Hang 'Em High - Fraud In Bond Ratings Leading To The Financial Crisis

One of the most insidious causes of the financial meltdown was the role of ratings agencies that gave triple-A ratings to tranches of subprime loans. I have been highlighting this issue for well over a year. You can read more of the background here. Finally, this issue is being addressed. And for possibly the first time in my life, I find myself in complete agreement with Democratic Senator Karl Levin. This from the NYT:

. . . The role of the rating agencies in the crisis came under sharp scrutiny Friday from the Senate’s Permanent Subcommittee on Investigations. Members grilled representatives from Moody’s and Standard & Poor’s about how they rated risky securities. The changes to financial regulation being debated in Washington would put the agencies under increased supervision by the S.E.C.

Carl M. Levin, the Michigan Democrat who heads the Senate panel, said in a statement: “A conveyor belt of high-risk securities, backed by toxic mortgages, got AAA ratings that turned out not to be worth the paper they were printed on.”

As part of its inquiry, the panel made public 581 pages of e-mail messages and other documents suggesting that executives and analysts at rating agencies embraced new business from Wall Street, even though they recognized they couldn’t properly analyze all of the banks’ products.

The documents also showed that in late 2006, some workers at the agencies were growing worried that their assessments and the models were flawed. They were particularly concerned about models rating collateralized debt obligations like Abacus.

According to former employees, the agencies received information about loans from banks and then fed that data into their models. That opened the door for Wall Street to massage some ratings.

For example, a top concern of investors was that mortgage deals be underpinned by a variety of loans. Few wanted investments backed by loans from only one part of the country or handled by one mortgage servicer.

But some bankers would simply list a different servicer, even though the bonds were serviced by the same institution, and thus produce a better rating, former agency employees said. Others relabeled parts of collateralized debt obligations in two ways so they would not be recognized by the computer models as being the same, these people said.

Banks were also able to get more favorable ratings by adding a small amount of commercial real estate loans to a mix of home loans, thus making the entire pool appear safer.

Sometimes agency employees caught and corrected such entries. Checking them all was difficult, however.

“If you dug into it, if you had the time, you would see errors that magically favored the banker,” said one former ratings executive, who like other former employees, asked not to be identified, given the controversy surrounding the industry. “If they had the time, they would fix it, but we were so overwhelmed.”

I am a big supporter of greed and virulently opposed to holding people criminaly liable for poor business judgement. But when it comes to fraud, I believe in the old adage of "hang 'em high." And it certainly sounds as if the practices involved in turning sub-prime loans into triple-A rated bonds crossed that line. I do hope Sen. Levin and his committee follow this one closely - though whether the answer is new regulation or merely enforcement of existing regulations as the answer is very much in question. The NYT also has a second article relating to this issue, Former Employees Criticize Culture of Rating Firms:

Perhaps the most riveting testimony came from Eric Kolchinsky, a former managing director at Moody’s who for most of 2007 oversaw the ratings of collateralized debt obligations backed by subprime mortgages.

“The vast majority of the analysts at Moody’s are honest individuals who try hard to do their jobs,” Mr. Kolchinsky said. “However, the incentives in the market for rating agency services favored, and still favor, short-term profits over credit quality.”

Mr. Kolchinsky added: “It was an unspoken understanding that loss of market share would cause a manager to lose his or her job.” He said he was suspended after warning in September 2007 that a batch of securities “being hyper-aggressively pushed by the bankers” had been given a rating that was too high because it was based on 2006 ratings that were about to be downgraded.

“I believe that to assign new ratings based on assumptions which I knew to be wrong would constitute securities fraud,” Mr. Kolchinsky said. . . .

Yes, it would. And heads really should roll over all of this.