Senator Levin's Forensic Exam of Credit Rating Agencies

By John Ballard

I watched enough of this Senate hearing on C-SPAN to make me feel better about financial regulatory reform. Under the steady leadership of Senator Carl Levin this six-hour event, probably missed by most Americans, is the legislative equivalent of a medical examiner's postmortem following a mass casualty event. The chairman had before him five of the movers and shakers of the credit rating agencies which gave their triple-A blessings to what proved to be junk-grade "investments" which led to the financial crisis of 2008.

Witnesses testified on the role of credit rating agencies in the financial crisis, using as case histories the credit rating agencies of Standard & Poor's and Moody's. This hearing was the third of a series of hearings the subcommittee held on Wall Street and the 2008 financial crisis. Panel Two Susan Barnes, current 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, current managing director for U.S. public finance, and former global practice leader for surveillance, Standard & Poor's Panel Raymond W. McDaniel Jr., chairman and CEO, Moody's Corp. Kathleen A. Corbet, former president, Standard & Poor's.

Check out this little snip that may add a new acronym to your vocabulary: IBGYBG.

Hint: it's kinda like KYA but different...

I wish I had time to watch the whole six hours but it's a luxury I cannot afford. Congressional hearings are like Wagnerian opera, moments of ecstasy (like the one captured above) separated by tedious stretches of monotony. I love Senator Levin's deadpan silence following the punch line.

But I saw enough to have the impression that our guys in the Senate are doing their jobs with workmanlike proficiency. No matter how they may act before the press, even Republicans cannot escape the fact that what happened in 2008 was a preventable financial catastrophe brought on by the garden-variety greed of vast numbers of adult professionals who at some level knew better, enabled by others whom they could blame, and overlooked by regulators asleep at the switch. The evidence is overwhelming, and thanks to the work of this committee, part of history.

Senator Levin's opening statement laid the groundwork in airtight prose, and what unfolded was more documentation than even the most dedicated critic could assail. The following clip from Senator Levin's opening statement seems long, but it is but a small part of the larger whole. I'm posting it here, not for detail study, but to illustrate the degree to which the investigation has gone to comb through the wreckage of the financial crisis of 2008 and discover what brought it about.

Residential mortgage backed securities, or RMBS, are one of the oldest types of structured finance. To create these securities, issuers bundle up large numbers of home mortgages into a pool, figure out the total revenue coming into the pool from all the mortgages, and then design a �waterfall� that assigns portions of the total incoming revenue to what are called �tranches.� Tranches are not collections of mortgages, they are simply recipients of income from the waterfall of mortgage payments coming into the pool.

Each tranche is used to issue a mortgaged backed security that receives a credit rating and is then sold to investors. The tranches that are first in line to receive revenues represent the safest investments in the pool, and are designed to get AAA ratings. Tranches lower down the line get their revenues only after the more senior tranches are paid, and their securities get lower credit ratings.

Wall Street didn�t stop there. They collected securities from RMBS transactions, put those into a pool, and resecuritized them into what are called collateralized debt obligations or CDOs. A CDO might contain, for example, BBB rated securities from 100 different residential mortgage pools. CDOs often also contain other types of assets, such as corporate bonds or credit default swaps. Wall Street firms also created so-called �synthetic CDOs� which did not contain actual assets, but simply referenced them. Like RMBS mortgage pools, CDOS were sliced and diced into tranches, and the resulting tranches used to create securities. The securities were rated � some AAA � and then sold to investors.

In exchange for large fees, Wall Street firms helped design the RMBS and CDO securities, worked with the credit rating agencies to obtain favorable ratings, and then sold the securities. Without credit ratings, Wall Street would have had a much harder time selling these products, because each investor would have had to rely on themselves to figure them out. Credit ratings helped make the sales possible by labeling certain investments as safe, using their trademark AAA ratings.

Wall Street firms also used financial engineering to combine AAA ratings � normally reserved for ultra-safe investments � with riskier securities, such as RMBS securities backed by high risk mortgages. Because the underlying mortgages were high risk, those RMBS paid out a higher return than safer loans. When those higher-paying securities also got AAA ratings, investors snapped them up. For awhile, everyone made money -- banks and mortgage brokers got rich selling high risk loans, Wall Street investment banks earned big fees creating and selling mortgage based securities, and investors profited from the higher returns.

But those AAA ratings created a false sense of security. High risk RMBS and CDOs turned out not to be safe investments. We heard in our first hearing how many of the high risk mortgages backing those securities were riddled with poor quality loans, contained fraudulent borrower information, or depended upon borrowers being able to refinance their loans before higher loan payments kicked in. When housing prices stopped climbing, and many borrowers could no longer refinance their loans, delinquency rates skyrocketed. RMBS and CDO securities rated as investment grade began incurring losses and were sharply downgraded.

Take, for example, a CDO known as Vertical ABS CDO 2007-1. In early 2007, UBS, which is a major bank, asked S&P and Moody�s to rate this CDO. The UBS banker, however, failed to cooperate with the analysts. One S&P analyst wrote in an email to colleagues: �Don�t see why we have to tolerate lack of cooperation. Deals likely not to perform.� That�s Exhibit 94b.

Despite the analyst�s judgment that the CDO was unlikely to perform, S&P rated it. So did Moody�s. In April 2007, both agencies gave AAA ratings to the CDO�s top 4 tranches. Six months later, both agencies downgraded the CDO which later collapsed. One of the purchasers, a hedge fund called Pursuit Partners, sued over the CDO�s quick demise. S&P and Moody�s were dropped from the lawsuit since current law does not authorize private lawsuits against them even for reckless or unreasonable ratings, but the court ordered UBS to set aside $35 million for a possible award to the investor. The legal pleadings included internal emails at UBS referring to the supposedly investment-grade Vertical securities as �crap� at the same time the bank was selling them.

Take another example. In January 2007, S&P was asked to rate an RMBS being assembled by Goldman Sachs using subprime loans from Fremont Investment and Loan, a subprime lender known for loans with high rates of delinquency. On January 24, 2007, an analyst wrote seeking advice from two senior analysts: �I have a Goldman deal with subprime Fremont collateral. Since Fremont collateral has been performing not so good, is there anything special I should be aware of?� One analyst responded: �No, we don't treat their collateral any differently.� The other asked: �are the FICO scores current?� �Yup,� came the reply. Then �You are good to go.� In other words, the analyst didn�t have to factor in any greater credit risk for an issuer known for poor quality loans, even though three weeks earlier S&P analysts had circulated an article about how Fremont had severed ties with 8,000 brokers due to loans with some of the highest delinquency rates in the industry. In the spring of 2007, Moody�s and S&P provided AAA ratings for 5 tranches of RMBS securities backed by Fremont mortgages. By October, both companies began downgrading the CDO. Today all five AAA tranches have been downgraded to junk status.

These are just two examples of securities given AAA ratings that turned out not to be worth the paper they were written on. There are many more.

I can recall reading in the fall of 2008 that brokers were avidly selling what they referred to as "neutron loans." Even if the borrower defaulted on a mortgage the underlying real estate securing the loan would still be there. That was back when some in Washington were blaming the whole mess on too many bad loans to poor people as the result of the Community Reinvestment Act. Seems like there turned out to bea lot more involved than that little population, no?

At one point Senator Levin made reference to "Monday's debate," quietly underscoring Harry Reid's announcement that Republican obstructionism will come to an end at that time. I almost hope they stage a filibuster against debating financial reform but this is an issue that is too big to ignore and at last the Democrats seem to know it.