Saturday, December 22, 2007

Barron's Cover Story on Moody's

Barron's Online
Monday, December 24, 2007

Failing Grade


THOUGH WALL STREET WAS SLOW to realize it, July 10 turned out to be Pearl Harbor Day for the global credit markets. On that day, credit-rating giants Moody's (MCO) and Standard & Poor's both shocked investors by announcing separately that they were taking negative rating actions against nearly $20 billion of 2006-vintage subprime-mortgage bonds because of spiraling delinquencies and foreclosures on the loans.

The credit downgrades have only increased since then, with Moody's alone chopping the ratings on more than half the 2006 subprime residential-mortgage-backed securities it had rated, including a whopping 97% of the slices, or tranches, it deemed single-A or below, according to a compilation made by Morgan Stanley Fixed Income Research.

Even worse has been the stunning speed with which the ratings agencies have acted. Investors in some $800 million of asset-backed commercial paper in Rhinebridge LLC, a bank-sponsored structured investment vehicle, or SIV, filled with U.S. subprime debt, suffered whiplash when the paper and related medium-term notes swung from S&P's highest credit ratings to default in four days in October. And this followed a Moody's report in July titled "SIVs, An Oasis of Calm in the Sub-Prime Maelstrom." Such precipitous ratings declines have come to be known as express-train downgrades, since there are no stops between Blue-Chip Land and oblivion.

All of this has landed the credit-rating agencies in the crosshairs of Congress, the Securities and Exchange Commission and several state attorneys general, just five years after the industry was taken to the woodshed for its failure to suss out the impending collapse of companies like Enron and WorldCom.

That spasm of reformist zeal resulted in the 2006 Credit Agency Reform Act -- but the law clearly didn't go far enough. That's why Barron's now proposes some fresh and far-reaching measures to fix the rating system, starting with steps to greatly increase competition. Moody's and Standard & Poor's have held far too strong a grip on the industry for anyone's good. It is high time for a change.

MAKE NO MISTAKE: THE LATEST debacle dwarfs the rating contretemps earlier in the millennium. In all, $650 billion of 2006 subprime mortgages were securitized in the past year. Moody's officials point out that only 15% or so of the dollar amount of that rated debt -- counting all tranches -- has gone bad, requiring downgrades. But the ripple effect of those downgrades has wreaked havoc throughout the global credit markets.

For one thing, many of the now-downgraded slices of subprime residential-mortgage-backed debt rated A or below were bundled or re-securitized into instruments called collateralized debt obligations, or CDOs.

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The agencies were key enablers of the mortgage mess, blessing many dubious securities.

Fatefully, the rating agencies decided to allow securitizers to slice these CDOs into a new capital structure that transmogrified 80% of the bonds into triple-A credits. It was assumed -- incorrectly -- that the 20% of the structure rated single-A or below would be more than adequate to absorb any losses suffered by the underlying mortgage pools from delinquencies or foreclosures. The reality: Price declines in these supposedly pristine triple-A tranches have triggered much of the mayhem.

This CDO paper, with a dollar value of $200 billion or more, spread like anthrax through the global credit markets. Banks and non-bank financial companies now are liquidating $350 billion of off-balance- sheet SIVs because the subprime CDO contagion has ruined their liquidity. A number of bond funds, state-government liquidity funds and even money-market funds have suffered losses as a result of investing in what they were led to believe was top-rated commercial paper and medium-term notes issued by the SIVs.

Moreover, major banking concerns from Merrill Lynch (ticker: MER) and Bear Stearns (BSC) to Citigroup (C), HSBC (HBC) and Deutsche Bank (DB) are taking nearly $100 billion in capital-depleting write-downs on CDOs and other subprime paper they either held on their balance sheets or had to put back on them.

These institutions may deserve the punishment, since they were among the biggest spewers of this poison. But global lending and liquidity has suffered mightily as a result, despite the best efforts of central banks in the U.S., England and Europe to unblock the system. Even interbank lending has ground to a halt. Banks simply don't trust one another's balance sheets, stuffed as they are with exotic mortgage paper that can't be valued with any precision.

To be sure, the rating agencies aren't solely responsible for this credit seizure. They were just one link in a subprime production line that stretched from sleazy storefront mortgage brokers, corrupt appraisers and avaricious originators to fee-crazed securitizers and, yes, mendacious borrowers.

But the rating agencies unquestionably were key enablers, by countenancing and legitimizing lethal capital structures. "We certainly saw as early as 2003 and 2004 that the subprime market was getting out of hand," Brian Clarkson, the president of Moody's, notes ruefully to Barron's. "We misjudged the magnitude of the problem, the fact that what we expected to be a tropical disturbance ended up being a Category 5 hurricane."

Standard & Poor's executives declined to speak with Barron's; a spokesman directed us to the company's published reports.

TO MAKE SURE SOMETHING like this doesn't happen again, policy makers and regulators must take bold action. Most important, the SEC should promote more competition in the industry by speeding up its approval of new agencies, designating them "nationally recognized statistical rating organization(s)."

Even though it is estimated that some 150 credit-rating agencies exist around the globe, the SEC has accorded this official status to only seven. They are the Big Three -- Moody's, S&P and Fitch -- plus insurance-industry specialist A.M. Best; the Canadian specialist Dominion Bond Rating Service, and two smaller Japanese bond raters.

Moody's and S&P dominate the industry, with a combined market share of 80%, leaving Fitch scrambling for about 10% to 15%. It's an industry with scant price competition. Most regulations, whether governing the asset quality of money-market holdings, bank or insurance-company loss reserves, broker-dealer net capital or investments of surplus corporate cash, require that the holdings be adjudged investment-grade by two officially designated agencies.

More often than not, Moody's and S&P get the assignment.


As a result, the two top dogs preside over what the Justice Department terms a partner monopoly, as opposed to an oligopoly. Rather than having to compete vigorously against each other as oligopolists, one's good fortune in winning a piece of business is typically followed by the other's receiving the same deal at the same lush fee level.

This duopoly has proven inordinately profitable, which perhaps explains why Warren Buffett is Moody's top shareholder, with a nearly 19% stake. S&P's results are buried in the financials of its publisher parent, McGraw Hill (MHP), but pure-play Moody's (MCO) earns some of the fattest margins in the S&P 500, with pretax income last year of $1.1 billion on a mere $2 billion in revenue. Even monopolists like Microsoft would kill for Moody's operating margins, typically 50% or more.

Competition from new agencies might create a healthy diversity of opinion, leading to more accurate assessments of debt issues' default probabilities.

Today, the Big Three often seem to operate in a universe of harmonic convergence, with ratings of the different agencies moving in elegantly choreographed lockstep up or down their rating scales. Like wildebeests -- or lemmings -- the agencies seemingly seek safety in numbers.

True, the agencies have long escaped any legal liability for issuing errant ratings by asserting that their actions constitute free speech protected by the First Amendment. In essence, they portray their ratings as nothing more than editorial opinion. And by sticking together, the agencies are less likely to incur the wrath of debt issuers and major investors when they voice negative opinions.

Obviously, the SEC worries that opening the gates too widely and precipitously to new rating-agency registrants might lead to an industry race to the bottom, with new entrants trying to scare up business by offering inflated ratings to issuers ranging from municipal-bond districts to corporations to securitizers.

This is by no means a trivial concern.

Dozens of Canadian corporations and government entities are stuck with some $40 billion of commercial paper in various non-bank Canadian SIVs that has been frozen indefinitely because Dominion Bond Rating Service failed to make sure that adequate backup liquidity facilities were in place when it gave the paper its top rating. Moody's and S&P were excluded from the ratings assignment because they insisted on tougher liquidity requirements. (A Dominion spokeswoman says the firm has now changed its methodology "to reflect tighter liquidity-backup requirements.")

Industry expert and Columbia Law School professor John Coffee Jr. has suggested an elegant solution to bolster rating-agency quality control, both to Barron's and in recent congressional testimony. He wants the SEC to require raters that have been granted official status to disclose in a central database the historical default rates of all classes of financial products that they've rated. Regulators and investors would thus have an effective means of assessing the raters' rigor.

"It's tremendously liberating to just work for investors and not worry about angering the issuer community," partner Sean Egan tells Barron's. "Not only have we been able to give investors earlier warnings of corporate frauds and other negative credit situations, but in many cases we've led the industry on upward credit revisions of worthy recipients."

Furthermore, Coffee argues, the SEC should discipline miscreant agencies by temporarily yanking their registration in areas where their ratings have been notably wrong.

Another good idea: Change how the agencies are paid. Currently, all seven agencies get most of their fee income from the issuers of debt and structured products like subprime CDOs, rather than from the buyers, investors.

Many critics ascribe the rating industry's woes to this stark conflict of interest. Former Clinton Secretary of Labor Robert Reich writes on his blog that the system is tantamount to movie studios' hiring critics to review their films and paying them only "if their reviews are positive enough to get lots of people to see the movie."

One investor-subscription-based rating service, Egan-Jones, has been trying fruitlessly to win official agency status for more than a decade. In that time, the Philadelphia concern has been miles ahead of the established agencies in downgrading the likes of Enron and WorldCom and more recently the mortgage and bond insurers, mortgage originators and investment banks caught up in the subprime-mortgage crisis.

The traditional rating agencies have been given an exemption from fair disclosure rules, allowing them special access to material nonpublic information from the issuer community. This information monopoly constitutes a serious barrier to competition from other rating concerns and puts the investor community at a severe disadvantage.

A sensible reform would end this special treatment and require systematic, timely release of credit information to all participants, particularly in complex structured products like mortgage CDOs. Not that the agencies made effective use of their inside knowledge of the myriad mortgage pools that backed many now-pancaked CDOS and SIVs.

BOTH MOODY'S AND S&P officials claim that their woes in the 2006 subprime arena are a result of unusual factors, including fraud by a number of borrowers and lenders. There's some validity to the claim. Nonetheless, the rating agencies shouldn't be absolved from responsibility.

Shortcomings by the agencies are hardly new. As economists Joseph Mason and Charles Calomiris reported recently, using Moody's own data, the agencies have had a less-than-sterling rating history with other classes of structured products, long before the blowup in 2006-vintage securitizations.

They noted that the five-year cumulative default rate between 1993 and 2005 was 24% for CDOs receiving Moody's lowest investment-grade rating of Baa. This compares with a five-year default rate of 2.2% on corporate bonds similarly rated from 1983 through 2005. Moody's later amended the CDO default rate to 17%, though at the end of 2006, to reflect subsequent asset recoveries on the busted debt. Even so, the almost eight-to-one loss ratio between the two classes of debt represents a yawning gap.

Several theories explain this discrepancy and none is particularly flattering to the rating agencies.

For one thing, it appears that investment banks have been pushing the agencies to inflate their ratings. The motivation isn't a mystery. Large structured-product securitizations bring banks upfront fees of as much as $2 million, with annual maintenance charges of $50,000 not uncommon. Likewise, the banks are large, repeat customers that can exert much more pressure on the agencies than the corporate client who makes only sporadic use of their services.


Structured products also represent the most lucrative, fastest-growing part of agency business. Moody's officials told Barron's that they accounted for more than 40% of the firm's revenue of late. One can surmise that structured products also have made an outsized contribution to agency profitability: Moody's earnings have more than doubled in the past four years.

Issuers aren't shy about punishing raters that don't play ball. Moody's recently revealed that its market share in commercial mortgage-backed securities had dropped from 75% to 25%. Why? Issuers apparently were retaliating for its tightened rating standards in the wake of the subprime debacle. Radian (RDN), a mortgage and bond insurer, dumped Fitch this year after the firm had downgraded the rating on Radian's financial-guaranty business below the single-A that the other rating agencies had delivered.

A hedge-fund manager suggests that social Darwinism may be at work in the apparent grade inflation of structured products. He maintains that the comparatively lower-paid rating-agency employees -- including many night-school MBAs -- are simply overmatched by the Harvard MBAs, MIT Ph.D.s and sophisticated computer models that the banks marshal in their pre-securitization discussions with the rating agencies.

The models or black boxes that the agencies have been using to rate structured products were flawed in their weighting of variables and underlying assumptions. Among other things, they failed to take into account investment bubbles that developed in all manner of structured products that led to heavy defaults in the past decade.

High-rated manufactured-housing securitizations, for instance, performed miserably early in the millennium, along with some earlier home- and commercial-mortgage securitizations and post-tech-wreck high-yield bond issues. Student-loan securitizations may be the next rating area to blow, and the triple-A ratings of bond insurers like MBIA (MBI) already are being called into question (see "A Roaring Buy2,").

But the subprime models have proved most damaging to the reputations of the rating agencies, not to mention the global credit markets. Recent reports by the research boutique CreditSights cite a number of problems with the rating agencies' assumptions. For one thing, CreditSights maintains, the agencies badly overestimated the size of the recoveries that sales of foreclosed properties would yield. The industry term for trends in housing prices -- "HPA," for home-price appreciation -- betrays a certain underlying bias that home prices will always rise over time. Not until summer did the rating agencies seem to wake up to the fact that HPA had become HPD -- home-price depreciation -- and was likely to trend down for some time.

Likewise, the agencies labored under the assumption that housing markets were regional and not national and therefore "uncorrelated." In other words, if Southern California hit the skids, rising prices in metropolitan New York would compensate for the downturn in the Golden State. Sadly, this historical behavior no longer holds in the current, nationwide crisis.

In addition, the rating agencies relied on spurious historical data to predict default rates, says Jeffrey Gundlach, chief investment officer at TCW, which oversees some $90 billion in mostly mortgage-backed debt. The models looked at the delinquency and default behavior of home owners over many decades. But the data in large part were based on conventional 30-year, fixed-rate mortgages that required borrowers to have significant equity in their homes.

This had little relevance to the suped-up subprime-mortgage environment of 2006, in which borrowers had no home equity, were encouraged to lie about their assets and income and often were speculating on homes or condominiums in which they didn't even plan to live. "The surge of defaults from the prime to subprime housing markets was absolutely predictable," Gundlach asserts. "If a borrower has no economic skin in the game as a result of a 100% or higher loan-to-value, then he's crazy to make even one monthly payment in a falling home market."

Gundlach has an excellent suggestion for reforming the rating industry that he has made to several agency executives: "Just Say No" when Wall Street asks them to rate securities that lack historically relevant data.

In today's credit panic, investors are fleeing from all manner of structured products, including securitizations backed by car loans, because of the fear unleashed by the subprime crisis. This bodes poorly for the rating agencies, both on the business and regulatory fronts.

Fast times are over for the now-chastened agencies, at least until the next bubble begins to inflate. Is there a chance the industry will act more responsibly the next time around?

Sure, but only if the reforms we pose are enacted.

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