Here’s the second of the Bloomberg series, `Failing Grades on Wall Street: Part 2 of 2.’
Race to Bottom’ at Moody’s, S&P Secured Subprime’s Boom, Bust
By Elliot Blair Smith
Excerpt: "Moody’s Corp. unveiled a new credit-rating model that Wall Street banks used to sow the seeds of their own demise. The formula allowed securities firms to sell more top-rated, subprime mortgage-backed bonds than ever before. 
A week later, Standard & Poor’s moved to revise its own methods. An S&P executive urged colleagues to adjust rating requirements for securities backed by commercial properties because of the “threat of losing deals.”
The world’s two largest bond-analysis providers repeatedly eased their standards as they pursued profits from structured investment pools sold by their clients, according to company documents, e-mails and interviews with more than 50 Wall Street professionals. It amounted to a “market-share war where criteria were relaxed,” says former S&P Managing Director Richard Gugliada.
“I knew it was wrong at the time,” says Gugliada, 46, who retired from the McGraw-Hill Cos. subsidiary in 2006 and was interviewed in May near his home in Staten Island, New York. “It was either that or skip the business. That wasn’t my mandate. My mandate was to find a way. Find the way.”
Wall Street underwrote $3.2 trillion of loans to homebuyers with bad credit and undocumented incomes from 2002 to 2007. Investment banks packaged much of that debt into investment pools that won AAA ratings, the gold standard, from New York-based Moody’s and S&P. Flawed grades on securities that later turned to junk now lie at the root of the worst financial crisis since the Great Depression, says economist Joseph Stiglitz.
`Would Have Stopped Flow’
“Without these AAA ratings, that would have stopped the flow of money,” says Stiglitz, 65, a professor at Columbia University in New York who won the Nobel Prize in 2001 for his analysis of markets with asymmetric information. S&P and Moody’s “were trying to please clients,” he said. “You not only grade a company but tell it how to get the grade it wants.”
Presidential candidates John McCain and Barack Obama lay responsibility for the carnage with Wall Street itself. The Securities and Exchange Commission in July identified S&P and Moody’s as accessories, finding they violated internal procedures and improperly managed the conflicts of interest inherent in providing credit ratings to the banks that paid them.
S&P and Moody’s earned as much as three times more for grading the most complex of these products, such as the unregulated investment pools known as collateralized debt obligations, as they did from corporate bonds. As homeowners defaulted, the raters have downgraded more than three-quarters of the AAA-rated CDO bonds issued in the last two years…
…Gilkes says he believed that competitive considerations, as communicated by management, intruded on S&P’s ratings decisions up until he left the London office in 2006.
“The discussion tends to proceed in this sort of way,” he says. “`Look, I know you’re not comfortable with such and such assumption, but apparently Moody’s are even lower, and, if that’s the only thing that is standing between rating this deal and not rating this deal, are we really hung up on that assumption?’ You don’t have infinite data. Nothing is perfect. So the line in the sand shifts and shifts, and can shift quite a bit.” 
`Golden Goose’
Gugliada says that when the subject came up of tightening S&P’s criteria, the co-director of CDO ratings, David Tesher, said: “Don’t kill the golden goose.”
S&P declined to make Tesher available for comment.
In the SEC’s July 8 report examining the role of the credit rating companies in the subprime crisis, the agency raised questions about the accuracy of grades on structured-finance products and “the integrity of the ratings process as a whole.”
“Let’s hope we are all wealthy and retired by the time this house of cards falters,” one unidentified analyst told a colleague in a December 2006 e-mail, according to the SEC report. The e-mail was signed with a computerized wink and smile: “;o).”
Moody’s stock peaked at $74.84 on Feb. 8, 2007, a day after London-based HSBC Holdings Plc said it would set aside about $10.56 billion for losses on U.S. home loans. That statement was among the first signs of the subprime meltdown.
The reckoning swept Wall Street five months later. On July 10, Moody’s cut its grades on $5.2 billion in subprime-backed CDOs. That same day, S&P said it was considering reductions on $12 billion of residential mortgage-backed securities...
“The greed of Wall Street knows no bounds,” says Stiglitz, the Nobel laureate. “They cheated on their models. But even without the cheating, their models were bad.”
By last month, Moody’s had downgraded 90 percent of all asset-backed CDO investments issued in 2006 and 2007, including 85 percent of the debt originally rated Aaa, according to Lucas at UBS Securities. S&P has reduced 84 percent of the CDO tranches it rated, including 76 percent of all AAAs.
“Credit in Latin means `to believe,”’ says former Moody’s analyst Sylvain Raynes, 50, now the head of his own New York bond-analysis firm, R&R Consulting. “Trust and credit is the same word. If you lose that confidence, you lose everything, because that confidence is the way Wall Street spells God.”
Full article here.
