More Hot Emails Put New Heat on the Credit Rating Agencies

Ratings Agencies executives Raymond W. McDaniel Jr., Chairman and CEO of Moody's, N.Y., and Kathleen Corbet, Former President of S&PThe Securities and Exchange Commission's civil fraud suit against Goldman Sachs has focused public outrage at that firm, but there's plenty of other targets for fury. For instance, in advance of today's grilling of rating agency personnel, including Moody's Chairman and CEO Raymond McDaniel and former Standard & Poor's President Kathleen Corbet (both pictured), the Senate Committee on Homeland Security and Governmental Affairs, Permanent Subcommittee on Investigations released nearly 600 pages of exhibits consisting mostly of internal emails from Standard & Poor's and Moody's.

The emails date back to 2004-07, that is, three years before the financial crisis started through the time it hit. They show that employees of the companies had no faith in the ratings their companies issued on mortgaged-backed securities, believing them inflated, not well analyzed and rendered to gain or maintain market share and make clients happy.

The committee made several findings of fact in a memo accompanying the exhibits, including:
  • Competitive pressures, particularly the struggle for market share, affected the ratings issued by Moody's (MCO) and S&P, a unit of McGraw-Hill (MHP).
  • The agencies used inadequate, inaccurate ratings models, and once the models were improved, failed to reevaluate securities they'd previously rated, which delayed downgrades.
  • The agencies knew that mortgage fraud, poor underwriting and unsustainable housing price appreciation was occurring, but didn't factor them into their risk analyses.
  • Despite the agencies' record profits, they underfunded the departments doing the ratings.
Despite the many disturbing emails released by committee (see excerpts below), the ratings agencies are unlikely to be any more vulnerable to lawsuit under the federal securities laws then they are now: So far they're undefeated in court. However that's because the federal laws apply to only a small number of actors, such as "underwriters," and the plaintiffs have been unable to define ratings agencies within such categories. Nonetheless, other types of suits, such as those brought by the Ohio and Connecticut attorneys general, might gain strength with these documents.

Behind-the-Scenes Pressure

These excerpts are the just a small piece of the data the committee released today. However, they give a flavor for the behind-the-scenes pressure on analysts to maintain market share by keeping banks happy. That meant ensuring that their methodologies produced the desired ratings, rather than more accurate ones. In sum, the excerpts and the volumes of evidence in all the exhibits portray two companies more concerned with their own profits than about whatever havoc their products -- ratings -- might wreak in the financial system.

A May, 2004 S&P email shows that even then competitive pressures were affecting rating methodology:

"We just lost a huge Mizuho RMBS deal to Moody's due to a huge difference in the required credit support level. . . . What we found from the arranger was that our support level was at least 10% higher than Moody's. . . . Based on arranger's feedback, we suspect that because Mizuho is a mega bank, [Moody's] ignored [two risks]. . . . Losing one or even several deals due to criteria issues, but this is so significant that it could have an impact in the future deals. There's no way we can get back on this one but we need to address this now in preparation for the future deals. I had a discussion with the team leaders here and we think that the only way to compete is to have a paradigm shift in thinking, especially with the interest rate risk."

As does this July, 2004 S&P email:
"We are meeting with your group this week to discuss adjusting criteria for rating CDOs of real estate assets this week because of the ongoing threat of losing deals. . . ." [emphasis in original]

A March, 2005 S&P email chain shows the agency was slow to roll out ratings model changes because the updated model produced harsher results. Parts of the chain:

"When we first reviewed [model] 6.0 results **a year ago** we saw the sub-prime and Alt-A numbers going up and that was a major point of contention which led to all the model tweaking we've done since. Version 6.0 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."

Waive the Rules for Goldman?


Over a half dozen additional emails from 2005 discuss the issue of what to do about currently rated deals if a new ratings system is adopted that, if applied retroactively, would downgrade the existing deals.

Also, a very long May 2005 S&P email chain that's highly technical amounts to a discussion on whether to apply existing criteria to a Goldman deal or waive them -- Goldman wanted the criteria waived. The chain ends with those wanting to hold Goldman to the standard losing a 4-3 vote, where the four voting to waive the criteria weren't named to the other three, and, unlike the three, gave no written reason for their votes.

A June 2005 S&P email shows not everyone supported letting market-share concerns influence ratings criteria:

"re: Privileged Criteria Deliberations:...(Why these questions come up every month is obvious – issuers don't like the outcome. However, the right thing to do is to educate all the issuers and bankers and make it clear that these are the criteria and that they are not-negotiable. If this is clearly communicated to all then there should be no monthly questions. *** Screwing with criteria to "get the deal" is putting the entire S&P franchise at risk – it's a bad idea.).

Hearing It From the Issuers


Some 2006 emails show pressure from investment banks pressing S&P not to change the ratings methods in ways that affect their deals:

"re: comstock (If our current structure, which we have been marketing to investors and the mgr, (and which we have been doing prior to the release of the beta cash flow assumptions) doesn't work under the new assumptions, this will not be good. Happy to comply, if we pass, but will ask for an exception if we fail...).

"heard you guys are revising your residential mbs rating method[o]logy... heard your ratings could be 5 notches back of moddys equivalent. gonna kill your resi biz. may force us [UBS] to do moodyfitch only cdos!".

That email led to internal S&P discussion: "We put out some criteria changes a couple of weeks ago that we will begin to use for deals closing in July. . . . Together these two changes will be making a moderate change in raising our credit support requirements going forward. However to say that these changes will leave us 5 notches back of Moody's sounds like a gross over statement...We certainly did [not] intend to do anything to bump us off a significant amount of deals."

"This Is Unacceptable"

The picture wasn't any prettier at Moody's. A couple of 2007 emails show that Moody's also had banks looking to avoid ratings methodolgy changes.

May, 2007 Moody's email: "Thanks again for your help (and Mark's) in getting Morgan Stanley up-to-speed with your new methodology. As we discussed last Friday, please find below a list of transactions with which Morgan Stanley is significantly engaged already. . . . We appreciate your willingness to grandfather these transactions [with regards to] Moody's old methodology."

August, 2007 Moody's email: "[E]ach of our current deals is in crisis mode. This is compounded by the fact that we have introduced new criteria for ABS [asset-backed securities] CDOs. Our changes are a response to the fact that we are already putting deals closed in the spring on watch for downgrade. This is unacceptable and we cannot rate the new deals in the same away [sic] we have done before. . . . bankers are under enormous pressure to turn their warehouses into CDO notes."

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