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Guest Post: The CDOs That Destroyed AIG: The Big Short Doesn't Quite Reveal What They Knew And When They Knew It

By Tyler Durden
Created 03/15/2010 - 22:35
Submitted by David Fiderer

It's been eighteen months since AIG collapsed, and Congress has yet to seriously focus on the most important questions: What did they know and when did they know it?

"What" refers to the fatal flaws in the collateralized debt obligations, or CDOs, that AIG insured.

"They" are the bankers that structured and sold the CDOs, plus the AIG executives who took on the credit risk, plus the rating agencies that handed out AAA ratings.

"When" harkens back to 2005 and 2006, when those toxic CDOs were first issued.

Just before the backdoor bailout of AIG's banks actually closed, Michael Lewis addressed what they knew and when they knew it in Portfolio. [1] He explained why the CDO market was ground zero for Wall Street malfeasance that led to the meltdown:

The funny thing, looking back on it, is how long it took for even someone who predicted the disaster to grasp its root causes... [Fund manager Steve] Eisman knew subprime lenders could be scumbags. What he underestimated was the total unabashed complicity of the upper class of American capitalism. For instance, he knew that the big Wall Street investment banks took huge piles of loans that in and of themselves might be rated BBB, threw them into a trust [i.e. a CDO], carved the trust into tranches, and wound up with 60 percent of the new total being rated AAA.
?But he couldn't figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. "I didn't understand how they were turning all this garbage into gold," he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. "We always asked the same question," says Eisman. "Where are the rating agencies in all of this? And I'd always get the same reaction. It was a smirk."

The Disaster Created Under Hank Paulson's Watch

That collective smirk reflected more than the bankers' contempt for the rating agencies' analyses. It was a way of maintaining deniability about CDO investments that were obviously designed to become insolvent at the time they were created. In The Big Short, Lewis expands on this point:

[T]here were large sums of money to be made, if you could somehow get [triple-B mortgage bonds] re-rated as triple-A, thereby lowering their perceived risk, however dishonestly and artificially. This is what Goldman Sachs had cleverly done.
This all started at the end of 2004, when:

Goldman was in the position of selling bonds to its customers created by its own traders, so they might bet against them...

According to a former Goldman derivatives trader, Goldman would buy the triple-A tranche of some CDO, pair it off with the credit default swaps AIG sold Goldman that insured the tranche (at a cost well below the yield of the tranche), declare the entire package risk-free, and hold it off its balance sheet. Of course, the whole thing wasn't risk free: If AIG went bust, the insurance was worthless, and Goldman would lose everything. Today, Goldman Sachs is, to put it mildly, unhelpful when asked to explain exactly what it did, and this lack of transparency extends to its own shareholders. "If a team of forensic accountants went over Goldman's books, they'd be shocked at just how good Goldman is at hiding things," says one former AIG FP employee, who helped to unravel the mess, and who was intimate with his Goldman counterparts.

The guy in charge of all this, Goldman's CEO, was Hank Paulson. When he moved over to Treasury, Paulson acknowledged that the subprime bubble, which he helped foment, was central to destabilizing the markets. As he wrote [2] exactly two years ago:

The turmoil in financial markets clearly was triggered by a dramatic weakening of underwriting standards for US subprime mortgages, beginning in late 2004 and extending into early 2007.
[Those are Paulson's italics, not mine.]

Goldman now says that it didn't manipulate anything; it simply responded to market demand. Or as Lloyd Blankfein testified, "what we did in that business was underwrite to [] the most sophisticated investors who sought that exposure." Of course, a lot of so-called sophisticated investors were played for suckers. Just ask Bernie Madoff's clientele.

According to Lewis, the guys at AIG who bought Goldman's deals had no idea that they were so heavily exposed to subprime residential mortgages. I still find this part of Lewis's story too weird to be believable. Most of the deals disclosed investment schedules, like Appendix B for Adirondack 2 [3], which were pretty easy to eyeball.

But even smart people can be fooled by CDO terminology, which is Orwellian by design. Consider the super-senior tranches of high grade multi-sector CDOs [4] that AIG insured via credit default swaps. Where else in the English-speaking world does "multi-sector" translate into "singularly invested in risky real estate mortgages"? Where else are "super-senior" tranches exclusively invested in deeply subordinated claims? And how is it that "high grade" CDOs are differentiated their mezzanine counterparts by a 2% sliver of capitalization, a virtual rounding error?

Lewis also writes that these CDO deals were never seriously questioned by AIG's then-CEO, Martin Sullivan. In June 2008, Sullivan was fired and replaced by Bob Willumstad, an outsider who had first joined AIG's board in April 2006, after the AIG had decided to stop insuring subprime CDOs.

In September 2008, the one thing that AIG had going for it was a CEO who had no reason to defend the toxic CDO deals that closed in 2005 and 2006. Willumstad could look regulators and investors in the eye and agree with Lewis's assessment:

Goldman created a bunch of multi-billion dollar deals that transferred to AIG the responsibility for all future losses from $20 billion in triple-B-rated subprime mortgage bonds. It was incredible: In exchange for a few million bucks a year, this insurance company was taking the very real risk that the $20 billion would simply go poof.
So Paulson unilaterally replaced Willumstad, and installed a crony, Goldman director Ed Liddy, who would never challenge the dodgy CDOs. In On the Brink [5], Paulson's lobotomized financial history, he goes after Willumstad with a passive aggressive smear. He recounts a comment from a former Goldman partner, billionaire investor Chris Flowers, at a meeting to discuss financing options for Lehman, on Saturday, September 13, 2008:

As everyone got up to leave, Chris Flowers motioned me aside and said, "Hank, can I tell you what a mess it is over at AIG?" He produced a piece of paper that he said showed AIG's day-to-day liquidity...Flowers told me that according to AIG's own projections the company would run out of cash in ten days.
"Is there a deal to be done?" I asked.

"They are totally incompetent," Flowers said. "I would only put money in if management was replaced."

I knew AIG was having problems--its shares had been pummeled all week--but I didn't expect this. In addition to its vast insurance operations, the company had written credit default swaps to insure obligations backed by mortgages. The housing market crash hurt AIG badly, and it had posted losses for the past three quarters.

With his "I-didn't-expect-this" story, Paulson expects us to believe that he was surprised to learn the exact problems that were laid out by AIG to the Fed, which kept Treasury fully apprised at all times, 48 hours earlier. On September 11, 2008 [6], AIG approached the New York Fed, which simultaneously informed Treasury, to inform all concerned that AIG was running out of cash because it was facing a ratings downgrade that was caused by credit default swaps on subprime mortgages. On that very day in that very building, New York Fed employees were trying to determine if AIG's bankruptcy would have presented an unacceptable systemic risk.

"I have been blessed with a good memory, so I almost never needed to take notes," writes Paulson, who also testified [7], "I did not know -- I had no knowledge of the size of the [CDO] claim of any bank." That must mean that the topic never came up during the 24 different phone calls he had with Lloyd Blankfein during the week that AIG was bailed out. Apparently, the information was never conveyed by his personal proxy, Dan Jester [8], who "was calling many of the shots at the insurer between mid-September, when the New York Fed decided to go ahead with the bailout, and the end of October 2008, when Jester was replaced at A.I.G. by another Treasury official because, according to The New York Times, of Jester's 'stockholdings in Goldman Sachs.'"

Paulson's little hit-and-run smear against Willumstad was intended to distract us from the source of the mess and to conflate blame on to those tasked with the cleanup. On the Brink never recounts Paulson's personal role in role in destroying AIG, his decision to replace Willumstad with Liddy, or his own analysis dated March 13, 2008. In typical "Who me?" fashion, Paulson decries the problems with opaque CDOs, but never mentions Goldman's pivotal role in creating the disaster. Lewis writes:

Goldman Sachs had created a security so opaque and complex that it would remain forever misunderstood by investors and rating agencies: the synthetic subprime mortgage bond-backed CDO, or collateralized debt obligation...[I]t didn't require any sort of genius to see the fortune to be had from the laundering of triple-B-rated bonds into triple-A-rated bonds. What demanded genius was finding $20 billion in triple-B-rated bonds to launder...To create a billion-dollar CDO composed solely of triple-B-rated subprime mortgage bonds, you needed to lend $50 billion in cash to actual human beings. That took time and effort. A credit default swap took neither.
Those synthetic CDOs, including the notorious Abacus CDOs, were not sold by AIG to the New York Fed, which only financed securities holding "real" assets. They remain on AIG's balance sheet, shrouded in secrecy.

The CDO Market Remains A Bunch of Black Boxes

The bankers and hedge fund managers who made billions selling these toxic CDOs are still smirking. They made billions by shorting those subprime bonds and CDOs, but almost all of their handiwork remains hidden, concealed from public view. The Big Short [9], The Greatest Trade Ever [10] and The Quants [11] never give us specifics. The authors never identify the particular CDOs that Greg Lippman, John Paulson or Alec Litowitz bet against. Without the actual details on the trades, we must rely on the hearsay narratives of three journalists; we cannot examine the hard evidence to trace through to what they knew and when they knew it.

CDOs are not like regular mortgage bonds, which may be scrutinized via their initial prospectuses registered with the S.E.C. Bonds such as GSAMP Trust 2005-HE4 [12] are structured so that the mortgage pool is essentially fixed at closing. What you see is what you get. Actual bond performance is available, for a price, from ABSNet [13].

CDOs are different. Everything is concealed. Aside from a relative handful of cases, the public has no access to the initial prospectuses. Even if a CDO prospectus were retrievable through the Irish Stock Exchange, that CDO's investment portfolio is still likely to be kept secret. Unlike subprime mortgage bonds, these CDOs had no legitimate business purpose. They neither financed the mortgages, which had been financed through the bonds, nor did they add to liquidity in the marketplace, since the CDOs were non-tradable black box investments.

You'll never figure out a CDO by reading a rating agency analysis, which offers a few cryptic comments of substance buried amid the boilerplate.

In addition, the CDOs are set up so that the asset manager can do all sorts of bait-and-switch maneuvers, within broad credit-rating based parameters, after the deal closes. CDO performance cannot be tracked, because the performance data is only accessible to CDO investors.

Hundreds of billions of fatally flawed subprime CDOs were created, but, with a handful of exceptions, we still do not know who bought what under what circumstances.

That's why the investigation into AIG's CDO exposure is such an important opportunity. For the first time in February, we had a schedule where we could match up the CDOs with the relevant exposure amounts with the insured counterparties. It sure looks like Societe Generale "bought" CDOs for the sole purpose of acting as a front for Goldman, which created most of the CDOs that AIG insured on SG's behalf. When The New York Times [14] pointed out the suspicious circumstances of SG's CDO positions, Goldman spokesman [15] Lucas van Praag responded with a non sequitur denial:

NYT assertion: "In addition, according to two people with knowledge of the positions a portion of the $11 billion in taxpayer money that went to Societe Generale, a French bank that traded with A.I.G, was subsequently transferred to Goldman under a deal the two banks had struck."?
The facts: The assertion is false and misleading. Goldman Sachs provided financing to many counterparties, but in that role we would not have known whether a counterparty had obtained credit default protection, let alone from whom or in what amount.

Neither van Praag, nor the Goldman lawyers who reviewed his statement, are confused. They simply want to confuse us. The Times didn't allege that Goldman provided financing to SG; it alleged the opposite--that SG provided financing to Goldman. By acting as the middleman in two back-to-back transactions, SG bought the credit risk from Goldman and simultaneously sold the same risk, in the form of a credit default swap, to AIG. In other words, SG acted like the character in the Edward Jones commercial [16] who, after submitting the highest bid at an art auction, says, "I want to go ahead and sell it now."

The best way to start to get to the bottom of all this is to pass a law that requires all performance reports of all private label mortgage securitizations, past and present, be made public. Second, as I wrote previously [17], there should be a national registry for every ownership claim, including every derivative claim, on a mortgage securitization. We won't get anywhere until these transactions are fully exposed to sunlight.

So far, Neil Barofsky, the TARP Inspector General appointed by Paulson, has shown no curiosity in finding out what they knew and when they knew it. His report [18] on the backdoor bailout of the CDO banks ignores the subject completely. The selective pursuit of evidence is a big topic for another piece.

AIG American International Group CDO Chris Flowers Collateralized Debt Obligations Counterparties Credit Default Swaps Ed Liddy Goldman Sachs Guest Post Hank Paulson Housing Market John Paulson Lehman Lehman Brothers Lloyd Blankfein Lucas Van Praag Market Crash Martin Sullivan Meltdown Michael Lewis Neil Barofsky New York Fed New York Times Rating Agencies Rating Agency ratings Real estate Subprime Mortgages TARP Transparency
Source URL:
[1] End by Michael Lewis.pdf
[3] 2005-2 LTD_23.01.06_2782.pdf
[4] [5]
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The Memory Span of Goldfish

In the current bonus bashing frenzy it might be interesting to pause and look back at:

Article from:The Independent (London, England) Article date:November 29, 2001 Author:Chris Hughes Financial Editor

"THE FORECAST collapse in City bonuses which the Government used to justify raising public borrowing requirements in Tuesday's pre- Budget report is unlikely to be as severe as the Chancellor predicted, economists said yesterday.

Radical revisions to assumptions about tax revenues from the financial services industry, in the form of both corporation tax and income tax on employees' annual bonuses, were the principal driver behind Gordon Brown's warning that the Government was anticipating a sharp drop in tax revenue next year. The impact of lower City bonuses alone was estimated at as much as pounds 1bn, while the weakness in equity markets was expected to have a negative effect into 2003."

Or this from 2005

"Projections for tax collection this year are still based on a forecast for economic growth of 3 to 3.5 per cent. The boom in corporate profits means that despite the shortfall on growth, corporation tax will still come in higher than expected. Sky-high oil prices and another record bonus season in the City should help too."

Or this from 2008

"The Treasury also expects to generate less cash from City bonuses, anticipating that income tax receipts will increase at a slower rate than wage inflation in the coming year."
and concluding with
"The pain inflicted by the Chancellor consisted of £1.7bn in environmental taxes, mainly on cars, £600m from drinkers and £500m from closing tax loopholes. However, while these indirect taxes will increase this year, direct taxes such as income tax will fall for some families as a result of last Budget's measures."

Yes, that's right, if they don't get to tax the bonuses (because they aren't paid) then they have to make up the tax revenue off of you, me, etc.

And even the Daily Mail as recently as August of this year:

"The prospect of soaring profits and bonuses at the U.S. firm could present the government with a serious dilemma. Chancellor Alistair Darling has been talking tough on eradicating profligate pay and excessive risk taking in the Square Mile.
But with borrowing set to exceed the £175billion level predicted in the April budget, Darling can ill afford to alienate one his biggest and most reliable payers. The government has come to rely on huge windfall gains from banks and oil companies over recent years."

Quite the conundrum. Not that I think the way that world economics runs right now is fair or just or good, I don't. But it is the economy we have. Are the people who work in banking heros paying the taxes that fund the country or villains who are stealing our money? The answer, it appears, is

Oh, look a castle!
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... manage to un-retire an attorney.

Wire: BLOOMBERG News (BN) Date: 2009-04-29 04:00:01
Flawed Credit Ratings Reap Profits as Regulators Fail Investors

By David Evans and Caroline Salas
April 29 (Bloomberg) -- Ron Grassi says he thought he had
retired five years ago after a 35-year career as a trial lawyer.
Now Grassi, 68, has set up a war room in his Tahoe City,
California, home to single-handedly take on Standard & Poor’s,
Moody’s Investors Service and Fitch Ratings. He’s sued the three
credit rating firms for negligence, fraud and deceit.
Grassi says the companies’ faulty debt analyses have been
at the core of the global financial meltdown and the firms
should be held accountable. Exhibit One is his own investment.
He and his wife, Sally, held $40,000 in Lehman Brothers Holdings
Inc. bonds because all three credit raters gave them at least an
A rating -- meaning they were a safe investment -- right until
Sept. 15, the day Lehman filed for bankruptcy.
“They’re supposed to spot time bombs,” Grassi says. “The
bombs exploded before the credit companies acted.”
As the U.S. and other economic powers devise ways to
overhaul financial regulations, they have yet to come up with
plans to address one issue at the heart of the crisis: the role
of the rating firms.
That’s partly because the reach of the three big credit
raters extends into virtually every corner of the financial
system. Everyone from banks to the agencies that regulate them
is hooked on ratings.
Debt grades are baked into hundreds of rules, laws and
private contracts that affect banking, insurance, mutual funds
and pension funds. U.S. Securities and Exchange Commission
guidelines, for example, require money market fund managers to
rely on ratings in deciding what to buy with $3.9 trillion of
investors’ money.

‘Stop Our Reliance’

State regulators depend on credit grades to monitor the
safety of $450 billion of bonds held by U.S. insurance
companies. Even the plans crafted by Federal Reserve Chairman
Ben S. Bernanke and Treasury Secretary Timothy Geithner to
stimulate the economy count on rating firms to determine how the
money will be spent.
“The key to policy going forward has to be to stop our
reliance on these credit ratings,” says Frank Partnoy, a
professor at the San Diego School of Law and a former
derivatives trader who has written four books on modern finance,
including Infectious Greed: How Deceit and Risk Corrupted the
Financial Markets (Times Books, 2003).
“Even though few people respect the credit raters, most
continue to rely on them,” Partnoy says. “We’ve become
addicted to them like a drug, and we have to figure out a way to
wean regulators and investors off of them.”

AIG Downgrade

Just how critical a role ratings firms play in the health
and stability of the financial system became clear in the case
of American International Group Inc., the New York-based insurer
that’s now a ward of the U.S. government.
On Sept. 16, one day after the three credit rating firms
downgraded AIG’s double-A score by two to three grades, private
contract provisions that AIG had with banks around the world
based on credit rating changes forced the insurer to hand over
billions of dollars of collateral to its customers. The company
didn’t have the cash.
Trying to avert a global financial cataclysm, the Federal
Reserve rescued AIG with an $85 billion loan -- the first of
four U.S. bailouts of the insurer.
Investors, traders and regulators have been questioning
whether credit rating companies serve a good purpose ever since
Enron Corp. imploded in 2001. Until four days before the
Houston-based energy company filed for what was then the
largest-ever U.S. bankruptcy, its debt had investment-grade
stamps of approval from S&P, Moody’s and Fitch.
In the run-up to the current financial crisis, credit
companies evolved from evaluators of debt into consultants.

‘Abjectly Failed’

They helped banks create $3.2 trillion of subprime mortgage
securities. Typically, the firms awarded triple-A ratings to 75
percent of those debt packages.
“Ratings agencies just abjectly failed in serving the
interests of investors,” SEC Commissioner Kathleen Casey says.
S&P President Deven Sharma says he knows his firm is taking
heat from all sides -- and he expects to turn that around.
“Our company has always operated by the principle that if
you do the right thing by the customers and the market,
ultimately you’ll succeed,” Sharma says.
Moody’s Chief Executive Officer Raymond McDaniel and Fitch
CEO Stephen Joynt declined to comment for this story.
“We are firmly committed to meeting the highest standards
of integrity in our ratings practice,” McDaniel said in an
April 15 SEC hearing.
“We remain committed to the highest standards of integrity
and objectivity in all aspects of our work,” Joynt told the

Ratings and Rescue

Notwithstanding the role the credit companies played in
fomenting disaster, the U.S. government is relying on them to
help fix the system they had a hand in breaking.
The Federal Reserve’s Term Asset-Backed Securities Loan
Facility, or TALF, will finance the purchase by taxpayers of as
much as $1 trillion of new securities backed by consumer loans
or other asset-backed debt -- on the condition they have
triple-A ratings.
And the Fed has also been buying commercial paper directly
from companies since October, only if the debt has at least the
equivalent of an A-1 rating, the second highest for short-term
credit. The three rating companies graded Lehman debt A-1 the
day it filed for bankruptcy.
The Fed’s financial rescue is good for the bottom lines of
the three rating firms, Connecticut Attorney General Richard
Blumenthal says. They could enjoy as much as $400 million in
fees that come from taxpayer money, he says.
S&P, Moody’s and Fitch, all based in New York, got their
official blessing from the SEC in 1975, when the regulator named
them Nationally Recognized Statistical Ratings Organizations.

Conflict of Interest

Seven companies, along with the big three, now have SEC
licensing. The regulator created the NRSRO designation after
deciding to set capital requirements for broker-dealers. The SEC
relies on ratings from the NRSROs to evaluate the bond holdings
of those firms.
At the core of the rating system is an inherent conflict of
interest, says Lawrence White, the Arthur E. Imperatore
Professor of Economics at New York University in Manhattan.
Credit raters are paid by the companies whose debt they analyze,
so the ratings might reflect a bias, he says.
“So long as you are delegating these decisions to for-
profit companies, inevitably there are going to be conflicts,”
he says.
In a March 25 report, policy makers from the Group of 20
nations recommended that credit rating companies be supervised
to provide more transparency, improve rating quality and avoid
conflicts of interest. The G-20 didn’t offer specifics.

52 Percent Profit Margin

As lawmakers scratch their heads over how to come up with
an alternative approach, the rating firms continue to pull in
rich profits.
Moody’s, the only one of the three that stands alone as a
publicly traded company, has averaged pretax profit margins of
52 percent over the past five years. It reported revenue of
$1.76 billion -- earning a pretax margin of 41 percent -- even
during the economic collapse in 2008.
S&P, Moody’s and Fitch control 98 percent of the market for
debt ratings in the U.S., according to the SEC. The
noncompetitive market leads to high fees, says SEC Commissioner
Casey, 43, appointed by President George W. Bush in July 2006 to
a five-year term. S&P, a unit of McGraw-Hill Cos., has profit
margins similar to those at Moody’s, she says.
“They’ve benefited from the monopoly status that they’ve
achieved with a tremendous amount of assistance from
regulators,” Casey says.
Sharma, 53, says S&P has justifiably earned its income.

‘People See Value’

“Why does anybody pay $200, or whatever, for Air Jordan
shoes?” he asks, sitting in a company boardroom high over the
southern tip of Manhattan. “It’s the same. People see value in
that. And it all boils down to the value of what people see in
Blumenthal says he sees little value in credit ratings. He
says raters shouldn’t be getting money from federal financial
rescue efforts.
“It rewards the very incompetence of Standard & Poors,
Moody’s and Fitch that helped cause our current financial
crisis,” he says. “It enables those specific credit rating
agencies to profit from their own self-enriching malfeasance.”
Blumenthal has subpoenaed documents from the three
companies to determine if they improperly influenced the TALF
rules to snatch business from smaller rivals.
S&P and Fitch deny Blumenthal’s accusations.

‘Without Merit’

“The investigation by the Connecticut attorney general is
without merit,” S&P Vice President Chris Atkins says. “The
attorney general fails to recognize S&P’s strong track record
rating consumer asset-backed securities, the assets that will be
included in the TALF program. S&P’s fees for this work are
subject to fee caps.”
Fitch Managing Director David Weinfurter says the
government makes all the rules -- not the rating firms.
“Fitch Ratings views Blumenthal’s investigation into
credit ratings eligibility requirements under TALF and other
federal lending programs as an unfortunate development stemming
from incomplete or inaccurate information,” he says.
Moody’s Senior Vice President Anthony Mirenda declined to
Sharma says it’s clear that his firm’s housing market
assumptions were incorrect. S&P is making its methodology
clearer so investors can better decide whether they agree with
the ratings, he says.

‘Talk to Us’

“The thing to do is make it transparent, ‘Here are our
criteria. Here are our analytics. Here are our assumptions. Here
are the stress-test scenarios. And now, if you have any
questions, talk to us,’” Sharma says.
The rating companies reaped a bonanza in fees earlier this
decade as they worked with financial firms to manufacture
collateralized debt obligations. Those creations held a mix of
questionable debt, including subprime mortgages, auto loans and
junk-rated assets.
S&P, Moody’s and Fitch won as much as three times more in
fees for grading structured securities than they charged for
rating ordinary bonds. The CDO market started to crash in mid-
2007, as investors learned the securities were jammed with bad
Financial firms around the world have reported about
$1.3 trillion in writedowns and losses in the past two years.
Alex Pollock, now a resident fellow at the American
Enterprise Institute in Washington, says more competition among
credit raters would reduce fees.

‘An SEC-Created Cartel’

“The rating agencies are an SEC-created cartel,” he says.
“Usually, issuers need at least two ratings, so they don’t even
have to compete.”
Pollock was president of the Federal Home Loan Bank in
Chicago from 1991 to 2004. The bank was rated triple-A by both
Moody’s and S&P. He says he recalls an annual ritual as he
visited with representatives of each company.
“They’d say, ‘Here’s what it’s going to cost,’” he says.
“I’d say, ‘That’s outrageous.’ They’d repeat, ‘This is what
it’s going to cost.’ Finally, I’d say, ‘OK.’ With no ratings,
you can’t sell your debt.”
Congress has held hearings on credit raters routinely this
decade, first in 2002 after Enron and then again each year
through 2008. In 2006, Congress passed the Credit Rating Agency
Reform Act, which gave the SEC limited authority to regulate
raters’ business practices.
The SEC adopted rules under the law in December 2008
banning rating firms from grading debt structures they designed
themselves. The law forbids the SEC from ordering the firms to
change their analytical methods.

Role of Congress

Only Congress has the power to overhaul the rating system.
So far, nobody has introduced legislation that would do that. In
a hearing on April 15, the SEC heard suggestions for legislation
on credit raters. Some of the loudest proponents for change are
in state government and on Wall Street. But no one’s agreed on
how to do it.
“We should replace ratings agencies,” says Peter Fisher,
managing director and co-head of fixed income at New York-based
BlackRock Inc., the largest publicly traded U.S. asset
management company.

‘Flash Forward’

“Our credit rating system is anachronistic,” he says.
“Eighty years ago, equities were thought to be complicated and
bonds were thought to be simple, so it appeared to make sense to
have a few rating agencies set up to tell us all what bonds to
buy. But flash forward to the slicing and dicing of credit
today, and it’s really a pretty wacky concept.”
To create competition, the U.S. should license individuals,
not companies, as credit rating professionals, Fisher says. They
should be more like equity analysts and would be primarily paid
by institutional investors, Fisher says. Neither equity analysts
nor those who work at rating companies currently need to be
Such a system wouldn’t be fair, says Daniel Fuss, vice
chairman of Boston-based Loomis Sayles & Co., which manages $106
billion. An investor-pay ratings model may give the biggest
money managers a huge advantage over smaller firms and
individuals because they can afford to pay for the analyses, he
“What about individuals?” he asks.
Eric Dinallo, New York’s top insurance regulator, proposes
a government takeover of the rating business.
“There’s nothing wrong with saying Moody’s or someone is
going to just become a government agency,” he says. “We’ve
hung the entire global economy on ratings.”

‘Like Consumer Reports’

Insurance companies are among the world’s largest bond
investors. Dinallo suggests that insurers could fund a credit
rating collective run by the National Association of Insurance
Commissioners, a group of state regulators.
“It would be like the Consumer Reports of credit
ratings,” Dinallo says, referring to the not-for-profit
magazine that provides unbiased reviews of consumer products.
Turning over the credit ratings to a consortium headed by
state governments could lead to lower quality because there
would be even less competition, Fuss says.
“I would be strongly opposed to the government taking over
the function of credit ratings,” he says. “I just don’t think
it would work at all. The business creativity, the drive, would
go straight out of it.”
At the April 15 SEC hearing, Joseph Grundfest, a professor
at Stanford Law School in Stanford, California, suggested a
variation of Dinallo’s idea. He said the SEC could authorize a
new kind of rating company, owned and run by the largest debt

‘Greater Discipline’

All bond issuers that pay for a traditional rating would
also have to buy a credit analysis from one of these firms.
SEC Commissioner Casey has another solution. She wants to
remove rating requirements from federal guidelines. She also
faults investors for shirking their responsibility to do
independent research, rather than simply looking to the grades
produced by credit raters.
“I’d like to promote greater competition in the market and
greater discipline,” she says. “Eliminating the references to
ratings will play a huge role in removing the undue reliance
that we’ve seen.”
Sharma, who became president of S&P in August 2007, agrees
with Casey that ratings are too enmeshed in SEC rules. He wants
the SEC to either get rid of references to rating companies in
regulations or add other benchmarks such as current market
prices, volatility and liquidity.
“Just don’t leave us the way it is today,” Sharma says.
“There’s too much risk of being overused and inappropriately

‘Hurt Now’

Sharma says that even with widespread regulatory reliance
on ratings, his firm will lose business if investors say it
doesn’t produce accurate ones.
“Our reputation is hurt now,” he says. “Let’s say it
continues to be hurt; it never comes back. Three other
competitors come back who do much-better-quality work. Investors
will finally say, ‘I don’t want S&P ratings.’”
S&P will prove to the public that it can help companies and
bondholders by updating and clarifying its rating methodology,
Sharma says. The company will also add commentary on the
liquidity and volatility of securities.

S&P’s New Steps

S&P has incorporated so-called credit stability into its
ratings to address the risk that ratings will fall several
levels under stress conditions, which is what happened to CDO
grades. The company has also created an ombudsman office in an
effort to resolve potential conflicts of interest.
Jerome Fons, who worked at Moody’s for 17 years and was
managing director for credit policy until August 2007, says
investors don’t have to wait for a change in the rating system.
They can learn more about the value of debt by tracking the
prices of credit-default swaps, he says.
The swaps, which are derivatives, are an unregulated type
of insurance in which one side bets that a company will default
and the other side, or counterparty, gambles that the firm won’t
fail. The higher the price of that protection, the greater the
perceived risk of default.

‘More Accurate’

“We know the spreads are more accurate than ratings,”
says Fons, now principal of Fons Risk Solutions, a credit risk
consulting firm in New York. Moody’s sells a service called
Moody’s Implied Ratings, which is based on prices of credit
swaps, debt and stock.
In July 2007, credit-default-swap traders started pricing
Bear Stearns Cos. and Lehman as if they were Ba1 rated, the
highest junk level. They pegged Merrill Lynch & Co. as a Ba1
credit three months later, according to the Moody’s model.
Each of those investment banks was stamped at investment
grade by the top three credit raters within weeks of when the
banks either failed or were rescued in 2008.
Lynn Tilton, who manages $6 billion as CEO of private
equity firm Patriarch Partners in New York, says she woke up one
morning in August 2007 convinced the banking system would
collapse and started buying gold coins.
“I predicted the banks would be insolvent,” Tilton says.
“My biggest issue was credit-default swaps. When the size of
that market started to dwarf gross domestic product by six or
seven times, then my understanding of what defaults would be in
a down market became clear: There’s no escaping.”

‘Collective Wisdom’

Investors like Tilton watched as the financial firms
tumbled while credit raters held on to investment-grade marks.
“If the ratings mandate weren’t there, we wouldn’t care
because the credit-default-swap markets can tell us basically
what we want to know about default probabilities,” NYU’s White
says. “I’m a market-oriented guy, so I’m more inclined to be
relying on the collective wisdom of the market participants.”
While credit-default-swap traders lack inside information
that companies give to credit raters, swap traders move faster
because they’re reacting to market changes every day.
San Diego School of Law’s Partnoy, who’s written law review
articles about credit rating firms for more than a decade and
has been a paid consultant to plaintiffs suing rating companies,
says raters hold back from downgrading because they know the
consequences can be dire.
In September, Moody’s and S&P downgraded AIG to A2 and A-,
the sixth- and seventh-highest investment-grade ratings. The
downgrades triggered CDS payouts and led to the U.S. lending AIG
$85 billion. The government has since more than doubled AIG’s
rescue funds.

‘Basically Trapped’

“When you get into a situation like we’re in right now
with AIG, the rating agencies are basically trapped into
maintaining high ratings because they know if they downgrade,
they don’t only have this regulatory effect but they have all
these effects,” Partnoy says.
“It’s all this stuff that basically turns the rating
downgrade into a bullet fired at the heart of a bunch of
institutions,” he says.
Sharma says S&P has never delayed a ratings change because
of potential downgrade results. He says his firm tells clients
not to use ratings as triggers in private contracts.
“We take action based on what we feel is right,” Sharma
While swap prices may be better than bond ratings at
predicting a disaster, swaps can also cause a disaster.
AIG, one of the world’s biggest sellers of CDS protection,
nearly collapsed -- taking the global financial system with it
-- when it didn’t have enough cash to honor its swaps contracts.
Loomis’s Fuss says relying on swap prices is a bad idea.

‘Not Always Right’

“The market is not always right,” he says. “An
unregulated market isn’t always a fair appraisal of value.”
Moody’s was the first credit rating firm in the U.S. It
started grading railroad bonds in 1909. Standard Statistics, a
precursor of S&P, began rating securities seven years later.
After the 1929 stock market crash, the government decided
it wasn’t able to determine the quality of the assets held by
banks on its own, Partnoy says. In 1931, the U.S. Treasury
started using bond ratings to analyze banks’ holdings.
James O’Connor, then comptroller of the currency, issued a
regulation in 1936 restricting banks to buying only securities
that were deemed high quality by at least two credit raters.
“One of the major responses was to try to find a way --
just as we are now with the stress tests and the examination of
the banks -- to figure out how to get the bad assets off the
banks’ books,” Partnoy says.
Since then, regulators have increasingly leaned on ratings
to police debt investing. In 1991, the SEC ruled that money
market mutual fund managers must put 95 percent of their
investments into highly rated commercial paper.

Avoiding Liability

Like auditors, lawyers and investment bankers, rating firms
serve as gatekeepers to the financial markets. They provide
assurances to bond investors. Unlike the others, ratings
companies have generally avoided liability for errors.
Grassi, the retired California lawyer, wants to change
that. He filed his lawsuit against the rating companies on Jan.
26 in state superior court in Placer County.
The white-haired lawyer discusses his case seated at a tiny
wooden desk in his small guest bedroom, with files spread over
both levels of a bunk bed. Grassi says in his complaint that the
raters were negligent for failing to downgrade Lehman Brothers
debt as the bank’s finances were deteriorating.
The day Lehman filed for bankruptcy, S&P rated the
investment bank’s debt as A, which according to S&P’s definition
means a “strong” capacity to meet financial commitments.
Moody’s rated Lehman A2 that day, which Moody’s defines as a
“low credit risk.” Fitch gave Lehman a grade of A+, which it
describes as “high credit quality.”

‘Without Merit’

“We’d like to have a jury hear this,” Grassi says. “This
wouldn’t be six economists, just six normal people. That would
scare the rating agencies to death.”
The rating companies haven’t yet filed responses. They’ve
asked the federal court in Sacramento to take jurisdiction from
the state court.
S&P and Fitch say they dispute Grassi’s allegations. “We
believe the complaint is without merit and intend to defend
against it vigorously,” S&P’s Atkins says.
Fitch’s Weinfurter says, “The lawsuit is fully without
merit and we will vigorously defend it.”
Mirenda at Moody’s declined to comment.
S&P included a standard disclaimer with Lehman’s ratings:
“Any user of the information contained herein should not rely
on any credit rating or other opinion contained herein in making
any investment decision.”

‘On Your Own’

Grassi isn’t deterred.
“They’re saying we know you’re going to rely on us and if
you get screwed, you’re on your own because our lawyers have
told us to put this paragraph in here,” he says.
The companies have defended their ratings from lawsuits,
arguing that they were just opinions, protected by the free
speech guarantees of the First Amendment to the U.S.
McGraw-Hill used the First Amendment defense in 1996 after
its subsidiary S&P was sued for professional negligence by
Orange County, California. S&P had given the county an AA-
rating before the county filed for the largest-ever municipal
Orange County alleged in its lawsuit that S&P had failed to
warn the government that its treasurer, Robert Citron, had made
risky investments with county cash.

Not Liable

The U.S. District Court in Santa Ana, California, ruled
that the county would have needed to prove the rating company’s
“knowledge of falsity or reckless disregard for the truth” to
win damages.
The court found that the credit rater couldn’t be held
liable for mere negligence, agreeing with S&P that it was
shielded by the First Amendment.
Sharma says rating companies shouldn’t be responsible when
investors misuse ratings.
“Hold us accountable for what you can,” he says. He
compares the rating companies to carmakers. “Look, if you drove
the car wrong, the manufacturer can’t be held negligent. But if
you designed the car wrong, then of course the manufacturer
should be held negligent.”
The bigger issue is whether the credit rating system should
be changed or even abolished. From California to New York to
Washington, investors and regulators are saying it doesn’t work.
No one has been able to fix it.

‘Like a Cancer’

The federal government created the rating cartel, and the
U.S. is as dependent on it as everyone else. So far, the
legislative branch hasn’t cleaned up the ratings mess.
“This problem really is like a cancer that has spread
throughout the entire investment system,” Partnoy says.
“You’ve got a body filled with little tumors, and you’ve got to
go through and find them and cut them out.”
As the U.S. has spent, lent or pledged about $12.8 trillion
in efforts to revive the slumping economy, and as President
Barack Obama and Congress have worked overtime to find a way out
of the deepest recession in 70 years, no one has taken steps
that would substantially fix a broken ratings system.
If the government doesn’t head in that direction, all of
its efforts at financial reform may be put in jeopardy by the
one piece of this puzzle that nobody has yet figured out how
to solve.

--With assistance from Shannon D. Harrington in New York.
Editor: Jonathan Neumann, Gail Roche

To contact the reporters on this story:
David Evans in Los Angeles at +1-323-782-4241 or
Caroline Salas in New York at +1-212-617-2314 or

Copyright (c) 2009, Bloomberg, L. P.
jespirals: (Default)
You'll notice that the first quarter earnings look much better than expected.

For an explanation read the preceding post.


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