WASHINGTON (CN) – Credit ratings agencies contributed significantly to the financial crisis by continuing to issue high ratings on residential mortgage-backed securities when the agencies knew the ratings were inflated, partly due to the industry’s cozy relationship with Wall Street, a Senate subcommittee investigation found.
Credit ratings giants Moody’s and Standard & Poor’s “allowed Wall Street to impact their analysis, their independence and their reputation for reliability,” investigations subcommittee chair Carl Levin, D-Mich., said in a somber hearing Friday examining the role of credit ratings agencies in the financial crisis. “And they did it for the money,” Levin said.
Ranking Republican Tom Coburn of Oklahoma accused the agencies of slapping AAA ratings on junk securities, creating “a false sense that the economy was stronger than it really was” and fueling the housing bubble. If anyone could have done something to prevent the financial crisis, Coburn argued in his written testimony, the ratings agencies could have.
The subcommittee’s evidence shows that Moody’s and S&P knew enough to downgrade a chunk of bad securities in late 2006, but they waited, and Wall Street drew in more bad investments. In the meantime, the ratings agencies continued to shell out investment-grade ratings to hundreds more mortgage-backed securities, all of which were later downgraded to junk status. The agencies raked in record profits by issuing the ratings, doubling their revenue from 2002 to 2007.
The firms also used “financial engineering” to group risky securities with high-quality ones, and “investors snapped them up,” Levin said. “For awhile, everyone made money.”
But in July 2007, the three credit ratings giants massively downgraded hundreds of subprime mortgage securities, making them “worthless,” Coburn said.
One of the major problems was ratings agencies’ close relationship to Wall Street, which created an “incredible” conflict of interest, according to Sen. Ted Kaufman, D-Del.
Levin added: “Credit rating executives got paid Wall Street-sized salaries” by the companies whose securities they were rating. “It’s like one of the parties in court paying the judge’s salary,” he said.
A panel of former employees at S&P’s and Moody’s gave consistent testimony of pressure from managers to get a larger slice of market share of the mortgage-backed securities and collateralized debt obligations, saying they felt like they would lose their job if they lost market share.
When Levin quoted the testimony to Moody’s CEO Raymond McDaniel Jr. later in the day, asking whether there was in fact strong internal emphasis on market share, McDaniel refused to confirm the statement outright.
“I believe attention to market share is one thing I should pay attention to,” McDaniel said.
When Levin pressed him to answer the question more directly, McDaniel said, “There is a strong internal emphasis on market coverage,” adding, “I understand that they can be conflated.”
The former employees also testified to the lack of adequate resources necessary to rate or re-rate securities, pressure to keep the investment banker customer satisfied, and an emphasis on the quantity over quality of assets.
Richard Michalek, former vice president senior credit officer at Moody’s, cited a “just say yes” culture to satiate “hungry investors,” describing an extremely competitive atmosphere that bred an “unwillingness to say no.”
Former Moody’s team managing director Eric Kolchinsky testified to a “see no evil, hear no evil” attitude in assigning ratings.
“It was part of the culture?” Levin asked.
“Yes, it was part of the culture,” Kolchinsky replied.
Moody’s and S&P’s executives told subcommittee members they were making changes at their organizations to address the failures to contributed to the financial crisis.
McDaniel said Moody’s has new measures in place, including cross-disciplinary techniques in rating committees to bring “richer perspective” to the process. “We’ve changed our methodologies,” he said.
When Kaufman asked if S&P’s was changing the way it incentivized people within the organization, former president Kathleen Corbet said, “It’s always been about the analytics of the ratings.”
“I’m sorry you didn’t hear the first panel,” Kaufman responded, referring to former employees’ testimony, “because it was pretty unanimous that that stopped at some point.”
“AAA will never again mean what it used to mean,” Kaufman said.