Tavakoli Structured Finance LLC

Tavakoli Structured Finance Revokes the Credit Rating Agencies’ NRSRO Designation

Note: This report was originally issued as a pdf and is reproduced here for web readability. Appendices with companion figures in the original pdf have been removed from this website.

Issues and Solutions for Restoring Credibility to the Credit Rating Agencies and Rehabilitating the Alternative Banking System

By Janet Tavakoli, President of Tavakoli Structured Finance, Inc.

July 26, 2011


Ten rating organizations are designated Nationally Recognized Statistical Rating Organizations: Moody’s Corporation; Standard & Poor’s Ratings Services (S&P, part of McGraw-Hill Cos., Inc.), Fitch, Inc., Best Company, Inc., DBRS Ltd., Egan-Jones Rating Company, Japan Credit Rating Agency, Ltd., Kroll Bond Rating Agency, Inc. (f/k/a LACE Financial Corp.), Rating and Investment Information, and Realpoint LLC. Moody’s and S&P are the most influential and have the most market share. Ratings, particularly those of Moody’s and S&P, are built into the global regulatory and market framework.

Ostensibly the U.S. Securities and Exchange Commission (SEC) qualifies the NRSRO designation. The SEC’s series of failures to check the creation and sale of hundreds of billions of dollars of blatantly misrated securitizations leading up to the financial crisis are beyond the scope of this report. It’s worth noting, however, that if the Food and Drug Administration failed to check the sale of tainted meat that repeatedly sickened a large segment of the population, we would demand a top to bottom overhaul of the organization and its methods.

Credit Derivatives & Securitization 3rd Edition by Janet Tavakoli

In February 2007, the SEC sought comments about the steps it should take to regulate the rating agencies. In my letter to the SEC dated February 13, 2007, I called for the SEC to revoke the rating agencies’ designation as Nationally Recognized Statistical Rating Organizations (NRSRO). Ratings for structured products were based on smoke and mirrors. (APPENDIX I.)

In upholding the NRSRO designation the SEC and Congress are as irrelevant to the truth as Galileo’s inquisitors when they forced him to recant his upholding of Copernicus’ idea that the earth moves around the sun. Fundamental truths are not changed by arbitrary legislation like Congress’s Credit Agency Reform Act of 2006, meant to improve ratings quality, or by the SEC’s regulation. Since the SEC failed to act, I now revoke the NRSRO designation for all credit rating agencies for every class of credit rating with the exception of corporations not engaged in structured finance in a meaningful way. Specifically, this revocation is for the following rating classes: structured financial products including, but not limited to, structured credit products, asset backed securities, and synthetic securitizations; financial institutions (including brokers or dealers and hedge funds), insurance companies, and sovereigns that have bailed out their banking systems and continue to fund them.

This report provides further background on this action focusing on the top two rating agencies, Moody’s and S&P, and suggests a multi- year process required to restore a credible NRSRO designation for the rating agencies.

A. Rating Agencies’ Role in the Financial Collapse: The Sovereign Effect

The U.S. and European economies are experiencing credit turmoil that is a side effect of the collapse of the alternative banking system, sometimes referred to as the “shadow” banking system. This is the financial system created using a combination of structured finance techniques employed over more than twenty years including special purpose vehicles, securitization, interest rate derivatives, commodity derivatives, currency derivatives, and credit derivatives.

At its best, the alternative banking system was a financial growth engine that provided a mechanism for efficient financing and risk distribution for borrowers that otherwise found it difficult to access traditional bank financing. The downfall of this system was due to a series of failures, chiefly the role of the largest banks that underwrote phony securitizations and failed to follow established laws governing the underwriting of the securities they sold. This was abetted by failures at the rating agencies, regulators, monoline insurers, and ancillary finance partners of investment banks: mortgage lenders, mortgage servicers, legal advisors, accountants, student loan providers, auto loan providers, credit card issuers, and academic consultants.

Most of the market for ratings is dominated by Moody’s and Standard & Poor’s, especially the U.S. market, where these two U.S.-based rating agencies have been entrenched and have most of the historical data. Fitch has played a more minor but significant role as both a primary and swing provider in the rating of structured financial products.

In the run up to the current crisis, the rating agencies misrated mortgage securitizations called Residential Mortgage-Backed Securities (RMBS) that included loans with poor underwriting standards and fraudulent loans; this risk wasn’t captured in the ratings. (APPENDIX II.) As mortgage lenders failed, new investors had to be found to pay off old investors i.e., mortgage lenders and the banks that funded them. When the business model became unsustainable, it devolved into a Ponzi scheme. (APPENDIX III.) The errors compounded with misrated collateralized debt obligations (CDOs) and CDO-squared products that were securitizations of misrated tranches. (APPENDICES IV. and V.) Credit derivatives technology added hidden risks and amplified problems. From the start “AAA”-rated tranches of these deals showed the high probability of significant principal loss. (See Section VI. for a more detailed discussion.) These were just a few of the rating agencies’ egregious debacles. This report will discuss a few more, but it is still a partial list.

In a July 2011 report, The Joint Forum at The Bank for International Settlements’ (BIS) Committee on Banking Supervision issued a report titled: “Report on Asset Securitisation Incentives.” Characteristic of most central banks and regulators in the global financial system, it did not identify the key rating agency issues and when it comes to other aspects of securitization, the word “fraud” is not mentioned anywhere in the report. This sort of denial enables repeat offenders.

This is ironic, because BIS enabled “super senior” tranches, supposedly the top-most “AAA” tranches of CDOs that used credit derivatives technology, since it awarded lower regulatory capital requirements for these tranches. The “super senior” tranches of synthetic CDOs, securitizations that use credit derivatives technology, made up most of each deal. This will be discussed in more detail later in this report.

The BIS report noted that from 1990 to 2006, the peak year for ABS issuance, “AAA” rated assets ballooned from 20 percent of rated fixed-income issuance to almost 55 percent. Many of these came at the tail end of this period when the “AAA” ratings were unwarranted, in fact many warranted a junk rating at the outset, but BIS didn’t mention that part. It also left out that in the first half of 2007, virtually every “AAA” of ABS CDOs warranted junk ratings.

Prior to the effective halt of private label securitizations in the latter part of 2007, the alternative banking system provided an outlet for more than 70% of bank loans. By June, 2008, just three months before the September 2008 financial meltdown, CDOs in default already exceeded $200 billion. More troubles were subsequently exposed in CDOs and a variety of other products. Investors included insurance companies, bank investment portfolios, mutual funds, pension funds, hedge funds, and other money managers. Every sector of society was affected as misrated products caused actual principal losses combined with loss in value due to declining market prices and illiquidity.

The perceived ability to remove ever increasing risk from the balance sheets of the largest banks through misrated securities backfired as risk boomeranged back onto the balance sheets of underwriters. Liquidity—coming up with needed cash—is now a global problem, since investors are wary of lending money (by investing) against potentially misrated assets.

Advance hedging and raising capital requirements would only have helped mitigate some of the failures of risk transference: failure of credit default swap counterparties, consolidation of assets of flawed-at-creation special purpose vehicles, and consolidation of failed “independent hedge fund” assets.

The general financial meltdown experienced in September 2008 was accompanied by the suppression of facts and self-serving misinformation by many of the key players. Capital buffers and hedges were insufficient, and the controversial choice was made to recapitalize the banks without inquiry into the causes and culprits. Unfortunately, the bailout was also done without conditions and no meaningful steps have been taken that will prevent a similar global financial catastrophe.

As of 2009, “AAA” issuance from Sovereigns that still have that rating ballooned to outstrip the “AAA” ABS issuance of 2006. This is no surprise. Government bailouts to recapitalize the banks meant that new sovereign debt had to be issued. Capital spending, the biggest driver of economic growth was starved of funds.

As a result of the enormous bailouts, sovereign debt ballooned imperiling the “AAA” ratings of many sovereign entities while debt issuance continued to expand. “AAA” asset issuance stood at around $5 trillion in 2006, and in 2009 it was around $6 trillion. A significant chunk had shifted from imploded ABS CDOs to “AAA” sovereign debt. (APPENDIX VI.) Sovereign ratings are lagging indicators of risk and are readjusted by the rating agencies only after the damage is already blindingly obvious and well-reported by other more reliable sources.

Dodd-Frank will not avert a future crisis any more than Sarbanes-Oxley was effective in averting the last crisis. Banks can appear to take mortgage loan risk on balance sheet, but can lay it off through derivatives or through structural games. The provisions in Dodd-Frank are easily thwarted through opaque structured finance. Another problem is that risks have ramped up in other opaque areas: currency derivatives, credit derivatives, interest and market-linked derivatives, and commodities derivatives and speculation. This report, however, will continue to focus on the rating agencies.

This report deals with only one critical aspect of what it will take to rehabilitate the alternative banking system. It is a necessary—but not sufficient condition—to address the various issues that have contributed to the credit rating agencies’ history of failure.

B. Rating Agencies’ Current Practice Is Junk Science

One cannot understand the strengths and weaknesses of any model unless one understands the risk characteristics of the target portfolios’ assets. This is accomplished by examining the underwriters’ due diligence, and demanding even more thorough due diligence from the underwriter, if it is warranted. Since this granular work wasn’t properly done by any reasonable professional standard, the rating agencies computer models employed inputs that were simply guesses (or worse, deliberate masks of the risk) instead of a rational assessment of value.

Rating agencies correctly point out that deal sponsors and investment bank underwriters are responsible for due diligence on the underlying collateral. Although the rating agencies do not perform due diligence for investors, they can demand evidence that proper due diligence has been performed before attempting to apply their respective ratings methodologies. In fact, it is not possible to perform a sound statistical analysis without it.

Statistics is the mathematical study of the probability and likelihood of events. Known information can be taken into account, and likelihoods and probabilities are inferred by taking a statistical sampling. The rating agencies have not lived up to the NRSRO designation by any reasonable professional standard.

For example, in the mortgage loan securitization market, a statistical sampling of the underlying mortgage loans should verify the integrity of the documentation, the identity of the borrower, the appraisal of the property, the borrower’s ability to repay the loan, and so on. Rating agencies should take reasonable steps to understand the character of the risk they are modeling. Yet, they seemingly rated risky deals without demanding evidence of thorough due diligence, or if they did, they ignored or didn’t understand the implications.

It seems the rating agencies either did not refuse to “rate” securitizations that lacked this evidence, or they ignored reports that revealed fatal asset flaws for many structured finance transactions. In more colloquial language, the rating agencies just made stuff up.

When rating agencies use old data for obviously new risks, it’s financial astrology. When rating agencies guess at “AAA” ratings (without the data to back it up), it’s financial alchemy. When rating agencies evaluate no-name CDO managers without asking for thorough background checks, it’s financial phrenology. In other words, the rating agencies practice junk science. The result is that junk, i.e., non –investment grade tranches of securitized assets routinely got “AAA” ratings prior to the meltdown of 2008. So-called super-safe “super seniors” were junk.

The rating agencies’ have turned their names to mud, and Congress and the SEC do not seem to have the expertise to even correctly identify the issues. When they adopted arbitrary rating labels as benchmarks, the BIS, Fed and SEC enabled junk science. Investors do not have an alternative to this flawed system other than to do their own fundamental credit analysis.


The rating agencies assert that they issue mere opinions, but the NRSRO designation gives ratings the appearance of being issued from a position of authority. Regulators and investors rely on this pseudo-authority. When named as defendants in legal disputes, rating agencies hid behind the shield of journalist-like privilege keeping notes confidential. Rating agencies claimed they only issue opinions, however negligent they were in adhering to any reasonable professional standard when formulating those opinions. Dodd-Frank takes steps to increase transparency, but 1) it hasn’t yet been implemented, 2) the approaches to several key identified problems have yet to be defined, and 3) the Act altogether missed some of the key issues. This will be addressed in more detail in Section VIII.

Bank regulators and insurance regulators have enacted capital rules for banks based on ratings. Many investment funds and investors have charters requiring them to only buy products that have been rated by one or more of the top three rating agencies. Since there is no independent standard to define the meaning of a rating, the rating agencies have unintentionally been given the power to change regulatory requirements. This is an extraordinary result given that the rating agencies are private companies.

Although they shouldn’t, many investors rely on the rating and the coupon when buying structured financial products. For many investors a high coupon did not indicate high risk. Some naïve and misguided investors viewed the extra compensation as the privilege of those fortunate enough to have enough high net worth to be offered complex products. These investors did not think they were taking on extraordinary credit risk and extraordinary “financial engineering” when they bought products with the “AAA” rating. They thought they were buying sound, albeit less liquid products, and the extra coupon was viewed as compensation for less transparency and less liquidity.

Money market funds and pension funds rely on ratings. Pension funds are required to buy investment grade rated investments. The SEC is proposing that mutual funds should not rely on ratings, but the SEC is missing a piece. The SEC should not allow an investment below a previously required rating. For example, if an investor relied on an “AAA” rating before and it did not work out, that should not mean the investor should ignore the requirement and invest in something with a lower rating, either. Rather, the investor should still be required to have an “AAA” rating and should be required to determine that the value of the investment lives up to the rating.

Ratings are relied upon as if they are based on reliable and reproducible methods, but they are not, especially when it comes to structured products.

A. Ratings Cartel: Moody’s, S&P, and Fitch

In 2003, I formally explained flaws with rated structured products in a book, Collateralized Debt Obligations & Structured Finance. I discussed these issues with the rating agencies and in various forums. There were already serious problems with inflated” AAA” ratings in securitizations that had inherent structural flaws, problems with supposedly investment grade rated collateral, and conflicts of interest that held investors’ capital hostage to the self-interest of “managers” and investment banks. Those conflicts of interest often resulted in substantial principal losses to investors, and the risk was not captured in the ratings. That fact that all three top rating agencies (the only raters relevant to the issue) failed seemed more than a coincidence.

Instead of taking measures to address these flaws, the rating agencies ramped up their flawed structured products ratings business.

This tactic was temporarily successful because the top rating agencies act as a quasi-cartel, and their fees magically converged. They have each participated in overrating “AAA” structured products backed by dodgy loans that took substantial principal losses. As I will explain later, by the end of 2006 it was clear that it wasn’t merely a question of misguided technique, the rating agencies’ integrity was questionable, and “AAA” ratings were meaningless.

Moody’s and S&P (Fitch was the exception) presented a fairly united front in defending their methods up to the September 2008 financial meltdown. Fitch, which also participated in overrating CDOs, seemed more responsive in downgrading structured products, but none of the three has meaningfully addressed the serious problems I discuss next.


The Dodd-Frank Act has not yet been implemented. Even when implemented, it will miss problems it should have addressed. This portion of the report addresses what can go wrong and all that has already gone wrong with the rating agencies. Dodd-Frank identified some, but not all of these problems. Subsequent sections illustrate these problems and the consequences they caused and will cause again. Section VIII. explains what Dodd-Frank got partially correct and what needs to be corrected to plug the gaping holes in the legislation and restore credibility to the rating agencies and the alternative banking system.

A. Rating Scales Are Self-Defined: Benchmarks and Methodologies Change Arbitrarily

Rating agencies define their own risk scales. (APPENDIX VII.) In other words, there is no independent, authoritative, or consistent definition of ratings benchmarks. Methodologies and models change at will. Global banking regulators and insurance company regulators have defined regulations and capital requirements that refer to these insubstantial ratings. An unintended consequence of the changeable ratings is rating agencies that were not elected and are not part of government have the ability to legislate by changing the meaning of their ratings.

Moody’s awards a rating based on its estimate of expected loss, a single piece of information, and assigns a rating based on the safest (least expected loss) to the riskiest (highest expected loss): Aaa, Aa1, Aa2, Aa3, A1, A2, A3, Baa1, Baa2, Baa3, Ba1, Ba2, Ba3, B1, B2, B3, Caa1, Caa2, Caa3, Ca, C. Anything above Baa3 is considered investment grade, and anything below that is considered speculative grade. Standard & Poor’s awards ratings based on default probabilities and labels products AAA, AA+, AA, AA–, and so on. Fitch uses the same labels as S&P. As with Moody’s, anything above BBB– is considered investment grade and anything below is considered speculative grade. I’ll use “AAA” to denote the highest rating, but will specifically name Moody’s, which uses the “Aaa” notation, when I am making a point specific to Moody’s.

“Super Senior” tranches are what I called “the greatest triumph of illusion in twentieth century finance,” in my 2003 book on CDOs. I asked where the regulators were, since this fantasy would lead to bitter disillusionment for investors. Supposedly, former “AAAs” were subordinated to this tranche. In other words, the “AAA” tranche became the “first loss” tranche for the so-called super senior. There was no standard definition for this tranche, and when I specifically asked Moody’s for the definition in 2002, it abdicated responsibility for coming up with one. I pointed out the former “AAA” was not the same as the new “AAA” that had become the “first loss” for the “super senior.” Yet the label was identical. One market definition for “super senior” was that the probability of loss was 10-6, meaning there was a one in a million chance of the investor taking the loss. Nothing could have been further from the truth. Some investors in late vintage “super senior” CDOs (2006-2007) lost all but a small single digit percentage of their initial investment. (APPENDIX VIII.)

Even the BIS bought into the “super senior” nonsense and awarded lower regulatory capital requirements for it. In 2002, I spoke to the head of market risk at the Chicago Fed about the problem and he dismissed it saying efficient markets meant the problem would be resolved in 18 months. How did that work out? In 2003, I wrote Jaimie Caruana, then head of the BIS, but received no response.

At the beginning of 2005 I wrote an article for Risk Professional rating the rating agencies. Moody’s claims its ratings reflect expected loss, a mathematical concept based on the probability of default and loss severity. Moody’s occasionally changes the expected loss that corresponds to a given rating. S&P emphasizes probability of default, and occasionally changes the probability of default level that corresponds to its ratings. Fitch’s model produced unreliable results, since Fitch kept changing its correlation matrix. Structurers using Fitch’s model dubbed it the “Fitch Random Ratings Model.”

There is tremendous moral hazard built into this system. The rating agencies enjoy extraordinary power. There is enormous incentive to fudge over serious mistakes. If an investment grade rated securitized asset shows increasing default rates in the asset portfolio, a rating agency might be tempted to change the definition of a rating rather than confront the inaccuracy of the rating, given that regulators and markets make decisions that are ratings-driven. Moreover, in order to gain market share, rating agencies may change their definitions and methodologies to win business from banks.

Since many money managers cannot buy bonds that are not rated investment grade, and since some are required to sell bonds that fall below investment grade, ratings have a huge impact. This is why when Moody’s admitted that impairment rates show no difference in performance between CDO tranches with a junk rating of BB– and an investment grade rating of BBB, it should have been headline financial news in mainstream financial newspapers, but it wasn’t. That problem was later swamped by misrated “AAA” structured products that were in reality non-investment grade junk.

It would seem logical that rating agencies ratings could be mapped onto each other, but they cannot. One would think that rating agencies would at least be internally consistent, but that isn’t necessarily so, especially when it comes to securitizations.

 B. Rating Agencies’ Excuses for Heterogeneous, Multi-year Failures

The rating agencies’ problems run deep. In late 2003, the Financial Times took rating agencies to task for misrating debt issued by scandal-ridden Parmalat, Enron and WorldCom. Fitch protested that “credit ratings bring greater transparency.” Standard & Poor’s retorted that “rating agencies are not auditors or investigators and are not empowered or able to unearth fraud.”

I responded to rating agencies’ protests. There was ample evidence that investors were misled if they believed rating agencies provided greater transparency for structured financial products. Investors relying on ratings to indicate structured products’ performance were consistently disappointed in a variety of securitizations. S&P provided a timely example after it downgraded Hollywood Funding’s deals backed by movie receipts from “AAA” (the highest credit rating possible meant to be safe from loss of principal) to BB (a noninvestment grade, i.e., junk rating, meaning principal is at risk and the investment is not suitable for investors expecting reasonable safety).

Bond insurers raised fraud as a defense against payment, and S&P had thought payment was unconditional. In other words, S&P had a fundamental misunderstanding about the primary character of the risk. If S&P read the documents at all, then it lacked the competence and expertise to understand the meaning of the documents.

By this time, the rating agencies had morphed into a cartel of sorts. They competed for market share and raced each other’s “standards” to the bottom. This wasn’t merely a failure of the rating agencies, however, it was a clear failure of regulators, since a loud alarm was already blaring from a series of similar rating “mishaps.” Rating agency failures were manifest in the rating of securitizations of manufactured housing loans, metals receivables, furniture receivables, subprime mortgage loans, and more.

When rating agencies make mistakes in securitizations backed by debt, the losses tend to be permanent and unfixable. The sole source of income is the portfolio of assets. When they repeatedly fail to understand the risk of the underlying assets—as they have done over several years for a variety of securitizations—they blow the entire job.


The Commercial Financial Services’ (CFS) debacle provides a stunning early example of the rating agencies’ incompetence. Rating agencies downgraded around $2 billion in securitizations backed by charged-off credit card receivables managed by Commercial Financial Services from investment grade to junk overnight.

Court cases involving alleged fraud at Commercial Financial Services were litigated for years in the U.S. courts. Facts were reported in the mainstream financial press and become public knowledge, yet regulators took no steps to correct problems with the rating agencies.

The proceedings of the public criminal trial of CFS’s former head, Bill Bartmann (United States of America v. William R. Bartmann), after which he was acquitted, gives insight into the flawed processes of the rating agencies, their cozy relationships with securitization professionals, and the failure of their regulators. Yet all involved were free to make the same mistakes in future asset-backed securitizations, particularly in the subprime mortgage market.

All of the top three rating agencies, Moody’s, Standard & Poor’s, and Fitch overrated CFS’s asset backed securitizations. (Duff & Phelps Credit Rating Co. rated CFS’s transactions and is now a part of Fitch. Fitch IBCA also rated CFS’s securitizations.) Only Moody’s declined to rate CFS’s later transactions, but it did not withdraw rating on deals it had already rated. All three rating agencies gave investment grade ratings to securitizations that merited a junk rating.

A. Underwriter Hired Analysts Who Rated the Deals

Underwriters hire employees of the rating agencies, and this can be a conflict of interest for rating agency employees. In this example, I focus on S&P. Chase Securities, lead underwriter for CFS, hired analysts from Standard & Poor’s familiar with its methodology to work on CFS’s securitizations. In fact, he was hired for his “expertise,” yet he later testified that he did not use his statistics training in his work. One of the analysts had special knowledge of S&P’s approach to evaluating CFS’s securitizations. He testified that he either authored the S&P credit memo or had close involvement with S&P’s credit memo that was passed on to Chase Securities.

The collateral for the securitizations, charged-off credit card receivables, were illiquid assets, and there were no publicly available prices. The only transactions were private and involved CFS and a handful of other participants. The ultimate value of the assets was projected based on an untested model and CFS’s representations of their ability to collect cash flows in the form of lump sum settlements or payments on “performing” loans in static pools of loans.

B. Rating Agencies Relied on Biased Proxy Data and Ignored Statistical Principles

S&P relied on data supplied by CFS, even though CFS had little experience with charged-off credit card receivables and claimed to have developed a proprietary model that was untested over time. Since a long period of historical data on charged-off credit card receivables was not available, CFS used data on unsecured consumer loans on which it had collected. Testimony by the Chase employee that formerly worked at S&P and testimony by an S&P employee revealed that CFS’s data did not include loans on which CFS was unsuccessful in achieving collections.

Among the weakness of this analysis were two key problems with the data:

  • Unsecured consumer loans were only a proxy for credit card receivables. The loan types had similarities, but also had important differences. The correlation between the payoff behaviors was unknown, and
  • S&P did not verify how the loans were chosen as data. They did not verify whether the loans had been chosen randomly. This wasn’t a representative sample of what might happen with charged-off credit card receivables, since it was reasonable to expect that CFS would not be able to collect on some of those loans. By including only loans on which collections occurred, the data was biased.

C. Rating Agencies Ignored Statistical Principles and Red Flags for Three Years

In his testimony, the former S&P employee said that he did not use his statistics training in his work regarding CFS, even when hired in Chase Securities’ research area with a dotted line reporting relationship to the Managing Director and Group Head of Asset Backed Origination and asked to draft a memo on this topic to his new boss.

S&P and Chase Securities became comfortable with CFS’s model, not because it was accurate, not because the results correlated with actual charged-off credit card collection data, not because it correlated with even the unsecured consumer loan data provided by CFS, but because it consistently produced results that made the loans used as collateral in the securities appear much better than CFS’s biased collection data provided on unsecured consumer loans.

D. Rating Agencies Ignored an Audit and “A Classic Situation for Fraud”

Yet there was nothing that verified the accuracy of the model’s results. S&P and Chase Securities did not verify the utility of the data provided by CFS and did not make sure the data was unbiased. A later audit report of the collectability of the loans revealed that CFS’s representations of the collectability of the loans were grossly inaccurate, yet this report was ignored.

The model results were arbitrary. As part of its ongoing due diligence – and in particular due to a senior Chase credit officer’s concerns that CFS presented “a classic situation for fraud,” Chase Securities failed to validate the model at the outset or at any other time in its relationship with CFS, and S&P failed to ask for any validation.

These problems occurred throughout a three year period, yet Chase Securities and the rating agencies did not uncover problems or publicly reveal red flags, of which there were many. Only Moody’s withdrew from rating further securities after CFS evolved to a new structure, but Moody’s did not downgrade securities it had already rated. Instead, issues became public due to the charity of a stranger. In the early fall of 1998, the rating agencies received an anonymous letter concerning the cash flows of the securitizations issued by CFS. The letter alleged that about 20 percent of cash collections on assets for the securitizations came from asset sales, even though the securitizations were supposed to be static pools from which only assets on which collections were zero or not cost effective could be sold. Furthermore, the sales were made to a newly incorporated company and the officers of the company were unknown.

On October 21, 1998, Duff & Phelps Credit Rating Co. (DCR) downgraded CFS’s securitizations six notches from single A to BB—from solidly investment grade to well below investment grade. DCR cited CFS’s reliance on sales of the securitizations’ assets to make payments due to investors. A couple of days later, Fitch IBCA lowered the rating of CFS’s securitized transactions to CC, 10 notches below investment grade. It claimed it relied on CFS’s representations that assets sales did not represent a significant amount of monthly collections, yet Fitch IBCA had apparently done no independent investigation of sales of which it was already aware. Moody’s and S&P also downgraded the transactions below investment grade. Shortly thereafter, all of the rating agencies stopped rating CFS’s securitizations.

On December 11, 1998, CFS filed for bankruptcy protection in the U.S. Bankruptcy Court for the Northern District of Oklahoma after its unsecured creditors threatened to file an involuntary bankruptcy petition. Jay L. Jones, then an executive officer of CFS and owner of the mysterious company that bought loans at inflated prices from CFS, pleaded guilty to a single count of conspiracy as part of a plea agreement in exchange for testimony against Bartmann, who was later acquitted. Jones was eventually convicted, sentenced to five years in prison for his role, and was released in January 2007. In a separate lawsuit, Chase Securities settled out of court for an undisclosed amount.

While rating agencies may not be responsible for performing due diligence, they need to see evidence of appropriate due diligence in order to rely on data used to perform a fundamental statistical analysis. As circumstances change and a growing stream of red flags are revealed, due diligence standards become more stringent. The fundamental bases for value in CDOs are the value of the underlying assets and the cash flow. The timing, frequency, magnitude, and probability of receipt of the cash flows are affected by a variety of factors. Just as in any financial transaction, common sense, checks on the character of securitization managers, and one’s ability to grasp the fundamentals of what is happening with the cash flows are key. Yet, time and again, rating agencies fail to follow fundamental principles of statistical analysis and make the same mistakes.


Securitizations are not the only area where rating agencies doled out phony “AAA” ratings. Ratings on leveraged synthetic credit products are often misleading. A recent example is the “AAA” rating achieved by products like the constant proportion debt obligation (CPDO), which is largely a leveraged bet on the credit quality and market spreads of indexes based on U.S. and European investment-grade companies. Besides credit risk, there is a substantial amount of financial engineering risk. Potential losses are due to defaults or market value changes (when spreads widen). The high leverage puts investors’ principal at risk, since it acts as first-loss protection on the leveraged exposure to the indexes.

A. CPDOs: Phony “AAA” Ratings for New Structured Credit Products

Constant Proportion Debt Obligations appeared on the market in 2006. I immediately flagged CPDOs as deserving a non-investment grade, i.e., junk rating. Yet, Moody’s and S&P awarded CPDOs “AAA” ratings. These leveraged bets on the credit quality and market spreads of indexes based on U.S. and European investment-grade companies put investors’ principal at significant risk.

Investors essentially took the risk of the first losses on leveraged exposure to the indexes, and there was no margin of safety. Scenario analysis revealed the flaws. I told the Financial Times in November 2006, “rating agencies have proved that when it comes to some structured credit products, a rating is meaningless. All AAAs are not created equal, and this is a prime example.”

The rating agencies careless enabling of this product through phony “AAA” ratings had an important side effect. U.S. pension funds found that the distortions in the market created by CPDOs caused them to lose money on both their investments and their hedges.

After rating an early CPDO transaction “Aaa,” Moody’s was criticized by industry professionals, including me. Moody’s then changed its rating methodology applying a different standard for subsequent transactions. Investors were attracted by the “Aaa” rating and the high coupons. The investment banks selling them were attracted to upfront fees of 1 percent plus annual servicing fees of up to 0.1 percent.

In May 2007, the Financial Times reported that Moody’s original “Aaa” ratings for CPDO were the result of a computer “bug,” and the ratings should have been (according to Moody’s) four notches lower.

It is difficult to tell whether Moody’s was taking half-measures to try to cover for its previously indefensible position, or whether it is really that flat out incompetent. In any case, four notches was inadequate, since that still left CPDOs with an investment grade rating. In February 2007, I had already written the SEC (and copied officers of all three rating agencies) that CPDOs had substantial principal risk, i.e., CPDOs merited junk ratings, and this was soon proved correct.

B. Moody’s Is Exposed Having Changed CPDO Rating Methodology

Moody’s documents showed that after it corrected the “bug,” it changed its methodology resulting in the ratings staying “Aaa” until January 2008, when credit spreads moved and proved the original ratings were ludicrous. The CPDOs were then downgraded several notches. As previously noted, even this was inadequate. Moody’s seemed to be floundering.

The part about Moody’s changing its methodology was not news to me. I had included that information in the letter to the SEC on proposed regulations in February 2007. I do not recall who told me about the change. If it was a secret, it was an open secret. All three rating agencies’ models have more patches than Microsoft software.

C. Moody’s: Both Methodology and Integrity Were Questionable

Moody’s “Aaa” rating seemed to be due to something more than a serious disagreement with my opinion. Moody’s internal memo said that the bug’s impact had been reduced after “improvements in the model.” This suggests that there may be a cause and effect. The initial reality of inconvenient lower ratings may have been covered up by the methodology change.

D. CPDO Investors Lost Most of Their Principal on New “Aaa” Rated Products

By January 2008, just under a year after my written comments to the SEC, Moody’s analysts wrote that two of the originally “Aaa” rated CPDOs would unwind and investors would lose approximately 90 percent of their principal.” The irony is that Moody’s is the rating agency that claims its “Aaa” rating is based on expected loss.

E. Standard & Poor’s Also Claimed a Model Error and Defended Its Unsound Methodology

Standard & Poor’s had also rated CPDOs “AAA.” In fact, it was the first to do so, and Moody’s later followed suit. S&P vigorously defended its ratings methodology, even after it downgraded CPDOs. S&P later disclosed that it too found an error in its computer models, but said: “This error did not result in a ratings change.”

S&P claimed its error was caught and remedied by its ratings process. Yet S&P’s ratings process didn’t catch the fact that the “AAA” products were incompetently rated at the outset when in fact the products deserved a junk rating.

In other words, S&P admitted to a model error while defending an unsound methodology. Its methods were in fact so unsound it initially awarded the “AAA” rating (as did Moody’s, so one should again question the “independence” of the rating agencies), admitted to a model error while temporarily defending an indefensible rating, and within a few months experienced the public humiliation of high principal losses on what was now obviously a product that merited a junk rating from the beginning.


In a repeat of the failings of previous debacles such as the previously noted CFS scandal, and despite examples of fraud and misconduct in mortgage loan origination revealed in the FAMCO and Ameriquest scandals, the rating agencies once again failed to live up to a reasonable professional standard in rating hundreds of billions of securities backed by mortgages, all of the products derived from them, all of the entities that issued them, and the entities that invested in them.

Although the subprime crisis has been a euphemism for the financial meltdown, various other financial products were overrated. Banks that created them and held them in inventory were also overrated. Banks that engaged in leveraged structured credit transactions and credit derivatives—all the major banks—were overrated. Sovereigns that these banks called home were also overrated.

The following examples focus on the problems of misrated mortgage backed securities or multi-sector CDOs that included mortgaged backed securities, since the housing market is such a large part of the U.S. economy and the implosion of these products affected banks, monoline insurers, insurance companies, pension funds, individual retirement accounts, mutual funds, and foreign investors.

The financial implosion of 2008 was not a “black swan” event or an unforeseeable problem. The following examples are not meant to be comprehensive or cover every institution in every category. Rather, I offer examples that typify preventable events and the ongoing failure of regulators to reign in the instigators of the collapse. The banks that ran the alternative banking system played a starring role while the rating agencies played a key supporting role.

A. Misrated From the Start: RMBSs, CDOs, CDO-Squared

Banks gave corrupt mortgage lenders with unsustainable business models large credit lines (similar to credit card debt) and packaged the loans into overrated private-label Residential Mortgage Backed Securities (RMBS). (APPENDIX II.) Most of the RMBS was rated “AAA,” since subordinated investors absorbed the risk of a pre-agreed amount of loan losses. But many RMBSs were backed by portfolios comprising risky fraud-riddled loans. Moreover, portfolios of mortgage loans often included loans for which the representations and warranties were breached. Most of the “AAA” investment was imperiled, and subordinated (lower rated) “investment grade” components were worthless. As mortgage lenders failed, new investors had to be found to pay off old investors i.e., mortgage lenders and the banks that funded them. When the business model became unsustainable, it devolved into a Ponzi scheme. (See APPENDIX III.)

The worst of the subprime loans were among the cohort originated from the end of 2004 through 2007, and these entities were primarily funded through credit lines and private label securitizations engineered by Wall Street banks including JPMorgan Chase, Citigroup, Bank of America, Merrill Lynch (now part of Bank of America), Lehman Brothers (now bankrupt), Morgan Stanley (now a bank that can borrow from the Fed), Goldman Sachs (now a bank that can borrow from the Fed), Bear Stearns (now a part of JPMorgan Chase), and others.

The rating agencies misrated Collateralized Debt Obligations (CDOs) that were re-securitizations of tranches of RMBSs. (APPENDICES IV. and V.) These so-called CDOs of Asset Backed Securities (CDOs of ABS), often used credit derivatives technology to transfer risk in a way that amplified risk to investors. These CDOs of ABS were often “multi-sector” deals and assets included not only misrated tranches of RMBSs but misrated tranches of other asset backed securities including student loans, auto loans, credit card receivables, consumer loans, and other tranches of misrated CDOs (which had other misrated CDO tranches in their asset portfolios). (APPENDIX IX.)

These errors compound when tranches of securitizations with flawed ratings are used as collateral in other CDOs. From the start “AAA”-rated tranches of these deals showed a high probability of significant principal loss. A product called CDO-squared included the mezzanine (middle-risk but still investment grade) tranches of misrated CDOs (which had other misrated CDO tranches in their asset portfolios) that were virtually worthless. The result was that “AAA” tranches of CDOs had enormous risk of principal loss at creation and merited non-investment grade, i.e., junk ratings.

The problem was magnified further when hedge funds applied leverage to these products, virtually guaranteeing eventual disaster. Flawed products purchased at par with the use of leverage are on a one-way trip down net asset value’s slippery slope. Yet rating agencies handed out “AAA” ratings on vehicles like structured investment vehicle “lites,” also known as SIV-lites. These vehicles employed short-term financing on long-dated assets that had flawed ratings. Structured Investment Vehicles (SIVs) and Asset Backed Commercial Paper Conduits (ABCP) were created to further temporarily offload “highly rated” tranches of CDOs. Real Estate Mortgage Investment Conduits (REMICs and Re-REMICs) were plagued with similar problematic ratings as RMBS and CDO products.

B. Credit Derivatives: Documentation Risk Not Captured By Ratings

Credit derivatives allowed the multiplication of risk. A fraud-riddled loan could be used over-and-over again in deal-after-deal, since the physical asset did not need to be part of the portfolio. The same was true of tranches of securitizations backed by fraud riddled loans. Instead, it was referenced as a “notional” asset. The notional risk could be transferred more than once. This seemed to happen only with the worst loans and worst tranches. Some RMBSs and CDOs were built to fail. This was very convenient for short sellers.

Credit derivatives and total return swaps added “financial engineering” risk to securitizations, and this risk was not captured by the ratings. These over-the-counter products at times included “documentation risk” detrimental to the investor.

C. 2006 Onward: Tail End of a Ponzi Scheme

HSBC took a $6 billion subprime write-off for the fourth quarter of 2006. None of the U.S. banks followed suit, although they should have. Many (including me) publicly challenged the failure to account for losses. By 2007, there was no excuse for the rating agencies, the SEC, and the banks that brought corrupt deals to market.

Instead, toxic securitization accelerated in the first half of 2007—classic malfeasance as a Ponzi scheme collapses. I projected hundreds of billions in principal losses for mortgage loans alone—not counting other troubled asset classes, derivative duplication, and leverage

By 2006, to keep what had now devolved into a Ponzi scheme going, more loans and securitizations were required. This is the classic end play of a Ponzi scheme. (APPENDIX III.) Lending standards plummeted and fraud by mortgage lenders accelerated to attract more borrowers. Collapsing mortgage lenders paid high dividends to shareholders (old investors) and interest on credit lines to Wall Street (old investors) with money raised from new investors in built-to-fail CDOs. New money allowed Wall Street to temporarily hide losses and pay enormous bonuses.

While this business at first may not have appeared to be Ponzi scheme, it crossed the breakeven point and the cover-ups began prior to 2007. By the end of 2006, public reports of implosions of large mortgage lenders eliminated CEOs’ and rating agencies’ plausible deniability, albeit problems were manifest well before then.

In August 2007, I explained to the Wall Street Journal, which reported the matter, that AIG had materially mismarked a more than $19 billion “super senior” credit default swap position that it was required to mark-to-market (market prices determine value). AIG said it would never experience a loss and took no accounting loss whatsoever. AIG’s market price loss was already material, and the underlying CDOs would soon have substantial principal loss (leading to losses for AIG) on just this one position alone. It also had other problematic positions on its balance sheet. A few months later auditors said AIG showed material weakness in its accounting. By September 2008, AIG was bailed out unjustly enriching its credit default swap and securities lending counterparties, including Goldman Sachs. Henry Paulson was CEO of Goldman at the time the problematic trades were put on, and he was Treasury Secretary with influence over the AIG bailout that enriched Goldman Sachs without conducting an investigation.

This is particularly poignant, because under Hank Paulson’s leadership, Goldman Sachs Alternative Mortgage Products, or GSAMP, was alleged to have created Garbage Sold At Mythical Prices. A complaint of alleged fraud on the part of Goldman Sachs detailed its close relationships with troubled mortgage lenders, Countrywide, New Century, and Fremont. A complaint showed Goldman knew of “an accelerating meltdown for subprime lenders such as New Century and Fremont.” Despite known serious loan problems, Goldman continued to securitize the loans and sell them in packages of residential mortgage backed securities.

An RMBS known as GSAMP-2006 S3 was among $494 million of securities bought by institutional investors in April 2006 and was created and distributed by Goldman Sachs Alternative Mortgage Products (GSAMP). Fortune’s Allan Sloan and Doris Burke followed the deal as its value slid ever downward as well as the fudgy way the deal’s deteriorating value seemed to be overstated by the trustee’s report. “Defaults and rating downgrades began almost immediately. In July 2008, the last piece of the issue originally rated below AAA defaulted — it stopped making interest payments. Now every month’s report by the issue’s trustee, Deutsche Bank, shows that the old AAAs — now rated D by S&P and Ca by Moody’s [junk ratings] — continue to rot out…[by the end of October] only $79.6 million of mortgages were left, supporting $159.9 million of bonds…But even worse, those mortgages aren’t worth anything like their $79.6 million of face value… the remaining bonds are worth maybe 10% of face value.”

D. Raters’ Role in Violation of Securities Laws: “Investment Grade Rated” Was Junk

Note that if you take a mezzanine (investment grade but lower rated than “AAA”) tranche of GSAMP’s previously mentioned RMBS, at the outset it has little value. In other words, “assets” such as these with “solid investment grade ratings” are nearly worthless junk. Yet mezzanine tranches such as these were routinely securitized into CDOs without disclosure that the rating labels were at the outset materially misleading.

The Congressional subprime probe revealed that due diligence reports such as those provided by Clayton Holdings Inc. showed grave problems with the original loans, yet these reports were either ignored or suppressed and this material information was not disclosed in deal documents when securities were sold.

Securities laws chiefly apply to financiers (the underwriters and traders) that create, sell, and trade securities. Underwriters are responsible for appropriate due diligence, an investigation into the risks. If you know or should know that investments are overrated and overpriced when they are sold, those facts must be specifically disclosed. Even sophisticated investors can be victims of fraud if they performed adequate due diligence and difficult-to-uncover material facts were withheld.

Rating agencies cannot competently rate securities without someone performing due diligence on the underlying collateral, and raters have to thoroughly examine it. Multi-year problems in the mortgage loan market combined with risky new products and lower underwriting standards were waving red flags. Although the rating agencies are not responsible for performing due diligence, under any professional standard they are required to review evidence of appropriate due diligence, and the bar for the definition of “appropriate” becomes higher in the face of more red flags.

In other words, it appears the rating agencies’ enabled the sale of mislabeled securities either through willful negligence or technical incompetence. Either way, the rating agencies do not merit the NRSRO designation.

E. Merrill Lynch’s Example of Ponzi Finance

Merrill Lynch was a part owner of California-based Ownit Mortgage Solutions. Ownit made second-lien mortgages, issued 45-year ARMs, and originated no-income-verification loans. In the words of William D. Dallas, its founder and CEO: “The market is paying me to do a no-income-verification loan more than it is paying me to do the full documentation loans.”

Michael Blum, Merrill Lynch’s head of global asset-backed finance sat on Ownit’s board. Neither Ownit nor Merrill can claim the relationship was arm’s length. Revenue was up around 33% in the first three quarters of 2006, but Ownit was losing money. In November of 2006, JPMorgan Chase told Ownit that its $500 million credit line would disappear on December 13. Ownit went bankrupt at the end of December 2006.

When Ownit imploded, Blum faxed in his resignation to Ownit’s Board of Directors. In this post Sarbanes-Oxley world, one might have expected Blum to insist on a thorough audit of Ownit instead of faxing in his resignation, particularly since Merrill didn’t stop securitizing Ownit’s loans. For example, Merrill brought an RMBS to market in early 2007 that included Ownit’s piggyback loans (second liens). Around 70 percent of the borrowers had not provided full documentation of either their income or assets, and most borrowers had a 100% loan to value ratio, meaning the mortgage balance was at least as great as the value of the property being mortgaged. At the time, home prices were weak and falling.

The deal’s documents omitted the fact that Merrill was Ownit’s largest creditor. In early 2008, the “AAA” tranche was downgraded to junk. Moody’s forecast that the original portfolio could lose around 60 percent of its value. In other words, the permanent value destruction of principal would be around 60 percent. Bond Fund of America was among the burned investors.

Instead of halting securitization activity to review loans, Merrill accelerated CDO activity in the first half of 2007. That was just a few months before private label mortgage securitization ground to halt in the U.S. JPMorgan, Ownit’s credit line provider, was no better, even if its CDO volume was lower than many other banks. For example, it is being sued for a deal called “Squared” brought to market in May 2007.

CDOs were often offloaded on naïve investors. Funds in Europe and the United States—including local government run funds—often find they did not understand the risks of complex structured financial products they own, because they relied on the “AAA” ratings for guidance. These Main Street government investors have no choice but to cut costs, aggressively go after back taxes, and—if the problem is bad enough—raise taxes. Main Street’s list of investors that feel burned is long and growing.

For example, the Springfield (Massachusetts) Finance Control Board alleged that Merrill Lynch & Co. sold it “AAA” rated CDO products backed by subprime debt without fully disclosing the risk. State law limits Springfield’s investments to government securities and short-term liquid investments. Regarding Springfield, I told the Wall Street Journal: “Merrill has to know its customers and sell them what’s suitable and appropriate. These CDOs are not.”

There is often a difference between an investor with a lot of money to manage and a sophisticated investor. That is why many compliance departments at investment banks ask that brokers and institutional salespeople to “know your customer.” Investments must be “suitable and appropriate” for investors. The idea is to sell complex products to investors that have the ability to understand and analyze the risk.

Springfield Finance Control Board was fortunate that its troubles received publicity. The “AAA” rated tranches were overrated and at the outset merited a “junk” rating. The three CDOs that Springfield originally purchased for $13.9 million in the summer of 2007 were valued by Merrill at around $1.2 million by January 2008. In the wake of negative publicity, Merrill repurchased the CDOs for the full amount of $13.9 million.

F. Merrill Lynch: Signs of A Classic Control Fraud

Through a variety of tricks and gimmicks, Merrill tried to hide risk that couldn’t be offloaded on unwary investors in a desperate game to avoid taking substantial accounting write downs in the first half of 2007. This presents all the earmarks of a classic control fraud. I reviewed all 30 of Merrill’s ABS CDOs brought to market in 2007 representing a notional amount of $32 billion. Without exception, all of them presented a classic situation for fraud. By June 10, 2008, all 30 had one or more “AAA” tranches downgraded to junk by one or more rating agencies. (APPENDIX X.)

Among the CDOs were multi-sector CDOs with a lot of mezzanine CDOs from other failing deals. When Merrill couldn’t find investors, it stuffed junk into new CDOs to hid losses by creating an artificial “bid” and covering the problematic tranches with phony investment grade ratings on new tranches. Merrill also issued CDO-squared products. One example is a CDO-squared called Durant issued in June 2007. Its portfolio consisted almost entirely of credit default swaps referencing mezzanine tranches of other very problematic CDOs with a couple of mezzanine CLO tranches and subprime home equity loan tranches thrown in. This entire CDO was a piece of junk right from the start. I am not just making these comments today, I made them publicly and ongoing before these phony deals came to market. Six months later, in January 2008, Durant was in liquidation. (APPENDICES X. and XI.)

Rating agencies and the SEC had no excuse for allowing deals like this to come to market (or appear to come to market, since Merrill also retained a lot of cynically repackaged and misrated risk, another characteristic of control fraud), particularly in 2007 when it was obvious mortgage lenders were imploding. In an article for Risk Professional (then called GARP Risk Review) at the beginning of 2007, I specifically mentioned Merrill’s securitization activity and that risk managers should get out before they become scapegoats. These problems were known, but by allowing securitization activity like this to continue, the rating agencies and the SEC enabled a cover-up of accounting losses through the issuance of phony securitizations.

G. Monoline Insurers

Throughout 2006-2008, the situation of the financial guarantors was much more desperate than the ratings reflected. The largest U.S. municipal bond insurers (called monolines even though they dabbled in other areas), Ambac and MBIA were still rated “AAA” in January 2008. The rating agencies expressed concern, but they performed ludicrous stress tests using insufficient default scenarios and recovery values that were much too high. I released a rebuttal. On the basis of projected loan losses alone, monolines were undercapitalized and did not merit an “AAA” rating. Although the insurance companies and the rating agencies denied it at the time, it was clear they would experience significant principal losses.

Once again, I was at odds with the slow response time and artificially high ratings of the rating agencies. As I noted in my report at the time, the situation was much worse than losses due to the fraud riddled loans. The CDOs also had stunning financial engineering risk. The monolines had insured CDOs and some late vintage multi-sector CDOs that were particularly ugly. MBIA had insured some of Merrill’s 2007 CDOs. The deals had enormous “cliff” risk from near worthless collateral used in the original portfolios. The rating agencies seemed to ignore this or perhaps they didn’t understand it.

APPENDIX XII shows problematic CDOs insured by Ambac and MBIA, the largest bond insurers—but not the only bond insures to implode after being misrated—and lists the underwriters and so-called managers of those deals. The deals are shown to be contemporaneous with my challenge of the rating agencies’ analysis. Based on their public statements, the rating agencies seemed incompetent. There is a possibility that they understood the problem and lied to prevent a public panic, but if so, they were very good at covering up any hidden expertise. Ambac and MBIA subsequently imploded. Ambac and MBIA later negotiated discounted settlements for many of these CDOs and some of the deals are in the midst of legal disputes.

H. Rating Agencies’ Misrepresentations Throughout 2007 and Beyond

In the face of trenchant criticism, the rating agencies continued to make excuses for their poor performance, saying the overwhelming majority of ratings actions (downgrades and declarations of events of default) had been directed at the weakest-quality subprime securities. They pointed out that few “AAA” tranches had been downgraded (by them).

The rating agencies claimed that “AAA” tranches were unlikely to experience a loss. This was laughable misdirection by the rating agencies. SIV-lite debt (SIV-lites invested in “AAA” CDOs) was subsequently downgraded to CCC from “AAA” almost overnight. “AAA”s from CPDOs, ABCP, CDOs, and CDO-Squareds, were downgraded to junk.

The rating agencies’ assertion at the time that it doesn’t matter much if only BBB-rated and lower tranches are downgraded was also misdirection. In the past, when BBB and below tranches were downgraded, “AAA” tranches were not downgraded because the deals were usually older deals and the higher-rated tranches were largely amortized with only a small principal balance remaining. There was very little risk to the higher-rated tranches. But many of the subprime-backed deals that had been downgraded were recent 2006–2007 vintages. More than 300 tranches of these new securitizations were placed on downgrade or negative watch by the rating agencies. No reasonable financial professional accepted that the “AAA” tranches of such deals were as creditworthy as the previous “AAA” tranches of non-mortgage and non-leveraged loan deals in which the lower tranches had not been downgraded.

If this were not bad enough, liquidity dried up due to oversupply of misrated product and too little demand for hard-to-value securities. The market not only penalized CDOs with wider credit spreads to account for the greater credit risk, but also penalized these tranches for their opacity. Prices decoupled from fundamental value causing even further price drops. The rating agencies assert that the entire price drop was due to lack of demand and illiquidity, but the cause of the lack of demand was the fact that many structured products were incorrectly rated at creation.

In other words, either through intention or incompetence the rating agencies lied in the sense that they made false statements that had grave consequences for investors and the global financial markets.


Sovereigns that bailed out banks are saddled with much greater government debt than before the crisis. In the spring of 2007, the Fed and the U.K.’s FSA reported that the degree of leverage in the global financial system was less than at the time of Long Term Capital Management, but in reality it was much greater. Global regulators are now repeating their mistakes. The risks in the interconnected global banking system have moved to currency trading and currency derivatives (remember the contribution of knock-in options to the 1995 currency crisis), leveraged loans, credit derivatives, market-linked derivatives, speculation in commodities, and both foreign and domestic government debt. Winston Churchill said we must alert somnolent authority to novel dangers; but our regulators are complacent, and the dangers are not novel.

With respect to the recent crisis, highly leveraged fixed income assets posed perils to the global banking system. When excessive leverage is combined with fixed income assets acquired at par, there is extreme risk. If the assets decline in value and liquidity becomes tight, it can cause a vicious cycle of selling that feeds on itself. If one combines that with foreign currency risk, one adds to the potential pain. If that is further accompanied by a price reduction that is due to a permanent or at least sustained price decline in underlying assets, it is virtually impossible for an undercapitalized overleveraged entity to recover from even a temporary liquidity shock. If a country cannot quickly refinance (roll financing), the collapse is quick and brutal. This isn’t a new discovery, this is simply a fact.

The structured component of international finance is so influential that the failure of the rating agencies to competently rate structured financial products—and their overall incompetence with derivatives—means that their sovereign ratings are largely meaningless. The various issues with Portugal, Ireland, Italy, Greece and Spain (the PIIGS) are beyond the scope of this report, but the rating agencies, already at sea, seem to be somewhat influenced by politics as downgrades lagged and in some cases continue to lag reality. The result is that ratings adjustments come long after the need for a downgrade is obvious. To be clear, this has nothing to do with the theory of efficient markets. The rating agencies seem to flounder and arrive late to the party.

Banks that engaged in leveraged borrowing and that trade derivatives including currency derivatives, credit derivatives, commodity derivatives, and interest rate derivatives are not within the ability of the rating agencies to competently rate. Since Governments’ and Central Banks’ finances are intimately tied with the global banking system, the rating agencies do not competently rate sovereign debt.

A. Sovereign Rating Example: Iceland’s “Aaa”

Moody’s misguided “Aaa” ratings were not limited to securitizations. In 2007, financial professionals derided Iceland’s inflated “Aaa” rating due to the risk posed by excessive leverage and excessive borrowing in foreign currencies. A cult YouTube video, apparently out of Bombay, India in 2007 mocked Moody’s and its “Aaa” Iceland rating. It was widely circulated among financial professionals.

Moody’s tried to temper its decision in a January 2008 report: “Iceland’s Aaa Ratings at a Crossroads.” It wrote: “Iceland enjoys high per capita incomes, well-developed political, economic and social institutions, favorable demographics and a fully-funded public pension system…Its government debt ratio is less than half the average of the Eurozone member countries.” Moody’s did all it could to rationalize its decision to maintain the “Aaa” rating.

As was true of many of Moody’s “Aaa” ratings, it was forced to give up the game. In October 2008, Iceland temporarily suspended stock trading and seized Kaupthing, the country’s largest bank, as its banking system collapsed and plunged the country into bankruptcy. Iceland’s external debt was around $70 billion at current exchange rates (then €50 billion) or around $218,000 for each of its 320,000 citizens.

B. United States: “AAA” in Label Only

The financial debacle was enabled by a classic control fraud within our largest banks. Wall Street’s huge bonus payments were based on suspect accounting, and bankers continue to seek those rewards by ramping up risk within the banks. Many banks’ current illusion of profitability is currently only made possible by taxpayers’ enormous subsidies including low cost borrowing, higher interest payments on bank capital deposits, a credit line for the FDIC (to be repaid with banks’ subsidized profits), and continued government debt guarantees on bank debt. A large share of certain banks’ tax-subsidized profits is due as reparation to unsophisticated investors, the U.S. taxpayers. While the Fed prints money, it seeks to keep short-term interest rates artificially low, essentially robbing investors who earn such low interest rates on “safe” investments, that after inflation, they are earning negative real returns.

The Fed uses tax dollars to keep some of our largest banks—weakened by reverse-Glass-Steagall mergers with troubled entities—from collapsing under heavy loan losses. U.S. taxpayers became unwilling unsophisticated investors funding Wall Street’s bailout.

In the wake of the global financial crisis, Bloomberg estimated that by March 21, 2009, pledges by the Federal Reserve, Treasury Department, Federal Deposit Insurance Corporation topped $12.8 trillion. The U.S. GDP was $14.2 trillion. At the time the pledges represented more than $42,000 for every man, woman and child in the U.S.

Massive hiding-in-plain-sight fraud damaged the U.S. economy. Housing prices didn’t just fall; they plummeted as the fraud unraveled. By the end of 2010, four million home loans were more than 50% underwater with an average of $107,000 negative equity; this alone is around $428 billion in negative equity. 7.8 million loans were 25% or more underwater. Most of these damaged borrowers were paying higher interest rates than the national average, couldn’t refinance, and were ineligible for HAMP, a government initiated refinancing program.

Securitized assets were dumped on the balance sheets of the Fed (and the Fed supplied near zero cost funding to plug holes in bank balance sheets and special government guarantees on bank debt), special purpose entities set up by the Fed, Fannie Mae, Freddie Mac, and the FHA (through government guarantees). Government guarantees allowed for new issuance of securitized mortgage loans that otherwise would have no buyers, since the rating agencies are widely mistrusted.

The effect of existing government entitlements and obligations combined with expanding bank debt, flawed loans, flawed securitizations, and leverage significantly weakened the U.S. economy stunting growth as money was diverted to the banks and away from capital spending, the biggest driver of any economy.

The damage of financial malfeasance was so extensive and the protocol of the bailout so profligate that the “AAA” rating of the United States has been rendered an incorrect but politically expedient label. The U.S. issues its debt in dollars, and if necessary can engage in a silent default by devaluing the U.S. dollar. To some extent, that has already happened.

The U.S. dollar is still the world’s reserve currency. It is also an “intervention” currency, and an “invoice” currency for much international trade. Central banks hold dollars as a reserve, and private agents hold dollar denominated investments. So far, the U.S. has the most well developed short-term financial markets, so when there is a “flight to quality,” which these days means the lessor of other evils, foreigners rush to liquid financial instruments like T-Bills.

Unlike the Yuan, the U.S. dollar is freely exchangeable in most of the world. The U.S. buys its major imports such as oil in dollars. But change is already in process. Iran has said it will accept Yuan for oil. There is talk of oil prices being expressed in a basket of currencies that will include gold. Gold is already being accepted as collateral on derivatives exchanges, and in this sense, gold is now recognized again as money for trading purposes.

The problem for the U.S. is that despite the temporary advantages, the world is diversifying into other currencies, including gold. The Yen and Deutsche Mark (before the Euro) were the former candidates for diversification. Future candidates may be the Yuan and perhaps a new Euro (if Germany prevails in getting its way). That will push up the value of those currencies and push down the value of the dollar.

Even if this doesn’t happen right away, the U.S. is in a weakened state and it is not immune to shocks. Recall the 1973 oil embargo, for example. Oil prices quadrupled overnight and the dollar fell from 350 yen to 250 and from 3.25 Swiss francs to 1.80. Two hour moves eclipsed the previous two decades. Then there was the 1995 U.S. dollar crisis brought about by the “tequila effect” when one of our debtors, Mexico, neared default and had to be bailed out.

When foreigners lose confidence in the United States, they don’t suddenly sell all of their assets or pull out all of their money (although some of that does happen), the immediate effect is a fast fall in the dollar. The Fed has compensated for the explosion in new debt by purchasing government bonds, but this strategy may not be sustainable, and if not, there may be a swift rise in interest rates.

The current “AAA” rating of the United States is not on merit, but it is a convenient fiction for the global financial markets, because no one yet has an alternative. It would be more accurate to say that the United States remains investment grade, because of our current role in the infrastructure of the global economy. Whether or not the rating agencies put an explicit downgrade on the United States is largely irrelevant. The United States has seen huge U.S. dollar fluctuations and higher interest rates in the past, and on its current course will see them again. The fundamentals of the U.S.’s increasing debt load, massive future entitlements, high unemployment rate, and weak economy with no meaningful growth plan speak for themselves.


The U.S. based rating agencies, Moody’s and S&P are subject to Congressional legislation and ostensibly regulated by the SEC. The Dodd-Frank Act attempted to address issues with the rating agencies, and it made several good suggestions, but missed key problems. Japan has a set of rules for the rating agencies, and Europe is developing a separate set of rules. Ratings are used globally, and it seems rating companies should be regulated by an international body.

A. Create Objective Benchmarks and Rating Scale: Revoke the Raters’ Ability to Legislate

Neither U.S. nor European regulators address the problem of rating agencies’ ability to make up their benchmarks and rating scales and change them at will. The discussion below has been further developed from the work of Dr. Arturo Cifuentes, a former Moody’s rating methodology developer, and Jose Miguel Cruz in their “White Paper on Rating Agency Reform,” issued from the department of industrial engineering at the University of Chile in May, 2010.

Moody’s and S&P each have a nine category scale with 21 notches. (See III. A. And APPENDIX VII. Note that “D” is not counted in the nine category scale, since it denotes default.) There is no reason to consider the ratings as having equivalent meanings. Moody’s and S&P base their scales on different concepts, expected loss and probability of default, respectively. The rating agencies employ different computational methods and different models. They each use their own data sets.

It is more than a little interesting to note, that the ratings are often similar, even when they are egregiously wrong, and even though they supposedly employ different theoretical frameworks. For example, both Moody’s and S&P awarded “AAA” ratings to CPDOs, a product developed in late 2006 that merited a non-investment grade rating, i.e., a junk rating and quickly fell apart. (See Section V.) It begs the question of whether the rating agencies are actually independent or whether they are being consistent with each other to maximize revenues.

Solution: A third party (the SEC, for example, unless it is replaced as the regulator, and it should be) should define the benchmarks and the rating scale. The rating agencies would no longer be free to choose benchmarks and effectively redefine the meaning of ratings. Rating agencies would only be entitled to issue ratings, i.e., determine where the creditworthiness fits in relative to the pre-defined benchmarks that correspond to the rating scale.

If a combination of levels of probability of default and loss given default (from which recovery value is determined) is used to create a rating scale—an appealing prospect—then two supplementary rating scales are in order. One scale would reflect the probability of default and one scale would show the loss given default.

Said another way, the ratings scale and the cutoffs would be objective and the same cutoffs and scales would be used by all rating agencies. The rating agencies would have no ability to change the cut-off values.

Implementation would require some global buy-in, and a comment period of say, three months, from stakeholders. Legacy ratings would be mapped to the new scale with the proviso that the mapping might be flawed due both to the flaws inherent in the original ratings process, and the fact that the theoretical approaches were originally different.

B. Solution: Eliminate “Mezzanine “AAA” Tranches and “Super Senior” Tranches

Neither U.S. nor European regulators address the problem of “first loss AAA” tranches and “super senior” tranches. Many “AAA” tranches had insufficient subordination to ever merit that rating based on the quality of the assets in reference portfolios. But even solving the problem of quality of assets in the portfolio does not solve the conceptual problem of “super seniors” being somehow superior to what was formerly a genuine “AAA.” The definition of “super senior” and the benchmark requirements to merit the designation were left undefined by the entire industry.

Super seniors were meant to be super safe, and even BIS enabled them by awarding favorable regulatory capital treatment to them to accommodate banks. In fact, “super seniors” are a gimmick created to achieve favorable regulatory capital treatment.

Not only did “super seniors” make a mockery of the “AAA” label, they did not live up to their name. Many investors in “super seniors” lost almost all of their initial investment when they invested in late vintage CDOs. Investment banks and banks that retained “super seniors” on their balance sheets and “insured” them to try to obtain income via a flawed regulatory capital and economic “arbitrage” ended up with heavy losses. (See also Section III. A. and APPENDIX VIII.)

C. Focus Is On Wrong Metrics with Uninformed Guesses as Model Inputs

Neither U.S. nor European regulators address the rating agencies’ apparent incompetence. For example, the heavy reliance on correlation models is the wrong way to go about determining whether any benchmark meets the requirement of a rating when the most important metrics are probability of default and loss given default (or said another way, recovery value in the event of default). It would have been more productive to spend all of the time and effort determining probability of default and recovery value and none of it on correlation.

In fact, the exercise of understanding the granular risk well enough to determine probability of default and recovery value gives one a much better understanding of correlation and how correlation among assets changes and converges under different scenarios. Once one understands that, one is keen to abandon the unstable correlation metric in favor of the granular approach. This may be part of the reason my analyses prove superior to the rating agencies time and again. Another reason may be conflicts of interest within the rating agencies themselves. Revenues were more important than ratings accuracy. (See Section VIII. E.)

Rating agencies adapted the Gaussian Copula model and black box correlation models for structured financial products. Correlation models try to determine if a portfolio’s assets will behave similarly when a reference asset strengthens or weakens. The models are highly unstable. They are like a chair that collapses beneath you as soon as you sit on it. Small changes to model inputs result in huge changes to the results. (See article following the letter in Appendix I.)

If you play with coins or dice, you know exactly what your inputs are and you can model all potential outcomes. You can examine the coins (heads or tails per coin), and you can model all of the possible outcomes. You can examine dice (one to six dots on each face of each cube), and again, a mathematical model can describe all potential outcomes. We may use a Monte Carlo model (or other model) to randomize the inputs (the flips and tosses), but we do not have to guess at the inputs for dice and cards; they are known in advance and the relationship between the inputs does not change.

Unlike cards and dice, the inputs to credit models are not exact representations of reality, they are estimates of variables. The inputs to credit models are a guess, but they should be educated guesses—not the complete stabs in the dark used by the rating agencies.

We rely on data approximations to come up with the inputs in the first place, and the relationships between the inputs can change. For example, most of the data describing how one corporation behaves in relationship to another is based on market prices such as stock prices or the prices of credit default swaps based on corporate debt. Moreover, there is very little of this already suspect data to work with. The results are guesses about relative price or yield spread movements, which result in a guess about the correlations. When a credit upset occurs in a financial sector, correlations that were previously fractional numbers tend to converge to one. Everything seems to fall apart at once. A model will calculate the wrong answer to nine decimal places, but it cannot tell you it is the wrong answer.

The biggest problem with correlation models is that even if they temporarily get the correct answer, they do not tell you what you need to know. The models estimate asset correlations instead of the necessary default correlations. Furthermore, the overwhelming flaw in the methodology is that if you want to make up a default correlation between two companies, you must make the false assumption that default probability does not vary, but of course it does.

Even if the models measured the default probability of individual companies—and they do not—if a company defaults, you still have to guess the recovery rate, the amount left over, if any, after all obligations are paid.

You cannot solve for two independent items of information from a single piece of information such as a letter grade or a price. You cannot get both the probability that a company will default and the amount of money you will have left if it does default.

Solution: Modelers must understand the granular credit risks in a portfolio. There is nothing wrong with employing a shortcut like a correlation model (even though there are better techniques), but a correlation model is not a substitute for examining due diligence to understand the character of the granular risk in a portfolio. For example, new risky mortgage loan products with corrupt underwriting standards failed in the same way no matter where they were located, and recovery values were much lower than the assumptions used by the rating agencies. This was knowable in advance. Mortgage loan originators had a known history of fraud. (Examples include FAMCO, Ameriquest, manufactured housing loan originators.) Yet in the recent debacle, rating agencies’ correlation assumptions were grossly incorrect at the outset.

D. Rating Agencies Must Review Evidence of Underwriters’ Due Diligence

Both the Dodd-Frank Act and proposals by European regulators call for more transparency about underlying collateral, but don’t hold rating agencies explicitly accountable for demanding thorough due diligence from underwriters, especially in the face of red flags that suggest third party fraud audits may be in order. A fraud audit doesn’t mean anyone is being accused of fraud, only that the audit will be thorough enough to uncover it if it exists. In the case of mortgage lenders and the underwriters themselves, one would have found the reports of Clayton Holdings that suggested that the securitizations created by underwriters were invalid as many loans representations and warranties had been breached, and the documentation of loan transfers seemed missing. Beyond that, the credit quality of the loans was so poor that the ratings were invalid.

The rating agencies are swift to point out that they do not perform due diligence on the data they use and take no responsibility for unearthing fraud; they merely provide an opinion. In past legal battles, rating agencies successfully claimed journalist-like privileges, refused to turn over notes of their analyses, and continued to issue opinions. Independent organizations exist, however, that perform rigorous due diligence for a fee. Underwriters can hire them, and rating agencies can demand to see the results. These reports include loan reviews, and audits ranging in thoroughness from a cursory review to a fraud audit depending on the circumstances.

The consequences of the unwholesome mix of lax underwriting standards and new risky loan products combined with varying degrees of overreaching, predatory lending, real estate speculation and outright fraud, were discoverable with reasonable due diligence. The egregious overrating of securitized products was completely preventable in the course of competent analysis.

The rating agencies could have—and should have—asked issuers and investment bank underwriters to demonstrate that they had performed a statistical sampling and verification of underlying loans in the proposed portfolios. This includes independent checks of appraisals, checks that mortgages have not been mis-sold, background checks of mortgage brokers, background checks on mortgage lenders, background checks of CDO managers, verification that the homeowner can cope with the reset when a “teaser” period comes to an end, and income verification on “stated” income loans.

The rating agencies underestimated default probabilities, underestimated loss given default, and overly relied on historical data when assigning ratings. In a repeat of past mistakes, the basis of the analysis was flawed, and the amount of protection required to award the various ratings was insufficient at the outset.

Solution: This requires a multi-part solution. Rating agencies may need an upgrade in the caliber of the people they hire, particularly since they’ve gotten probability of default and loss given default incorrect even on a granular basis (Enron and other granular risks). The Dodd-Frank Act calls for more transparency of the data and the criteria used by the rating agencies. That is a good idea, but as stated before, there should be third-party criteria for the benchmarks (the cutoffs) and the rating scale that corresponds to those benchmarks. A further step is to redirect the focus of the rating agencies from correlation to probability of default and loss given default.

E. Rating Accuracy Should Be the Only Measurement of Success

Neither the Dodd-Frank Act nor the European regulators clearly address the problem of conflicts of interest within the rating agencies. Dodd-Frank asks for two independent members in the administrative and supervisory board whose compensation isn’t linked to rating agencies’ results, presumably revenue targets. Agencies should focus on ratings issuance and not simultaneously provide advisory or consultancy services. The rules nebulously call for employees with knowledge and experience. The rules also call for staff turnover to avoid employees getting too close to entities they rate.

The problem with this approach is the rating agencies will claim they already do all of the above. They will insist their people have the correct knowledge and experience. The key problem, however, is that business managers with revenue and market share targets sacrificed ratings accuracy. There were no consequences for this behavior. The rating “agencies” are companies, and shareholders like to see revenue growth.

The awarding of so much power to the rating agencies created a welfare state of ongoing fees. Even today, there is rating shopping for products like Re-Remics. This indicates how ineffective the regulators have been and how ineffective the proposed rules will be in future.

It’s time to make the goal and the measurement clear. The rating agencies are private companies owned by shareholders and management will therefore always push for ways to increase revenue in order to get higher compensation. Regulators can counter this by insisting on only one measurement of success. Rating accuracy can be the only measurement of success.

Using rating accuracy as a measurement of success, Moody’s, S&P, and Fitch, the top three rating agencies, have all been failures. The NRSRO designation is completely unwarranted, and this is why I’ve revoked it. Beyond that, regulators should consider disqualifying rating companies from issuing any ratings whatsoever if there is a repeat of past “mistakes.”

Solution: The consequence of making rating accuracy the only metric of success is that rating agencies/companies will have an incentive to purge management and withhold bonus compensation from managers that are not capable of producing accurate ratings for fear of losing the right to issue any ratings at all.

Regulators can rate the rating agencies on the basis of accuracy and put companies on probation, meaning the companies can lose the right to issue any ratings. Whether or not regulators choose to take this step, the NRSRO doesn’t apply to any of the existing rating agencies, and in order to win that designation—which is above and beyond the previously mentioned ability to issue ratings—the rating agencies must demonstrate that they have completely overhauled methods and can produce accurate ratings.

F. Conflicts of Interest: Chinese Wall Is Needed

Within the rating agencies, analysts often report to business managers interested in building market share and revenues whether or not it comes at the expense of ratings accuracy. There is no “Chinese Wall” to protect ratings analysts from business managers whose bonuses depend on increasing revenues and market share.

Solution: Since the rating agencies are private companies, they can choose their own system of compensation. Maximizing revenues at the expense of rating accuracy is contrary to public interest. Raters should be shielded from marketing managers and corporate management, and their compensation should be based solely on rating accuracy. See also the solution for Section E.

G. Conflicts of Interest: Joint Ventures

Rating agencies market risk consulting and models to banks and investors. At times, rating agencies have engaged in joint ventures with banks. For example, S&P entered into a joint venture with Bank of America Securities in the spring of 2003 to market Bank of America’s Lighthouse model. Bank of America Securities and S&P used the model to determine credit option adjusted spreads (OAS) and ratings analysis for credit portfolios. BAS’s senior manager wrote an email to his staff lauding the benefits of the joint venture with S&P: “This could be a significant development for us and give us entre into a lot of accounts in both Europe and US that we might not have by coordinating with S&P… If we handle this the right way, it could be a powerful tool, especially to clients below our radar screen or outside our reach internationally that S&P might have influence over.” BAS described a very cozy—and potentially very lucrative—relationship.

Solution: The Dodd-Frank Act and the European regulators recognize this as a problem and recommend this type of consulting should not be simultaneous with ratings issuance, but they don’t go far enough. This sort of consulting business should be spun off. The stakes are so high for the rating “agencies” that if rating companies want to participate as raters in the global financial markets, they should have a single focus.

H. Conflicts of Interest: Banks and Rated Entities Hiring Raters’ Employees

Banks often hire rating agency analysts for their connections and influence within the agencies. There have been cases in which analysts hopeful of employment at a bank rated that bank’s securitizations created and sold for a given issuer/sponsor and later worked on securitizations of the same issuer/sponsor once employed by the bank. This poses another type of conflict of interest for the rating agencies. Analysts are tempted to be accommodating. (See Section IV. for the Commercial Financial Services’s example.)

Solution: The Dodd-Frank Act asks for not-yet-created rules to adopt an employee look-back so that rating agencies can review ratings when an employee seeks or obtains employment with an entity that is subject to a credit rating. This is a good idea. A better idea is to ask if the incentives within the rating agencies and the lure of potentially lucrative jobs outside rating agencies resulted in collusion between rating agencies and banks to egregiously misrate securities at the outset, since that was the ratings result. The tough question was avoided in favor of a not-yet-defined rule. Another part of this solution should be to prohibit employees for accepting such employment for a period of two years, especially since remaining rating agency employees that engage in the look-back review are still subject to the same conflicts of interest that inspired the look-back review.

I. Mistaken Idea: Rating Agencies Design Securities

For all of their mistakes, the rating agencies have been unfairly characterized as having been the architect or co-architect of asset backed securitizations. While it is true that rating agencies were often over-accommodating to underwriters, they don’t design transactions by giving excessive guidance to bankers. Any project that requires approvals will have give-and-take in order to see the task to completion. The contribution of the dialogue between rating agencies and bankers to our current crisis has been blown out of proportion. That may serve the interests of banks that want to deflect attention from their failures in their duties as underwriters—not to mention their failure to comply with securities laws—but it does not help to define or solve the real problems.

Solution: See Section E.

J. A Mistaken Idea On Fees, and the Real Fee Issue

Bankers raise capital by selling the bonds and equity investments that result from a securitization of assets. A small portion of the capital is earmarked to pay the law firms, rating agencies, accountants, administrators, trustees, banks’ structured finance professionals, banks’ salespeople and traders, and so on. The idea that bankers pay rating agencies a rating fee thus creating a conflict of interest is a mistaken area of focus. In fact, proceeds from the investors from whom the capital is raised are paying the rating agencies’ fees. If investors in a deal agree they want an unrated deal, they can forego the rating altogether, albeit that is not practical for institutional investors whose charters or regulators require rated products. If one wants to use the argument that receiving pay from proceeds creates a conflict of interest, then one must apply it to the lawyers, accountants and any other professional not directly employed by the underwriter.

While it is a concern, this issue has been blown way out of proportion. It would be more accurate to say that in the pressure to gain market share and increase revenues, rating agencies deliberately lowered standards to win business any way they could. This would likely have been a problem even if investors paid them directly.

Solution: Both the Dodd-Frank Act and the European Regulators got the solution even when they didn’t correctly define the problem. Most of the rating agencies’ fees from a securitization are paid as a large upfront fee with a small ongoing maintenance fee until the securitization either unwinds or matures. If rating agencies’ fees are paid over time, their interests would be better aligned with investors.

The rules should go a step further. It would also be a pious idea to make fees contingent upon the accuracy of the ratings for investment grade rated notes. One could achieve this by subordinating rating agencies’ realigned ongoing fee payments to the payments to the investment grade rated note investors.

The further issue is the compensation of the management of the rating agencies. Again, making ratings accuracy the only measurement of success (from a regulatory point of view) and ranking and disqualifying rating agencies from being eligible to issue ratings whatsoever would be an effective incentive to realign priorities within the rating agencies. Irrespective of the previous comments, I revoke the NRSRO designation—which is separate from the ability to issue ratings—of all the rating agencies.

K. Ban Credit Derivatives and Total Return Swaps in Rated Structured Financial Products

Neither the Dodd-Frank Act nor European regulators tackle this issue head on. Credit derivatives technology was used to reference the worst credits more than once in more than one securitization. Total return swaps were also employed in some CDOs. All of these transactions are over-the-counter (OTC) meaning these derivatives are not transparent and do not trade on exchanges. Buried within the documentation are numerous ways to stuff hidden risks into the portfolio. This discussion is beyond the scope of this report, but rating agencies have proved themselves inadequate to the task of unpacking these risks and putting a sensible rating on securitizations that include these risks.

In fact, many “experts” in credit derivatives have been caught off guard by hidden risks. There have been many private disputes about the meaning of the language in over-the-counter documentation. Making the documents public on a web site may provide more disclosure, but that isn’t the same thing as transparency.

Solution: Ban the use of credit derivatives and total return swaps in rated structured finance transactions.

L. Other Derivatives in Rated Structured Financial Products

Neither the Dodd-Frank Act nor European regulators deal with raters’ ability to cope with derivatives. Based on my past interaction with the rating agencies, they do not have sufficient competence in foreign exchange derivatives (and quantoed deals), commodity derivatives, or interest rate derivatives to award credit ratings to deals that include the risk presented by the derivatives, even when the derivatives are labeled as “hedges.”

Solution: See Section E.

M. “Managed” Deals

Neither the Dodd-Frank Act nor European regulators address this. In the CDO debacle, most of the deals were “managed.” There is evidence that deal managers had a variety of unacceptable issues including but not limited to 1) shady backgrounds that were discoverable in the course of normal due diligence, 2) close ties with banks that underwrote deals and a dependence on those banks for fee revenue, 3) conflicts of interest with CDO investors and other funds managed by the “manager.” Some of these managers were fly-by-night operations that went bankrupt or are now effectively without any business.

Partial Solution: Background checks are a partial solution, but the reality is that when a manager has a conflict of interest with the CDO investor, it has never turned out well for investors, and ratings have proved meaningless. There are ways of putting “handcuffs” on managers by writing trading rules into the documents, yet even these rules can be thwarted.

N. An Observation: “Agencies” are Companies; Shareholders Cannot Govern Rating Agencies

Neither the Dodd-Frank Act nor European regulators address this. The rating agencies are shareholder owned entities and are in the unusual position of having enormous power, which they’ve perverted and abused. They can at will change the definition and methodology for their ratings and thus the capital reserved by several financial entities. By getting the ratings so risibly wrong on investment grade products, they’ve enabled a global financial meltdown.

Warren Buffett, CEO of Berkshire Hathaway, has sometimes said that shareholders must demand changes to limit compensation and excesses of company officers, but he himself did no such thing when it came to Berkshire Hathaway’s investment in Moody’s, at least while it raked in fees from rating structured products. At the end of 2007, after the issuance of misrated private label securitization had ground to a halt, Berkshire Hathaway still owned 48 million shares of Moody’s Corporation, the same number of shares Berkshire Hathaway owned in 2005. The shares represented just over 19 percent of Moody’s capital stock. To the best of my knowledge, at no time did Buffett interfere or attempt to positively influence the behavior of the rating agencies when it came to the misrated financial products that damaged the financial system. Yet at the time, Buffett was not completely unaware of the problem.

It’s ironic that Buffett makes no secret of the fact that he himself disregards ratings when making investment decisions. He is concerned with the ratings of Berkshire Hathaway only to the extent that other investors rely on them. Ratings affect Berkshire Hathaway’s cost of borrowing and its ability to attract insurance premiums. Buffett has recently been selling off blocks of his shares of Moody’s.

The role of the rating agencies has been so pervasive and influential that it cannot be left up to “efficient market” forces—proven to be inefficient and distorted through crony capitalism—or to shareholders to correct problems.

Solution: Regulators cannot make shareholders do anything, but they can change the incentives. (See Section E.)

O. Thwarting Dodd-Frank: Risk Retention and “Conflict of Interest” Transactions

The Dodd-Frank Act provided a reason for me to laugh out loud at a couple of sections. First, it is useful to point out that had existing securities laws been enforced, the “added” prohibitions in the Dodd-Frank Act wouldn’t be necessary. Yet regulators and Congress abdicated. The clock on the Statute of Limitations is running out for enforcement (five years for securities fraud). Denial of widespread malfeasance and fraud leads to the type of ineffective legislation evident in the Dodd-Frank Act.

In an attempt to say “We Fixed It!” the Act proposes stern sounding prohibitions that any competent structured finance professional can thwart. The first is the idea of risk retention. Congress may recall Goldman’s CEO, Lloyd Blankfein, claiming that Goldman retained the ‘first loss” risk of CDOs. I can think of several ways in which Blankfein can make that statement with a straight face, while Goldman may have had virtually no risk whatsoever.

Dodd-Frank asks for at least 5% risk retention and the position must be unhedged. In addition, the waterfall of the cash flows must be made available. I can think of several ways to thwart this rule’s intention. Here’s just one way that doesn’t even involve derivatives. As I explained in my 2003 book, one can create a CDO in which the “first loss” risk is actually safer than the “AAA” tranche of the CDO since cash flows are diverted to the “first loss” risk holder in a hidden way. I defy regulators to read the deal documentation and figure it out. So much for Dodd-Frank’s “risk retention.”

Moreover, it pays to state the blindingly obvious. The Act is relying on clever people who thwarted existing disclosure requirements, and who remain unpunished, to now follow the disclosure requirements of the Act. Good luck with that.

Solution: The goal is to prevent corrupt underwriters from selling junk as “investment grade,” and from selling junk as “AAA.” The global financial community has chosen to hide under their desks rather than confront this issue. Given this reality, it may be more effective to insist that “AAA” meets third-party global benchmarks and has a global meaning. If rating agencies cannot produce ratings that live up to that meaning, they should no longer be allowed to issue ratings.


The global market and regulatory framework has been built around credit ratings, even though savvy market professionals know better than to rely on them. Banks, hedge funds, insurance companies, pension funds, and corporations are all affected by ratings. Even the over-the-counter trading market is affected by ratings. Collateral requirements for swap counterparties are just one example of a ratings driven requirement. Banks have different capital reserve requirements depending on the ratings of assets. Insurance companies, pension funds, and mutual funds all have ratings requirements in their regulations or charters. Ratings driven regulations have been adopted globally, albeit regulations vary by venue.

Yet there is global distrust of the rating agencies. Congress and the SEC have not faced up to the key problems. The Dodd-Frank legislation in the United States illustrates Congress’s poor grasp of many of the issues and its inability—or unwillingness—to address them. Rating agencies have not been held accountable for past poor performance. The possibility of malfeasance or collusion with fraud has been skirted rather than addressed.

The Dodd-Frank Act proposes that financial regulations eliminate references to credit ratings for stock brokerages and money funds, but this has not yet been implemented. Likewise, banking regulators are pushing back on Dodd-Frank and asking for rewrites; in other words, they are stalling. The mistake in the Dodd-Frank Act is that there is no reliable globally recognized system with which to replace ratings as an indication of credit risk. Banks, insurance companies, pension funds, mutual funds, and other investors should do their own credit assessments, but the reality is they relied on rating agencies, and they continue to look to them for guidance.

Until there is an objective reproducible and reliable method of providing credit ratings to securitizations, it will be impossible to rehabilitate the alternative banking system. If one is to wean the global financial system off of government guaranteed debt, there has to be a viable means of agreeing on creditworthiness.

The top rating agencies, Moody’s and S&P, have a multi-year history of failure in rating some granular corporate credit risks and have a spectacular history of failure in rating heterogeneous structured credit products and securitizations. In particular, in rating securitizations, they have not followed statistical principles by any reasonable professional standard. None of the other rating agencies show evidence of filling this role, and would have to qualify in order to credibly rate these products. For this reason, I’ve revoked the Nationally Recognized Statistical Rating Organization (NRSRO) designation for all of the rating agencies for all but corporations that do not engage in a major way in structured financial products.

Just because the problem of creating a viable global credit rating system is difficult doesn’t mean it shouldn’t be done. In fact, it is precisely because it is difficult that there is a great need to thoroughly address the issue. The rating “agencies” are actually corporations, and they are domiciled in different countries. Nonetheless, an international regulator can determine which of these corporations will eventually earn the NRSRO designation. Meanwhile, it can determine which rating agencies will be allowed to continue to issue ratings, albeit without the NRSRO designation.

In revoking the NRSRO designation, I’m making the statement that I’m better qualified to opine on this than Congress or the SEC, since this is a matter of reasonable professional standards in following statistical principles. The top rating agencies, the one’s most relevant to the global financial community, do not meet the standard. The “Nationally Recognized Statistical Rating Organization” label cannot be legislated or awarded by regulators when it is demonstrably false any more than they can enact legislation to make the sun move around the earth.

The solution is to raise one or more rating agencies up to standard to merit the NRSRO label. Meanwhile, rating agencies can continue to issue ratings but must commit to coming up to standard. Those that cannot should have the privilege of issuing ratings completely revoked. The second part of the solution is to develop global third party benchmarks and global third party rating scales and make accurate ratings the only measurement of success.

Structured Finance and Collateralized Debt Obligations by Janet Tavakoli
Fifty Years in Wall Street by Henry Clews. Foreword by Janet Tavakoli. Part One of Two.

See more books by Janet Tavakoli.

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