Yielding to Wall Street, raters ‘drink the Kool-Aid’

Introduction

In the lead up to the financial meltdown, Wall Street firms routinely exerted influence on the nation’s largest credit rating companies — which judge the quality and safety of bonds — and the companies often surrendered to the pressure, a Senate panel has found.

The rating companies, Standard & Poor’s and Moody’s, regularly awarded generous grades to thousands of mortgage-related investments that later collapsed and precipitated the financial crisis. Investors rely on the raters’ assessments in deciding what to buy and sell.

But an examination, conducted by the Senate’s Permanent Subcommittee on Investigations, uncovered internal e-mails and documents that describe the raters as “beholden” to investment banks — firms the raters referred to as their “clients.”

In an October 2007 e-mail, Moody’s chief risk officer warned the company’s chief executive, Raymond McDaniel, that Moody’s employees are “continually ‘pitched’ by bankers,” a process that can “color credit judgment, sometimes improving it, other times degrading it (we ‘drink the Kool-Aid’).” The risk officer said such influence “does constitute a ‘risk’ to ratings quality.”

The subcommittee on Thursday released this e-mail and excerpts from some 500 other documents collected during its probe of the rating companies. In response, Moody’s spokesman Michael Adler said the company has “rigorous and transparent methodologies.” S&P spokesman Chris Atkins said the company has “learned some important lessons from the recent crisis” and made “significant enhancements to increase the transparency, governance, and quality of our ratings.” In the past, the raters have said their critics are wrong to characterize ordinary discussions about a rating as any kind of collusion.

The subcommittee found that both companies eased their standards as they battled for control over the credit rating business. The raters, internal e-mails suggest, knew that some mortgage investments were flawed but gave them good grades anyway.

“I’m not surprised; there has been rampant appraisal and underwriting fraud in the [mortgage] industry for quite some time as pressure has mounted to feed the origination machine,” an S&P managing director wrote in a 2006 e-mail.

That year was crucial for the raters. Between 2006 and 2007, S&P and Moody’s each rated 10,000 mortgage securities, according to the subcommitee. Their revenues soared, peaking in 2007 at nearly $3 billion. But the raters later had to downgrade 90 percent of the risky mortgage securities they awarded top ratings to between 2004 and 2007, according to an analysis by BlackRock Solutions provided by the subcommittee.

Such downgrades have been blamed for triggering the financial meltdown.

“I don’t think either of these companies have served their shareholders or the country well,” said Sen. Carl Levin (D-MI), chairman of the subcommittee. “They were excessively influenced by investment bankers.”

The Huffington Post Investigative Fund reported last year that rating analysts worked closely with financial institutions as they created mortgage investments. Banks often structured the financial products and then sold them to pension funds and other investors.

In the most recent lawsuit filed against the raters, Ohio’s Attorney General Richard Cordray accused the companies of being “intimately involved in structuring” investments that caused retirement funds for police officers, firefighters and teachers to lose $457 million.

Internal e-mails of Moody’s and S&P, released by the subcommittee, provide a window into Wall Street’s influence over the raters, said Levin.

S&P’s residential mortgage rating group has “become so beholden to their top issuers [investment banks] for revenue they have all developed a kind of Stockholm Syndrome,” an S&P employee wrote in 2006.

A June 2007 e-mail exchange between a Moody’s analyst and an investment banker highlights how fees seeped into rating discussions. The analyst told the banker that a particular rating likely could not be finalized until the “fee issue” was resolved.

The banker, who worked for Merrill Lynch, responded: “We are agreeing to this under the assumption that this will not be a precedent for any future deals and that you will work with us further on this transaction to try to get to some middle ground with respect to the ratings.”

According to an e-mail Moody’s provided to the Investigative Fund late Thursday, there was more to the conversation. The Moody’s analyst replied to the Merrill Lynch banker later that day: “We will certainly continue working with you on this transaction, but analytical discussions/outcomes should be independent of any fee discussions.”

Levin, however, said that competitive pressures affected the ratings process.

In a 2004 e-mail, an S&P employee discussed “adjusting” rating procedures “because of the ongoing threat of losing deals.”

Anxieties over losing deals surfaced in another instance.

“We just lost a huge [mortgage deal] to Moody’s due to a huge difference in the required credit support level,” an S&P employee said in another 2004 e-mail. “There’s no way we can get back on this one but we need to address this now in preparation for the future deals.”

S&P’s concerns cost them precious time, according to an e-mail released by the subcommittee.

A new version of the S&P ratings model, “could’ve been released months ago and resources assigned elsewhere if we didn’t have to massage the sub-prime and Alt-A numbers to preserve market share,” an S&P employee wrote in 2005.

Some rating company employees appear to have objected to the changes.

In a 2005 e-mail, one employee wrote: “Screwing with [the model’s] criteria to ‘get the deal’ is putting the entire S&P franchise at risk — it’s a bad idea.”