Rating agencies "sold their souls"

The heads of the major rating agencies faced public humiliation this week, as hearings in the US Congress blamed them for the oversights and mis-estimates behind the credit crisis.

Appearing before the House Oversight Committee, Standard & Poor's chief executive Deven Sharma argued that ratings had been used "in ways for which they were not designed", adding that "virtually no one — be they homeowners, financial institutions, rating agencies, regulators, or investors — anticipated what is occurring".

The issuer-pays business model of the three main agencies came under fire. Jerome Fons, a former chief economist for Moody's mortgage-backed securities (MBS) group, said: "A large part of the blame can be placed on the inherent conflicts of interest found in the issuer-pays business model and rating shopping by issuers of structured securities".

The pressure on the agencies to grow their businesses, in particular Moody's after it listed as an independent company, led to slipping standards: "Originators of structured securities typically chose the agency with the lowest standards, engendering a race to the bottom in terms of rating quality."

Another witness, Frank Reiter, a former managing director with S&P's credit market team, highlighted poor-quality assessment of the risk involved: S&P had developed a better model for assessing mortgage risk in 2001, he said, but it was not implemented due to budget restrictions. The same was true for a still more accurate model developed in 2003.

"By 2001, the focus at S&P was profits for the parent company, McGraw-Hill- it was not on incurring additional expense. Second, there was an intense debate within the ratings groups as to whether we needed loan level data and related analyses. The managing director of the surveillance area for RMBS did not believe loan level data was necessary and that had the effect of quashing all requests for funds to build in-house data bases. A third reason given was that the RMBS group enjoyed the largest ratings market share among the three major rating agencies (often 92% or better), and improving the model would not add to S&P’s revenues," Raiter said.

Raiter's concerns about the limited budget for credit modelling, however, went unvoiced in his earlier testimony about mortgage ratings before Congress in November 2003, as the latest and most accurate model for assessing mortgage risk was being shelved by S&P management. Then still employed at S&P, he described the agency's ratings as "an effective and objective tool in the market’s evaluation and assessment of credit risk" and added: "Standard & Poor’s takes great care to assure that its credit ratings are viewed by the market as highly credible and relevant and will continue to review its practices, policies and procedures on an ongoing basis and modify or enhance them".

Sean Egan, head of the smaller non-recognised agency Egan-Jones, complained that the "circular" requirement for agencies to be nationally recognised before the SEC would accept them had created a highly profitable but ultimately disastrous "partner monopoly" between the three nationally recognised agencies.

The Committee also produced a number of subpoenaed emails and online conversations, highlighting how the drive for market share had undermined rating standards. In one March 2007 email, Moody's chief executive Ray McDaniel complained that "the market...actually penalizes quality by awarding rating mandates based on the lowest credit enhancement needed for the highest rating. Unchecked, competition on this basis can place the entire financial system at risk".

He added that he routinely set team leaders targets in terms of both rating quality and market share and expected them to "square the circle".

The pressure this created on analysts was displayed in one April 2007 instant message conversation. "That deal is ridiculous...we should not be rating it", complained S&P structured finance analyst Rahul Shah. Colleague Shannon Mooney told him: "I know...the model does not capture half of the risk" but added "we rate every deal. It could be structured by cows and we would rate it".

Other emails described Moody's growing awareness in 2007 that its reputation among large institutional investors was being eroded: several investment officers at leading fund managers complained credit ratings were no longer timely or reliable, and that the methodology behind them was seriously flawed.

See also: Surprise over "severe" Fitch CDO cuts
CPDOs under review as Moody’s announces further error
How secure are ratings?
Berating agencies