Thursday, April 29, 2010

Role of Credit Rating Agencies on the Financial Crisis

Original posted on Alston & Bird LLC's website by Melinda Calisti:

On April 23, the U.S. Senate Permanent Subcommittee on Investigations (PSI) held a hearing entitled “Wall Street and the Financial Crisis: The Role of Credit Rating Agencies.” The hearing is the third in a series of PSI hearings examining some of the causes and consequences of the recent financial crisis. On April 14, the PSI held a hearing which focused on the role of high risk mortgages in the failure of Washington Mutual Bank (WaMu). On April 16, the PSI’s hearing focused on the role of bank regulators in the failure

of WaMu. Testifying before the PSI were the following witnesses:

Panel 1

  • Frank Raiter, former Managing Director, Mortgage-Backed Securities, Standard & Poor’s
  • Richard Michalek, former Vice President and Senior Credit Officer, Structured Derivative Products Group, Moody’s Investors Service
  • Eric Kolchinsky, former Team Managing Director, Structured Derivative Products Group, Moody’s Investors Service
  • Arturo Cifuentes, former Senior Vice-President, Moody’s Investors Service and current Director, Finance Center, University of Chile

Panel 2

  • Susan Barnes, Managing Director, Mortgage-Backed Securities, and former North American Practice Leader, Residential Mortgage-Backed Securities, Standard & Poor’s
  • Yuri Yoshizawa, Group Managing Director, Structured Finance, Moody’s Investors Service
  • Peter D’erchia, Managing Director, U.S. Public Finance and former Global Practice Leader, Surveillance, Standard & Poor’s

Panel 3

In his introductory statement, Chairman Carl Levin (D-MI) presented the role that the credit agencies played in the financial crisis by stating “had credit-rating agencies been more careful in issuing rating or downgraded rating in a more responsible manner, we maybe would have averted the crisis.” According to Chairman Levin, investors’ “trust has been broken” because of the role the largest credit agencies “fueled the financial crisis.”

Chairman Levin’s conclusions were the result of an 18-month investigation, including review of millions of pages of documents, certain of which were released by the PSI, and more than 100 interviews and depositions. The investigation found that 91% of the AAA-rated, residential mortgage-backed securities issued in 2007 and 93% issued in 2006 have now been downgraded to junk status. Thus, in July 2007 when Moody’s and S&P announced mass downgrades of hundreds of subprime mortgage-backed securities, “those downgrades shocked the markets and banks, pension funds and others were held holding billions of dollars of unmarketable securities.” According to Chairman Levin, had the credit agencies taken more care in issuing rating or revised ratings more swiftly, the impact of those toxic mortgages on the financial markets would have been greatly reduced. However, the credit agencies felt pressure to provide favorable credit ratings for complex securities, amid concerns about competition and the lack of data about the mortgage securities the analysts were rating. “Credit-rating agencies allowed Wall Street to impact their analysis, their independent and their reputation for reliability,” said Chairman Levin.

In the first panel, Mr. Raiter, who was attending the hearing under subpoena, noted several factors that resulted in the major rating agencies to fail to adequately assess the risks associated with new mortgage products, including: (1) the lack of oversight of the rating agencies by the SEC and other regulatory bodies, (2) the “disconnect” between senior managers and the analytical managers responsible for assigning ratings, and (3) the separation of the initial ratings process from the subsequent surveillance of performance of the rated bonds. According to Raiter, the “disconnect” between senior manager and analytical managers helped to award high ratings to risky investments because management pressured analysts to earn fees by attracting business from banks. In addition, according to Mr. Raiter, the preferred status granted to the credit rating agencies meant that there was no regulatory overnight nor established standards to measure the quality or performance of the ratings.

According to Mr. Kolchinsky, “the cause of the financial crisis lies primarily with the misaligned incentives in the financial system. Individuals across the financial food chain, from the mortgage broker to the CDO banker were compensated based on quantity rather than quality [and] the situation was no different at the rating agencies.” Mr. Michalek stated that the independence of Moody’s Structured Derivative Products Group changed dramatically during his tenure and acknowledged that the competition amongst credit agencies meant there was constant pressure to accept deals. According to Mr. Michalek, “the unwillingness to say ‘no’ grew. The message from management was not, ‘just say no,’ but instead, ‘just say yes’.” Agreeing with the PSI’s conclusion that the credit agencies were using inaccurate rating models that were affected by competitive pressure, Mr. Cifuentes noted that a core problem was that credit rating agencies determined the basis for the ratings. He emphasized that the “raters can change what BBB means. [The basis for the ratings] is screwed up at a very fundamental level.”

Panelists who are current executives at the rating agencies were generally more reluctant to acknowledge the effects of competitive pressures and stressed the rating agencies’ efforts to improve ratings quality. Despite skepticism expressed by Sen. Edward Kaufman (D-DE), Ms. Yoshizawa claimed that she “personally [did not] feel undue pressure from the top to increase business.” Ms. Barnes claimed to have no knowledge of incentives being tied directly to the number of deals rated. Mr. McDaniel said he was unaware of terminations related to market share issues. In addition, although Mr. McDaniel testified that Moody’s was not satisfied with the performance of their ratings, he asserted that “neither [Moody’s] nor most other market participants, observers, or regulators fully anticipated the severity or speed of deterioration in the financial markets.” In addition, the current executives argued that their firms took actions they assumed appropriate at the time, such as Mr. D’Erchia who stated that S&P has “always been committed to doing the best we can to develop and maintain appropriate ratings.

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