"How Moody's Sold its Ratings -- and Sold Out Investors"

Robert Waldmann says "This McClatchy article by Kevin G Hall seems important to me." It does seem like there was "market failure in everything" when it comes to mortgage markets, from the incentives faced by the homeowner (non-recourse loans) and real estate agent ( maximize commission income) at the very first point of contact, through other points in the system such as appraisers, mortgage brokers, and bank managers.

Maybe fixing the incentive problems at each of these steps would have stopped the problem, or at least made it much less severe, but maybe not. In any case, it's clear that markets failed to self regulate at many key points, and that there are problems that need to be fixed covering the entire spectrum from the sale of higher priced, higher profit mortgage contracts to unwary homeowners when better options were available to the incentives bank managers had to maximize short-run profits and accumulate too much risk.

But the flow of toxic paper upward through the system should have had a gatekeeper of last resort, or at least a thorough checkpoint, and that was the ratings agencies. I don't think the failure of the ratings agencies, by itself, caused the financial crisis, but it was an important contributor and it's one of the things that needs to be fixed:

How Moody's sold its ratings -- and sold out investors, by Kevin G. Hall, McClatchy Newspapers: As the housing market collapsed in late 2007, Moody's Investors Service, whose investment ratings were widely trusted, responded by purging analysts and executives who warned of trouble and promoting those who helped Wall Street plunge the country into its worst financial crisis since the Great Depression.

A McClatchy investigation has found that Moody's punished executives who questioned why the company was risking its reputation by putting its profits ahead of providing trustworthy ratings for investment offerings.

Instead, Moody's promoted executives who headed its "structured finance" division, which assisted Wall Street in packaging loans into securities for sale to investors. It also stacked its compliance department with the people who awarded the highest ratings to pools of mortgages that soon were downgraded to junk. Such products have another name now: "toxic assets."

As Congress tackles the broadest proposed overhaul of financial regulation since the 1930s, however, lawmakers still aren't fully aware of what went wrong at the bond rating agencies, and so they may fail to address misaligned incentives...

The Securities and Exchange Commission issued a blistering report on how profit motives had undermined the integrity of ratings at Moody's and its main competitors, Fitch Ratings and Standard & Poor's,... but the full extent of Moody's internal strife never has been publicly revealed.

Moody's ... disputes every allegation against it. "Moody's has rigorous standards in place to protect the integrity of ratings from commercial considerations," said Michael Adler, Moody's vice president for corporate communications... Insiders, however, say that wasn't true before the financial meltdown.

To promote competition, in the 1970s ratings agencies were allowed to switch from having investors pay for ratings to having the issuers of debt pay for them. That led the ratings agencies to compete for business by currying favor with investment banks that would pay handsomely for the ratings they wanted.

Wall Street paid as much as $1 million for some ratings, and ratings agency profits soared. This new revenue stream swamped earnings from ordinary ratings. ... Ratings agencies thrived on the profits that came from giving the investment banks what they wanted, and investors worldwide gorged themselves on bonds backed by U.S. car loans, credit card debt, student loans and, especially, mortgages. ...

Nobody cared about due diligence so long as the money kept pouring in during the housing boom. ...

One Moody's executive who soared through the ranks during the boom years was Brian Clarkson, the guru of structured finance. He was promoted to company president just as the bottom fell out of the housing market. Several former Moody's executives said he made subordinates fear they'd be fired if they didn't issue ratings that matched competitors' and helped preserve Moody's market share. ...

Clarkson rose to the top in August 2007, just as the subprime crisis was claiming its first victims. Soon afterward, a number of analysts and compliance officials who'd raised concerns about the soundness of the ratings process were purged and replaced with people from structured finance. ...

Another mid-level Moody's executive ... recalls being horrified by the purge. "It is just something unthinkable, putting business people in the compliance department. It's not acceptable. I was very upset, frustrated," the executive said. "I think they corrupted the compliance department." ...

Others who worked at Moody's at the time described a culture of willful ignorance in which executives knew how far lending standards had fallen and that they were giving top ratings to risky products.

"I could see it coming at the tail end of 2006, but it was too late. You knew it was just insane," said one former Moody's manager. "They certainly weren't going to do anything to mess with the revenue machine." ...[...more...]...