The risk analysis failure at the rating agencies

NY Times:

“These errors make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both.”

— A Moody’s managing director responding anonymously to an internal management survey, September 2007.

The housing mania was in full swing in 2005 when analysts at Moody’s Investors Service, the nation’s oldest and most prestigious credit-rating agency, were pressured to go back to the drawing board.

Moody’s, which judges the quality of debt that corporations and banks issue to raise money, had just graded a pool of securities underwritten by Countrywide Financial, the nation’s largest mortgage lender. But Countrywide complained that the assessment was too tough.

The next day, Moody’s changed its rating, even though no new and significant information had come to light, according to two people briefed on the change who requested anonymity to preserve their professional relationships.

Moody’s had assigned high grades to many securities containing Countrywide mortgages. Those securities and mortgages, issued during the lending spree of recent years, later soured — leaving investors with large losses and homeowners and communities struggling with foreclosures.

That was not the only time Moody’s softened its stance on Countrywide securities. It elevated ratings several times after Countrywide complained, the people briefed on the matter say.

Since the subprime mortgage troubles exploded into a full-blown financial crisis last year, the three top credit-rating agencies — Moody’s, Standard & Poor’s and Fitch Ratings — have faced a firestorm of criticism about whether their rosy ratings of mortgage securities generated billions of dollars in losses to investors who relied on them.

The agencies are supposed to help investors evaluate the risk of what they are buying. But some former employees and many investors say the agencies, which were paid far more to rate complicated mortgage-related securities than to assess more traditional debt, either underestimated the risk of mortgage debt or simply overlooked its danger so they could rake in large profits during the housing boom.

A Moody’s spokesman, Anthony Mirenda, said the company would not change ratings without substantive reasons. “As a matter of policy, Moody’s is obligated to reconvene a rating committee if there is new information put forth by an issuer that could have a material impact on a security’s creditworthiness,” he said, “and our policies prohibit changes to ratings for anything other than credit considerations.”

He added that “Moody’s knows of no instances in which a reconvened rating committee resulted in improper changes to ratings on Countrywide securities.”

Bank of America, which took over Countrywide earlier this year, said it could not verify details of prior management’s interactions with Moody’s.

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That the credit-rating agencies missed immense problems in the mortgage-related securities they blessed is undeniable. Moody’s declined to say how many classes of the securities it has downgraded. But the number is in the thousands and the original value in the hundreds of billions of dollars.

When Moody’s began lowering the ratings of a wave of debt in July 2007, many investors were incredulous.

“If you can’t figure out the loss ahead of the fact, what’s the use of using your ratings?” asked an executive with Fortis Investments, a money management firm, in a July 2007 e-mail message to Moody’s. “You have legitimized these things, leading people into dangerous risk.”

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There is more.

Rating agencies perform a valuable service beyond the obvious. Not only do they help investors make a judgment about investments, when they are working well, they help issuers understand the risks of their business and how to manage those risks, by asking probing questions.

What happened with the mortgage backed securities was a failure of assumptions that led to a massive failure in risk analysis. The failure of risk analysis went well beyond the rating agencies. The issuers and the investment bankers and their lawyers and accountants also missed it, not to mention government agencies.

Most of the missed risks involved the downside of highly leveraged transactions. Leverage adds momentum to the movement of the market and when it turns down it is like adding negative G forces which make it hard to recover before a crash.

I think the rating agencies screwed up just like the other participants in the market, but I don't think they bet their reputation just to get the fees. If they and the investment bankers had understood the risks, I don't think these deals would have been done. Obviously these people could not be successful if they were totally risk adverse, but rational people rarely risk the company on an investment that can go below zero.

Still, these companies are going to have a difficult time rebuilding the trust of investors who lost billions by relying on their faulty judgment of risks.