10 Years Since the Financial Crisis: July 2007 – Credit Rating Agencies – Key Enablers of the Financial Crisis: “We Were Either Incompetent or Sold Our Soul to the Devil for Revenue”

Credit Rating Agencies Moody’s and Standard and Poor’s (S&P) had some of their most profitable years ever whilst issuing ratings which were catastrophically misleading. The mortgage-backed securities which were at the heart of the crisis could not have been marketed without their approval. Their models relied on a series of dodgy assumptions about the extent to which house prices could fall and the number of households who would default. The historic data they plugged into their models failed to account for rampant mortgage fraud and weak lending standards with many borrowers no longer having to provide proof of their income. Investment banks threatened to take their business elsewhere unless the rating agencies met their demands. In 2006, the rating agencies had begun to update their models but failed to review their recent ratings – apparently not wanting to admit to mistakes.

On 10th July 2007, the agencies announced the first mass downgrade of products which had been backed by sub-prime mortgages. Products which had been rated as AAA were eventually downgraded to junk status and investors began to realise that the credit ratings did not reflect the risk of losses. Banks like RBS and HBOS which had blindly relied on these ratings incurred billions of pounds of losses which were ultimately borne by UK taxpayers. But despite their staggering incompetence and role as enablers of the financial crisis the business model of rating agencies remains unchanged and they continue to prosper.

Credit Rating Agencies

Credit Rating Agencies fulfil an absolutely vital role in the financial markets. They are supposed to provide investors with an independent assessment of the probability that a debt will be repaid. Credit ratings use a scale of rating which runs from AAA to C.

The standard definition of a AAA rating is that the company or product has an extremely strong capacity to meet its financial commitments and returns to investors.

In the run up to the financial crisis, banks designed ever more complex products to sell to investors – involving the packaging and repackaging, slicing and dicing of mortgages into products called Collateralised Debt Obligations (CDOs) where it was very difficult to understand all the risks. As these products were so opaque and complex investors often placed reliance on the credit rating to determine whether they should buy them.

Some investors such as banks and investment funds applied rules which required them to aim to buy or hold bonds with certain high ratings. Regulators were also so confident in the ability of credit rating agencies that they hardwired them into the system determining the capital banks were required to hold against losses when buying these securities.

Issuer pays

Until the 1970s and 1980s ratings agencies made their money by charging investors subscription fees for the information. The business model employed by Rating Agencies then changed to what is called “issuer pays”. This means the issuer of the bond or financial product pays a fee to one or more rating agencies when they submit it to be rated. This introduces a clear conflict of interest as there will be short-term commercial pressures on rating agencies to weaken their assessments in order to retain business.

Ratings shopping – Competition to weaken their assessments

There was competition between the different rating agencies – but this had perverse results. There was a strong internal focus on market share and margins. Models were tweaked, with one employee taking about “massaging” the numbers to preserve market share. Some employees within the rating agencies appeared to recognise this risk:

“Screwing with [the model’s] criteria to ‘get the deal’ is putting the entire S&P franchise at risk – it’s a bad idea”

Investment banks bringing products to Moody’s and S&P to be rated had an ongoing relationship with the rating agencies and put pressure on the agencies to provide guidance about how to structure products to achieve the required rating. There was significant pressure put on staff at the credit rating agencies to deliver favourable ratings with the threat that if they didn’t then business would be taken elsewhere. When asked by the Financial Crisis Inquiry Commission if the investment banks frequently threatened to withdraw their business if they didn’t get their desired rating, a manager at Moody’s replied: “Oh God, are you kidding? All the time. I mean, that’s routine. I mean, they would threaten you all of the time. . . . It’s like, ‘Well, next time, we’re just going to go with Fitch and S&P.’”

Dodgy assumptions

In estimating the potential losses from a package of mortgages statistical models were used to estimate of the number of people who would fail to make repayments and the losses which could be incurred in a variety of scenarios. But these models rested on a series of dodgy assumptions.

The rating agencies also relied on historical data when estimating the probability of default. This took little or no account of the weakening standards in the sub-prime mortgage market or the fact that many borrowers no longer had to prove their income – one employee admitted that “the data was gathered and computed during a time when loans with over 100% LTV or no stated income were rare”.

There was also an underappreciation of the link between falling house prices and mortgage defaults. Rating agencies assumed that people would go to far greater lengths to pay the mortgage following a fall in house prices than they actually did.

The models used in the CDO market also failed to consider the potential for a nationwide fall in house prices. This meant that the fact that a widespread fall in house prices could cause a large number of defaults and threaten some of the more highly-rated securities wasn’t adequately considered.

In December 2006, discussing the assumptions about correlation of defaults an S&P employee said “Rating agencies continue to create an even bigger monster – the CDO market. Let’s hope we are wealthy and retired by the time this house of cards falters.”

Finally, the rating agencies didn’t realise (or didn’t ask any questions about the issue) that hedge fund managers were engaging in deals with investment banks to put together securities which were designed to fail. For example, S&P didn’t know that hedge fund manager John Paulson had been involved in picking the mortgages going into a deal which it would rate AAA.

Updated models but didn’t go back over old deals

The rating agencies were changing their models during 2006 to take account some of the changes in the data they were observing. However, they did not go back and retest some of the recently issued securities with their new models. If they had it would have led to far earlier downgrades and warning to the market. Their failure to go back meant that the products continued to carry misleading ratings.

Mass Downgrades

On 10th July, both Moodys and S&P announced the mass downgrading of numerous products backed by sub-prime mortgages. S&P downgraded 612 subprime RMBS with an original value of $7.3 billion, and Moody’s downgraded 399 subprime RMBS with an original value of $5.2 billion. The rating agencies said that they were undertaking this action because of the high number of people failing to make repayments, mostly stemming from lax underwriting standards in effect when the loans were originally made. According to S&P, sub-prime loans made in 2006, had accumulated delinquencies far in excess of historical norms and at much higher rates than the agency initially anticipated.

On the conference call to discuss the downgrades one hedge fund manager repeatedly asked “What is it that you know today that the markets didn’t know three months ago”.

The scope and surprise (amongst some investors) of these downgrades led to a widespread loss of confidence in markets for mortgage-backed securities and the CDOs which banks had been manufacturing. Investors simply could not trust the ratings assigned to these products and found it very difficult to understand the risks and what these products now might be worth. These concerns led to a sharp fall in the price of securities backed by sub-prime mortgages. Investors became less willing to buy or gain exposure to these securities – starting the freeze in markets which became the credit crunch.

Structured Investment Vehicles: An Oasis of Calm

Despite these downgrades the rating agencies still didn’t seem to realise the implications for financial markets. On the 20th July, Moody’s described Structured Investment Vehicles (SIVs) – off-balance sheet vehicles which had been used to finance the purchase of mortgage-backed securities – as an “Oasis of Calm in the Sub-Prime Maelstrom” Within a month there had been a “large-scale rush for the exits” in the markets used to fund these vehicles”. SIVs began to liquidate their assets and by the end of the year banks had to take many of their SIVs back on to their balance sheets – exposing them to losses and hurting their liquidity.

Another “false alarm” in terms of bank systemic risk

There was also over-optimism regarding the effect on banks. In its report issued on 25th July “Another False Alarm in Terms of Banking Systemic Risk but a Reality Check”, Moody’s said that “The shock-absorption capacity of the core of the financial system is very high” and that “the current episode does not seem to raise genuine systemic risk concerns, with Moody’s core bank ratings displaying a high degree of resilience in this regard.”

Margin Call

The turmoil in markets for mortgage-backed securities accelerated after the cut in the ratings. Previously highly-rated securities declined in value and there were margin calls all over Wall Street. On 26th July 2007 Goldman Sachs sent an email to AIG:

Sorry to bother you on vacation, but margin call coming your way…on $20 billion of super-senior. This was accompanied by a demand for $1.8 billion.

AIG officials discussing this demand said that the number was “well bigger than any we ever planned for” and called Goldman’s prices “ridiculous”.

We were incompetent or sold our soul to the Devil for revenue

A manager at Moody’s in an email sent in September 2007 summed up the situation:

“[W]hy didn’t we envision that credit would tighten after being loose, and housing prices would fall after rising, after all most economic events are cyclical and bubbles inevitably burst. Combined, these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue, or a bit of both. Moody’s franchise value is based on staying AHEAD OF THE PACK on credit analysis and instead we are in the middle of the pack. I would like more candor from senior management about our errors and how we will address them in the future.”

Ratings relied on by bankers

The fact that the ratings could be systematically wrong and could result in significant losses does not appear to have crossed the minds of some bankers. Sir Tom McKillop, Chairman of RBS at the time of the financial crisis told the Treasury Committee:

“We never imagined the parts we were holding, a large part of it was triple A or super senior, we never imagined, as Fred [Goodwin] said earlier, that [they] could end up as 10 cents in the dollar.”

In 2004, HBOS had made the decision to change how some of its assets were invested. Previously they had all been invested in gilts but the change allowed it to invest in other securities, overwhelmingly rated AAA. This meant that the bank incurred losses of £8.6 billion during the credit crunch, although as markets rebounded this loss was reduced to £3.2 billion.

Jo Dawson, who had been appointed Group Risk Director at HBOS in January 2005 and remained in that post until February 2006 and is now a Director of the Prudential Assurance Company had this to say about the losses incurred by HBOS and the Alt-A securities it held (a type of security which included mortgages which were between prime and sub-prime).

To be honest—I think this was part of the challenge in 2008 when it started—I probably would not have known what an alt-A security was at that time. I knew that treasury were the experts in that and they were telling us that these are securities that are AAA-rated externally.

Securitisation is brilliant isn’t it

This blindness to the risks of securitisation due to the inadequacy of the ratings was shared by regulators. Central banks and banking regulators believed that spreading out the risk from the banking system through securitisation had improved the resilience of the banking system. In August 2007, the Governor of the Bank of England said:

[There is] a very, very key point here, which is that our banking system is much more resilient than in the past. Precisely because many of these risks are no longer on their balance sheets but have been sold off to people willing and probably more able to bear it. Now some have always had a preference for a banking system in which all the risks are sort of concentrated there. But I think then you create extraordinary risky institutions with highly illiquid assets in the forms of loans to households and medium sized business, matched by highly illiquid liabilities. And that’s a very risky system and as I said in the Mansion House speech that’s you know ultimately what gave rise to the concept of the need for a lender of last resort, where the central bank was thought to have to be ready to step in at any point to rescue a banking system that was vulnerable to quite small shifts in sentiment. We don’t have a system that is a fragile as that now. The growth of securitisation has reduced that fragility significantly.

Regulators also believed that rating agencies deserved an important role in determining the capital which should be held by banks against the various risks they were taking. Both of these judgements turned out to be catastrophically wrong.

“The fundamental problem of securitization – one that was missed by regulators and bankers alike until the crisis actually hit – was that the combination of inadequate ratings oversight and the inclusion of poor-quality underlying assets (such as sub-prime mortgages) allowed for a reduction in the global capital cushion without actually reducing the level of risk.”

Regulators recently decided to rename the “shadow banking system” as “market-based finance”. It remains to be seen what role the rating agencies will be able to carve out for themselves in this new system and the fast growing Peer-2-Peer lending market.

Essential cogs in the wheel of financial destruction: Incompetence no barrier to prospering as a rating agency

As early as 1999, academics were pointing out that despite their worsening performance the rating agencies were more prosperous than ever. In the 1990s they failed to spot problems in the Mexican and Asian economies. They missed corporate failures at Enron and Worldcom.

The American Financial Crisis Inquiry Commission concluded that:

“The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies”

In defending themselves against lawsuits after the financial crisis, Standard & Poor’s put forward what academics described as a most remarkable defence:

“In its defence, Standard & Poor’s argues (without admitting any rating bias) that it has never made a legally binding promise to produce objective and independent credit ratings. Instead, the agency describes its mission “to provide high-quality, objective, rigorous analytical information” as well as instructions to its employees like “Ratings Services must preserve the objectivity, integrity and independence of its ratings” as aspirational statements of how business should be conducted. According to The Wall Street Journal it is almost as if Standard & Poor’s feels impelled to characterise its claims of independence and objectivity as mere “puffery” that was “never meant to be taken at face value by investors”. For an agency whose business model is based on its reputation as an impartial ‘gatekeeper’ of fixed income markets, this defence is most remarkable.”

Crisis? What Crisis?

It seems strange to think that despite their role in the financial crisis and the billions of dollars of losses suffered by investors and taxpayers the business model of rating agencies remains unchanged. Reforms introduced after the crisis have failed to loosen the dominant position of the big 3 rating agencies. In 2016, the Wall Street Journal said “What Crisis? Big Ratings Firms Stronger Than Ever: S&P, Moody’s and Fitch issue more than 95% of global bond ratings, and profits are nearing all-time highs


Ratings agencies