All the Devils Are Here [183]
The rating agencies were in the midst of a spectacularly profitable run. “The first half of 2007 was the strongest we had in five years,” Moody’s CEO Ray McDaniel would later say; its revenues had hit $1.2 billion over that period. Why? Because the Wall Street firms could all see the handwriting on the wall. With the ABX declining and triple-A tranches faltering, the CDO business was soon going to shut down. So Wall Street raced to shove as many CDOs out the door as it could; firms like Goldman wanted to get the bad paper off their own books onto someone else’s while there was still time. In that same six-month period, from January to June 2007, CDO issuance peaked at more than $180 billion. “[B]ankers are under enormous pressure to turn their warehouses into CDO notes,” Eric Kolchinsky, the Moody’s executive in charge of rating asset-backed CDOs, wrote in an August 2007 e-mail. Amazingly, the rating agencies continued to facilitate that effort by rating large chunks of these deals triple-A.
Had the agencies noticed the increasing early payment defaults that had started in 2006? Of course. S&P and Moody’s had responded by increasing the amount of credit enhancement required to get investment-grade ratings on securities backed by subprime mortgages. But as the Senate Permanent Subcommittee on Investigations would later point out, neither agency went back to test old mortgage-backed securities or old CDOs using this new methodology. Thus, the old, flawed ratings continued to live on in portfolios all over Wall Street. Even worse, they were recycled into new synthetic CDOs, as old tranches were referenced in new securities. “Reevaluating existing RMBS securities with the revised model would likely have led to downgrades, angry issuers, and even angrier investors, so S&P didn’t do it,” said Senator Carl Levin, subcommittee chairman. Moody’s didn’t, either.
Despite the optimistic glow the rating agency put on things to the outside world, there were plenty of people internally who feared the worst. In an e-mail exchange in early September 2006 among S&P employees, Richard Koch, a director in S&P’s structured products group, cited a BusinessWeek article on the bad lending practices in option ARMs. “This is frightening. It wreaks [sic] of greed, unregulated brokers, and ‘not so prudent’ lenders... Hope our friends with large portfolios of these mortgages are preparing for the inevitable.” Six weeks later, Michael Gutierrez, another director in S&P’s structured products group, forwarded a Wall Street Journal story to several colleagues about how ever looser lending standards were leading to higher defaults. He wrote, “Pretty grim news as we suspected—note also the ‘mailing in the keys and walking away’ epidemic has begun—I think things are going to get mighty ugly next year!”
“I smell class action!” responded a colleague.
By February, S&P was having internal discussions about how to respond to the deteriorating value of mortgage-backed securities. “I talked to Tommy yesterday and he thinks that the ratings are not going to hold through 2007,” wrote Ernestine Warner, S&P’s head of global surveillance, to Peter D’Erchia, an S&P managing director. “He asked me to begin discussing taking rating actions earlier on the poor performing deals.” She continued, “I have been thinking about this for much of the night.”
On March 18, one unnamed employee at S&P sent this in an e-mail: “To give you a confidential tidbit among friends the subprime brouhaha is reaching serious levels—tomorrow morning key members of the RMBS rating division are scheduled to make a presentation to Terry McGraw CEO of McGraw-Hill Companies and his executive committee on the entire