This morning, reports the Wall Street Journal, credit ratings agency Standard & Poor’s sharply downgraded its rating for bond insurer Ambac Financial, anticipating that the company’s debt obligations would continue to absorb losses.
Why should we care?
Because this seemingly mundane piece of financial news offers a window into one of the crucial — and often under-covered — causes of the financial crisis currently shaking Washington and the country: the role of the credit ratings agencies. And inside that wider crisis, as we’ll be making clear in the coming weeks, there’s perhaps as much muck, both personal and institutional, as anything the Bush administration has given us over the last eight years.
First, a very quick and dirty rundown of the issue:
The banks and insurers felled by the collapse of the housing market relied on the three major credit ratings agencies — S&P, Moody’s, and Fitch — to rate the mortgage-backed securities that they offered to investors. But here’s the problem: the ratings agencies are paid for their work by the very banks and insurers for whom they’re producing ratings. If the banks don’t like the rating they receive from one ratings agency, they can simply go to another agency that’s willing to produce a more favorable score — what’s known as “ratings shopping.”
As a result, the agencies have an obvious incentive to knowingly inflate their ratings — and sometimes even to rate junk securities that shouldn’t even get a rating at all. And since many of these securities turned out to be all but worthless pools of home-loan mortgages, that’s exactly what the ratings agencies often did.
Internal agency documents released last month as part of an investigation by Rep. Henry Waxman’s House Oversight and Government Reform Committee show that at least some ratings analysts were aware that their ratings were more about increasing their company’s bottom line than accurately gauging the value of the securities at issue.
Here’s one IM exchange from April 2007, between two S&P analysts, reported last month by the Wall Street Journal –:
Rahul Dilip Shah: btw — that deal is ridiculous.
Shannon Mooney: I know right … model def does not capture half of the risk
Shah: we should not be rating it.
Mooney: it could be structured by cows and we would rate it.
And in a 2007 presentation to directors, Moody’s CEO Raymond McDaniel wrote:
Analysts and MDs [managing directors] are continually ‘pitched’ by bankers, issuers, investors — all with reasonable arguments — whose views can color credit judgment, sometimes improving it, other times degrading it (we ‘drink the kool-aid’). Coupled with strong internal emphasis on market share & margin focus, this does constitute a ‘risk’ to ratings quality.
At a hearing he held on the issue, Waxman himself quoted another S&P analyst asserting:
Rating agencies continue to create an ever-bigger monster, the CDO market. Let’s hope we are all wealthy and retired by the time this house of cards falters.
The ratings agencies are now being forced by events to at last downgrade some of these securities — hence today’s news about S&P’s belated move to downgrade Ambac, which sent the company’s stock plummeting.
Indeed, this same dynamic preceded the collapse of insurance giant AIG in September. Until the 15th of that month, S&P had rated its unsecured debt at AA minus, far above what it merited given the value of the underlying mortgages — leading investors to see AIG as a secure bet. When, on that day, S&P suddenly and severely cut their rating to bring it into line with reality, the company was required to post $14 billion to comply with the terms of the credit default swap agreements they had entered into. That was $14 billion AIG didn’t have, and all of a sudden, U.S. taxpayers were on the hook.
It doesn’t have to be this way. Sean Egan is a founder of Egan-Jones, an independent ratings agency that’s paid not by insurers, but by investors. In testimony before Waxman’s committee, and again in an interview with TPMmuckraker, Egan emphasized that — despite the apparent personal corruption of individual analysts and senior management at the agencies — the only way to fix the problem is for the federal government to take steps to re-align the system of incentives that prevails on the agencies. If they’re rewarded for giving investors an accurate picture of the value of securities, they’ll be likely to do so. If not, they’ll keep pumping up their ratings to please the banks. And soon enough, a new house of cards will rise and fall.