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Rating a culture of Moody's manipulation

AS the housing market collapsed in late 2007, Moody's Investors Service, whose investment ratings were widely trusted, responded by purging analysts and executives who warned of trouble and promoting those who helped Wall Street plunge the country into its worst financial crisis since the Great Depression.

A newspaper investigation has found that Moody's punished executives who questioned why the company was risking its reputation by putting its profits ahead of providing trustworthy ratings for investment offerings. Instead, Moody's promoted executives who headed its "structured finance" division, which packaged loans into securities for sale to investors.

It also stacked its compliance department with the people who awarded the highest ratings to pools of mortgages that soon were downgraded to junk.

Such products have another name now: "toxic assets".

As Congress tackles the broadest proposed overhaul of financial regulation since the 1930s, however, lawmakers still aren't fully aware of what went wrong at the bond-rating agencies, and so they may fail to address misaligned incentives such as granting stock options to mid-level employees, which can be an incentive to issue positive ratings rather than honest ones.

The Securities and Exchange Commission issued a blistering report on how profit motives had undermined the integrity of ratings at Moody's and its main competitors, Fitch Ratings and Standard & Poor's, in July 2008, but the full extent of Moody's internal strife never has been publicly revealed.

Moody's, which rates McClatchy's debt and assigns it quite low value, disputes every allegation against it.

"Moody's has rigorous standards in place to protect the integrity of ratings from commercial considerations," Moody's vice-president for corporate communications, Michael Adler, said.

But insiders say that wasn't true before the financial meltdown.

"The story at Moody's doesn't start in 2007; it starts in 2000," said Mark Froeba, a Harvard-educated lawyer and senior vice-president who joined Moody's structured finance group in 1997.

"This was a systematic and aggressive strategy to replace a culture that was very conservative, an accuracy-and-quality oriented (culture), a getting-the-rating-right kind of culture, with a culture that was supposed to be 'business-friendly', but was consistently less likely to assign a rating that was tougher than our competitors," Mr Froeba said.

After Mr Froeba and others raised concerns that the methodology Moody's was using to rate investment offerings allowed the firm's profit interests to trump honest ratings, he and nine other outspoken critics in his group were "downsized" in December 2007.

"As a matter of policy, Moody's does not comment on personnel matters, but no employee has ever been let go for trying to strengthen our compliance function," Mr Adler said.

Moody's was spun off from Dun & Bradstreet in 2000, and the first company shares began trading on October 31 that year at $US12.57.

Executives set out to erase a conservative corporate culture.

To promote competition, in the 1970s ratings agencies were allowed to switch from having investors pay for ratings to having the issuers of debt pay for them.

That led the ratings agencies to compete for business by currying favour with investment banks that would pay handsomely for the ratings they wanted.

Wall Street paid as much as $US1million for some ratings, and ratings agency profits soared.

This new revenue stream swamped earnings from ordinary ratings.

"In 2001, Moody's had revenues of $US800.7m; in 2005, they were up to $US1.73billion; and in 2006, $US2.037bn.

"The exploding profits were fees from packaging ... and for granting the top-class AAA ratings, which were supposed to mean they were as safe as US government securities," Lawrence McDonald said in his recent book, A Colossal Failure of Common Sense. He's a former vice-president at now-defunct Lehman Brothers, one of the high-flying investment banks that helped create the global economic crisis.

From late 2006 till early last year, however, the housing market unravelled, poisoning first mortgage finance, then global finance. More than 60 per cent of the bonds backed by mortgages have had their ratings downgraded.

"How on earth could a bond issue be AAA one day and junk the next unless something spectacularly stupid has taken place?," McDonald wrote.

"But maybe it was something spectacularly dishonest, like taking that colossal amount of fees in return for doing what Lehman and the rest wanted." Ratings agencies thrived on the profits that came from giving the investment banks what they wanted, and investors worldwide gorged themselves on bonds backed by US car loans, credit-card debt, student loans and, especially, mortgages.

Before granting AAA ratings to bonds that pension funds, university endowments and other institutional investors trusted, the ratings agencies didn't bother to scrutinise the loans that were being pooled into the bonds. Instead, they relied on malleable mathematical models that proved worthless.

"Everyone else goes out and does factual verification or due diligence. The credit rating agencies state that they are just assuming the facts that they are given," said John Coffee, a finance expert at Columbia University.

"This system will not get fixed until someone credible does the necessary due diligence."

Nobody cared about due diligence so long as the money kept pouring in during the housing boom. Moody's stock peaked in February 2007 at more than $US72 a share.

One Moody's executive who soared through the ranks during the boom years was Brian Clarkson, the guru of structured finance. He was promoted to company president just as the bottom fell out of the housing market.

Several former Moody's executives said he made subordinates fear they would be fired if they didn't issue ratings that matched competitors' and helped preserve Moody's market share.

Mr Froeba said his Moody's team manager would tell his team that he, the manager, would be fired if Moody's lost a single deal.

"If your manager is saying that at meetings, what is he trying to tell you?" Mr Froeba asked.

In the 1990s, Sylvain Raynes helped pioneer the rating of so-called exotic assets.

He worked for Mr Clarkson.

"In my days, I was pressured to do nothing, to not do my job," said Mr Raynes, who left Moody's in 1997.

"I saw in two instances -- two deals and a rental-car deal -- manipulation of the rating process to the detriment of investors."

When Moody's went public in 2000, mid-level executives were given stock options.

That gave them an incentive to consider not just the accuracy of their ratings, but the effect they'd have on Moody's -- and their own -- bottom lines.

"It didn't force you into a corrupt decision, but none of us thought we were going to make money working there, and suddenly you look at a statement online and it's (worth) hundreds and hundreds of thousands (of dollars).

"And it's beyond your wildest dreams working there that you could make that kind of money," said one former mid-level manager, who requested anonymity to protect his current Wall Street job.

Mr Adler, the Moody's spokesman, insisted that compensation of Moody's analysts and senior managers was "not linked to the financial performance of their business unit".

Mr Clarkson couldn't be reached to comment.

Others who worked at Moody's at the time described a culture of wilful ignorance in which executives knew how far lending standards had fallen and that they were giving top ratings to risky products.

"I could see it coming at the tail end of 2006, but it was too late.

"You knew it was just insane," said one former Moody's manager.

"They certainly weren't going to do anything to mess with the revenue machine."

Rating a culture of Moody's manipulation | The Australian

Bastian Gross

German Mathquant
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