All the Devils Are Here [71]
Structured financial products needed more than just a rating, though. They needed a high rating. The whole purpose of an asset-backed security was to take assets that could never merit a triple-A rating on their own and transform them into products safe enough to be rated that highly. Triple-A securities could be bought by investors like money market funds and pension funds. They could be used by banks to reduce capital requirements. The combination of tranching—with its cascading levels of risk that used the riskier tranches in the capital structure to protect the higher-rated tranches—and the other credit enhancement techniques that fortified the triple-As made that possible.
The rating agencies had always been stingy about bestowing triple-A status on corporate debt. In 2007, for instance, only six companies had a triple-A rating. Yet when it came to tranches of mortgage-backed securities, the rating agencies handed out triple-As like candy. Literally tens of thousands of mortgage-backed tranches were rated triple-A.
In the early years, the securities performed well. That was true even of the relatively small batch of asset-backed securities that used subprime mortgages. They had plenty of credit enhancements, and besides, housing prices were going up, the way they were “supposed” to, which kept defaults to a minimum. But the rating agencies continued to slap their triple-As on subprime securities even as the underwriting deteriorated—and as the housing boom turned into an outright bubble, waiting to burst. When it did burst, the rating agencies, and the investors who had depended on them, were caught flat-footed.
There were many reasons why the rating agencies continued to grant triple-As long after they should have stopped: an erosion of standards, a willful suspension of skepticism, a hunger for big fees and market share, and an inability to stand up to Wall Street. Not least, Moody’s and the other rating agencies turned their backs on their own integrity. “The story of the crisis,” says a former Moody’s executive, “is how Moody’s put its profits ahead of what was right.”
After an internal meeting held in the fall of 2007, as the financial crisis was gaining steam, a Moody’s employee complained that he would like more “candor” about the company’s “errors,” as he called them. “[They] make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both.”
A little bit of both, indeed.
John Moody, the founder of Moody’s, was a muckraking journalist who in 1900 published something called Moody’s Manual of Industrial and Miscellaneous Securities. This publication, which investors took to immediately, formed the origins of Moody’s. At first, it offered statistical information about stocks. Then Moody began adding analysis, ranking stocks with letter grades. Finally, he shifted his focus from stocks to bonds. This was his eureka moment.
There has always been far less information available about bonds than stocks. Bonds don’t trade on public exchanges, and most of the information about them is held by the investment bankers and traders who are trying to sell them. Moody saw his manual as a means of leveling the playing field. As the circulation of his publication grew, others copied him. Henry Varnum Poor, who edited the American Railroad Journal, engaged his son to begin rating bonds in 1922; after a merger with Standard Statistics in 1941, the company became known as Standard & Poor’s.
The credit rating business didn’t change much until the