Released last week, a new 650-page Senate report on the financial crisis describes multiple aspects of a financial system run amok, including the way in which bankers muscled ratings agencies to turbo-charge their deal-making machine. The detail in the report is fascinating -- three emails tell you more about the causes of the crisis than any technical discussion:
May the highest rating win!
From: Banker, UBS
To: Senior manager, S&P (a unit of the McGraw-Hill Cos.
"[H]eard you guys are revising your residential mbs [mortgage backed security] rating methodology. ... [H]eard your ratings could be 5 notches back of [Moody's
Translation: Don't even think about using a new, stricter model to rate mortgage-backed securities. We'll take our business to your two biggest competitors, and you can expect all the other banks to do the same.
Making up the rules as you go along
From: Investment Banker, Citigroup
To: Analyst, S&P
"I am VERY concerned about this E3 [new CDO rating model]. If our current struc[ture], which we have been marketing to investors ... doesn't work under the new assumptions, this will not be good. Happy to comply, if we pass, but will ask for an exception if we fail."
Translation: We're always happy to follow the rules ... as long as we get exactly what we want. If we don't, we'll just ignore the rules and ask for an exception.
The exceptions quickly became the new rule.
Getting your money's worth
In some cases, the bankers were even more brazen:
From: Merrill Lynch (now part of Bank of America
To: Moody's
"We are OK with the revised fee schedule for this transaction. We are agreeing to this under the assumption that this will not be a precedent for any future deals and that you will work with us further on this transaction to try and get to some middle ground with respect to the ratings."
Translation: You'll get paid, but you need to get with the program on the rating.
And while it may have been unusual for a banker to try to tie fees directly to the result of the rating process, that wasn't even necessary since the two were linked implicitly because of the structure of the business. Bankers and credit analysts had a common goal: closing deals. Lots of them.
Breaking down the deal machine
Ratings agencies earned fees from the banks on completed securitizations. In order to close these deals, the bankers need to find clients that are willing to buy the securities. These clients will only buy securities that are highly rated, and that brings us full circle back to the ratings agencies. In summary, ratings agencies -- like bankers -- wanted as many deals to close as possible, and they were in a position to facilitate that by assigning ratings that would ensure the deals were successful.
Credit analysts who became obstacles to the smooth functioning of the deal machine as a result of diligence, quickly found themselves pushed aside. As this former Moody's analyst testified:
"During my tenure at Moody's, I was explicitly told that I was 'not welcome' on deals structured by certain banks. ... I was told by my then-current managing director in 2001 that I was 'asked to be replaced' on future deals by ... CSFB [Credit Suisse First Boston], and then at Merrill Lynch. Years later, I was told by a different managing director that a CDO team leader at Goldman Sachs also asked, while praising the thoroughness of my work, that after four transactions he would prefer another lawyer be given an opportunity to work on his deals."
"No one gives a [expletive] if Goldman likes General Electric paper."
In The Big Short, Michael Lewis profiles several of the very few investors who foresaw the credit crisis and made huge profits betting against subprime securities. One of those investors, Steve Eisman, understood perfectly the dysfunctional relationship between bankers and credit analysts, and the perverse impact on the market for mortgage securities:
"[The ratings agency people] are underpaid. The smartest ones leave for Wall street to mainpulate the firms they used to work for. There should be no greater thing you can do as an analyst than to be a Moody's analyst. It should be, 'I can't go higher as an analyst than to be a Moody's analyst.' Instead it's the bottom. No one gives a [expletive] if Goldman likes General Electric paper. If Moody's downgrades GE paper, it is a big deal. So why does the guy at Moody's want to work at Goldman Sachs? The guy who is the bank analyst at Goldman Sachs should want to work at Moody's. It should be that elite."
Official power vs. effective power
That dichotomy lies at the heart of the dysfunctional subprime market. As nationally recognized statistical rating organizations, or NRSROs, rating agencies had official power in these markets; their stamp of approval was necessary for banks to sell the securities. However, bankers had effective power -- they were smarter, more aggressive, and they controlled the deal flow. I have never met nor heard of a Goldman Sachs banker who wanted to work at Moody's -- not then, not now, and I don't expect I ever will.
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