Lawmakers are now asserting that credit rating agencies (CRAs) like Moody's Investors Service and Standard and Poor's Ratings Services failed to expose the lurking dangers.
"Rating agencies continue to create and even bigger monster - the CDO Market," wrote one S&P employee in an internal e-mail in December of 2006. "Let's hope we are all wealthy and retired by the time this house of cards falters. :o)."
The e-mailed pages of other documents were presented as evidence at a hearing on Capitol Hill Friday.
The Subcommittee is accusing the credit agencies of contributing to the crisis in several major ways: By using ineffective models to measure risk, by inflating ratings because of pressure from banks, by ignoring early warning signs and by failing to quickly disclose the risk on existing products once it was discovered.
Lousy modeling
Wall Street relies heavily on the CRAs tasked with analyzing risk and giving debt a "grade" that reflects the borrower's ability to pay the underlying loans, and therefore determines overall risk to the investor. The safest are given an AAA rating.
The Subcommittee asserts that the CRAs were well aware of the risks in the housing market and used rating models they knew inflated the grades given to securities.
As a result, AAA-ratings were issued far too often.
"This is frightening. It wreaks of greed, unregulated brokers, and 'not so prudent' lenders," said one S&P internal e-mail dated September 2006. And another from that same month: "...this is like another banking crisis potentially looming!!"
As the real estate market worsened, the flawed risk models were exposed as the underlying home loans began defaulting.
The agencies were forced to revamp their models in 2006, but they chose to continue using the old models on existing securities, the Subcommittee says, out of fear that the ratings would be downgraded, resulting in very unhappy customers.
Pressured by bullies
Because investment banks hire credit rating agencies to assess the risk of their portfolios, the agencies have an incentive to give the banks the ratings they want, or else risk losing market share to competitors.
"Credit rating agencies allowed Wall Street to impact their analysis, their independence and their reputation for reliability," said Levin during Friday's hearing. "And they did it for the money."
For example, in an e-mail the Subcommittee obtained from April of 2006, a Moody's employee complained of feeling pressure from Goldman Sachs, which was eager to start selling a high-rated product.
"I am getting serious pushback from Goldman on a deal that they want to go to market with today.*** Goldman needs more of an explanation (I do not know how to get around this without telling them we were wrong in the past)."
0:00/2:08Credit rating agencies under fire
Executives from S&P and Moody's (MCO) acknowledged during the hearing that investment banks shop around for the best rating. Some agreed that ultimately, it's the investment banks who are their clients, not the investors who end up with the securities.
So it often comes down to a choice between issuing a correct, but unfavorable rating and losing business, or inflating a rating to keep a customer, as several exhibits from the Subcommittee's investigation show.
"We are meeting with your group this week to discuss adjusting criteria for rating CDOs of real estate assets this week because of the ongoing threat of losing deals," said one internal S&P e-mail from August 2004. "Lose the CDO and lose the base business - a self reinforcing loop."
In his testimony, Richard Michalek, former vice president of the Structured Derivative Products Group at Moody's admitted that he felt constant pressure to accept deals, even if they looked risky.
"The independence of the group changed dramatically during my tenure," said Michalek. "The unwillingness to say 'no' grew."
"The message from management was not, 'just say no,' but instead, 'just say yes,'" he said.
Delayed Reaction
It wasn't until the brink of the mortgage meltdown in 2007 that the rating agencies finally began applying their new models to existing securities, realizing that the inflated ratings on the mortgage-backed securities and CDO's weren't going to hold.
This realization resulted in a mass downgrade, shocking the market and leaving investors with securities worth less than the paper they were printed on, said Levin.
In 2007, a whopping 91% of AAA-rated mortgage securities were downgraded to junk status, meaning they were now the riskiest kind of security.
"Looking back, if any single event can be identified as the immediate trigger of the 2007 financial crisis, it would be the mass downgrades," said Levin. "Those downgrades hit the market like a hammer, making it clear that [they] had been a colossal mistake."
And what makes it worse, said Levin, is that credit raters and the banks knew that what they were giving to investors was junk all along.
In one e-mail, a UBS employee even refers to the securities he was selling investors as "crap."
Berkshire Hathaway ranks number one in reputationSEC fraud probe leads to Goldman Sachs
