Does DOJ probe mean the government is finally turning up heat on the rating agencies?

Introduction

The financial meltdown of 2008 had many architects. The credit rating agencies, which bestowed the highest grades on pools of toxic mortgages, may bear the most blame.

The Financial Crisis Inquiry Commission concluded that the rating agencies were “essential cogs in the wheel of financial destruction” and that the crisis “could not have happened without the rating agencies.”

With the new disclosure that the Department of Justice is investigating whether Standard & Poor’s improperly boosted ratings, iWatch News took a look at what government investigators and former employers have said about the inner workings of the agencies. While S&P appears to currently be in the government’s crosshairs, far more is known about what went on behind the scenes at Moody’s, S&P’s biggest rival.

This partly owes to an investigation of Moody’s by the Securities and Exchange Commission. The SEC looked at whether Moody’s had purposefully failed to downgrade a group of derivatives worth about $1 billion even after it learned that the company had made a mistake in its analysis of the products’ worth.

The most damning evidence appeared in the form of an email from a Moody’s managing director.

“In this particular case we seem to face an important reputation risk issue,” the managing director wrote in an internal email. “To be fully honest this issue is so important that I would feel inclined at this stage to minimize ratings impact…rather than even allow for the possibility of a hint that the model has a bug.”

That investigation died on the vine. The SEC said last August that because the ratings committee that graded the securities met in Europe, it couldn’t sue in U.S. federal court. It closed the investigation without bringing charges.

Moody’s also attracted the most attention from the FCIC, which examined the agency as a “case study” in its January 2011 report. The report includes the testimony of several former executives who said that the agency prized profit above accuracy and treated compliance officers as a nuisance.

Scott McCleskey, a former head of compliance, said he voiced concerns that the agency was not monitoring ratings on municipal debt, and that he was told by senior managers not to mention these claims in email or writing.

In his testimony he also told a story of a private Moody’s dinner. He said that he was approached by Brian Clarkson, who ran the structured finance group before becoming president of the company. Clarkson, McCleskey claims, shouted at him in front of the board of directors.

“How much revenue did compliance bring in this quarter?” Clarkson asked, according to McCleskey. “Nothing, nothing.”

Later, two of McCleskey’s senior compliance officers—and eventually, McCleskey himself—were fired.

Other Moody’s officers also testified that profit was more important to Moody’s than sound ratings.

“When I joined Moody’s in late 1997, an analyst’s worst fear was that we would contribute to the assignment of a rating that was wrong,” said Mark Froeba, former senior vice president. “When I left Moody’s, an analyst’s worst fear was that he would do something, or she, that would allow him or her to be singled out for jeopardizing Moody’s market share.”

Richard Michalek, a former Moody’s vice president and senior credit officer, testified to the FCIC, “The threat of losing business to a competitor, even if not realized, absolutely tilted the balance away from an independent arbiter of risk towards a captive facilitator of risk transfer.”

Moody’s officials, and Clarkson, vigorously disputed in testimony before the FCIC that the pursuit of profits had led to any compliance shortcuts.

In testimony before the House Oversight Committee, Eric Kolchinsky, a former Moody’s managing director, said senior managers pushed revenue over ratings quality and were willing to fire employees who disagreed.

These allegations by former Moody’s officers, while unflattering, do not necessarily constitute enough evidence to win a criminal fraud case, however. Prosecutors typically want a smoking gun—evidence in the form of an email or other document showing that Moody’s or another agency gave a security a high grade while privately acknowledging that the risk of failure was much higher than they thought.

The DOJ’s record in financial crisis criminal fraud prosecutions is also not very good. The agency lost a high-profile case against two former Bear Stearns executives in 2009, and in February dropped a two-year investigation of former Countrywide Financial chief executive Angelo Mozilo without bringing charges.

This may explain why the DOJ is reportedly trying to build a civil case against S&P. The burden of proof in a civil case is not as high.

McCleskey, the former Moody’s compliance officer, told iWatch News that he suspects that the investigation will lead to a fine against S&P, “but not a fine that cripples them.” He said that evidence uncovered in the investigation, however, could be used as fodder in a rash of lawsuits by state attorneys general and investors.

Harold Barnett, a professor at Roosevelt University in Chicago, explained a methodology that prosecutors might use to build a case against S&P or other ratings agencies. Barnett said that liability can be established by comparing the ratings issued by the agencies to what the banks securitizing the loans were telling their investors about the risk involved.

In a recent study, Barnett examined 32 mortgage-backed securities pools securitized by Goldman Sachs from 2005 to 2007. Both S&P and Moody’s rated the pools identically, with 81 percent receiving the highest grades. As of June 2010, Moody’s projected that the securities had lost 35 percent of their value, or nearly $10 billion.

Even as the agencies were giving top grades to the mortgages, Goldman was warning investors of increased risk in the subprime market—warnings available to the ratings agencies, Barnett said. But the agencies did not act until after the bottom fell out of the market.

From 2000 to 2007 Moody’s rated nearly 45,000 mortgage-related securities as triple-A, according to the FCIC report. This compares with six private-sector companies in the United States that carried this coveted rating in early 2010, the report says.

In 2006 alone, Moody’s put its triple-A stamp of approval on 30 mortgage-related securities every working day, the FCIC report says. “The results were disastrous: 83 percent of the mortgage securities rated triple-A that year ultimately were downgraded.”