse sort.

In time, CDOs became by far the biggest buyers of triple-B tranches of mortgage-backed securities, purchasing and reassembling an astonishing 85 to 95 percent of them at the peak, according to a presentation by Karan P. S. Chabba, Bear Stearns’s structured credit strategist. Among other consequences, this practice helped perpetuate the worst, most dangerous securities, because they were the ones that had the highest yield relative to their rating. One Wall Street executive would later liken CDOs to “purifying uranium until you get to the stuff that’s the most toxic.”

Lang Gibson, a former Merrill Lynch CDO research analyst, wrote a novel after the crisis in which a character describes the CDO market as a Ponzi scheme. You can see his point. As the triple-Bs were endlessly recycled, CDOs begat CDO squareds (in which triple-B portions of CDOs were reassembled into a new CDO) and even CDO cubeds (reassembed triple-B tranches of CDO squareds). The rise of ratings arbitrage helped push sales of CDOs from $69 billion in 2000 to around $500 billion in 2006. It was an endless cycle of madness.

The rating agencies were at the very heart of the madness. The entire edifice would have collapsed without their participation. “Get the rating out the door—that was it,” says a former S&P executive. Once a tranche of a mortgage-backed security was stamped triple-A, nobody ever went back and reanalyzed it as it was rebundled into a CDO. “We simply assumed triple-A was a triple-A,” says a former Moody’s managing director who worked on CDOs.

The analysts in structured finance were working twelve to fifteen hours a day. They made a fraction of the pay of even a junior investment banker. There were far more deals in the pipeline than they could possibly handle. They were overwhelmed. “We were growing so fast, we couldn’t keep staff, and we were grossly underresourced,” recalls a former Moody’s structured finance executive. Moody’s top brass, he says, thought the mania would end with home prices flattening out, and as a result they wouldn’t add staff because they didn’t want to be stuck with the cost of employees if the revenues slowed down. “They were so stingy,” he says. At both Moody’s and S&P, former employees say there was a move away from hiring people with backgrounds in credit and toward hiring recent business school graduates or foreigners with green cards to keep costs down.

And of course nobody had the time or the inclination to examine the actual mortgages upon which this entire edifice had been built. If they had done so—if they had taken a hard look at the subprime mortgages that were at the heart of the securities they were rating triple-A—it would have meant putting an end to an immensely profitable business. “It seems to me that we had blinders on and never questioned the information we were given,” a former Moody’s executive later wrote. “It is our job to think of the worst-case scenarios and model them. Why didn’t we envision that credit would tighten after being loose and housing prices would fall after rising? After all, most economic events are cyclical and bubbles inevitably burst.”

After leaving Moody’s, Mark Adelson joined Nomura Securities, where he was the head of structured finance research. At securitization conferences, he would look around at the audience and think to himself, “No one in that room had ever loaned or collected back one red cent. Any schmuck can lend it out. The trick is getting it back!”

In the fall of 2007, after it all started melting down, a Moody’s managing director wrote in a memo, “My recommendation is that we do not rate ABS [asset-backed securities] CDOs. The reasoning behind this recommendation is that due to the complexity of the product and multiple layers of risk, it is NEVER possible to have the requisite amount of information to rate.” But that had been true long before 2007.

By the fall of 2005, Moody’s market capitalization had grown to more than $15 billion. That was roughly the same as Bear Stearns. Yet Bear Stearns had 11,000 employees and $7 billion of revenue, while Moody’s had 2,500 employees and $1.6 billion of revenue. Moody’s operating margins were consistently over 50 percent, making it one of the most profitable companies in existence—more profitable, on a margin basis, than Exxon Mobil or Microsoft. Between the time it was spun off into a public company and February 2007, its stock had risen 340 percent. Structured finance was approaching 50 percent of Moody’s revenue—up from 28 percent in 1998. It accounted for pretty much all of Moody’s growth.

And in August 2007, Brian Clarkson was named president of Moody’s. His compensation that year was $3.2 million.

I
t was the 2004 holiday season, and a college student—let’s call him Bob—was home in Sacramento. One night, out on the town, he met another young man—Slickdaddy G, Bob nicknamed him. Slickdaddy G, who was twenty-six, was a “larger-than-life personality type,” Bob recalls. “He had perfectly highlighted blond hair, short and gelled, perfect white teeth, perfect bronzed skin.” He also had his own limo driver and a seemingly endless supply of money. Bob joined Slickdaddy G for a night of club hopping, picking up pretty girls and drinking Dom Pérignon. The crew ended up at a penthouse apartment—it was just called “the P”—where an “insane party” was taking place. “A DJ, and more girls, booze, and drugs than you can imagine,” says Bob. “It was one of the crazier experiences of my life to this point.” The next morning, Bob asked Slickdaddy G, “What the hell do you do?”

“Ameriquest” came the reply. “I’m in the mortgage business.”

Incredibly, the subprime mortgage business, which had been left for dead, had come roaring back, bigger than ever. Never mind that most of the mortgage originators during the first subprime bubble—subprime one, let’s call it—had gone bust, or that giving mortgages to shaky borrowers had led to a rather unsurprising rise in foreclosures. And never mind that the subprime financial model had been very nearly discredited. “Subprime one,” says Josh Rosner, “was the petri dish.”

The second subprime bubble was as wild as anything ever seen in American business. During subprime two, kids just out of school—sometimes high school—became loan officers, some of them pulling down $30,000 or $40,000 a month. (Slickdaddy G told Bob that in one especially good month he took home $125,000.) In some places, like Ameriquest’s Sacramento offices, where Bob had taken a job in 2005, drug usage was an open secret,
former loan officers say, especially coke and meth, so that the loan officers could sell fourteen hours a day. And the money poured in.