All the Devils Are Here [77]
“Most of the big investors—they like ratings to be scapegoats,” says Jerome Fons. “They say, ‘Oh, we do our own analysis,’ but then when things go bad—well, it’s the fault of the credit rating agencies.” Or as Clarkson later ranted to other Moody’s executives during an internal meeting in the fall of 2007, “It’s perfect to be able to blame us for everything.... By blaming us, you don’t have to blame anybody else.”
Of all the securities whose existence depended on their ability to get a triple-A rating, none would become more pervasive—or do more damage—than collateralized debt obligations, or CDOs. CDOs, which had first been invented in the late 1980s but didn’t become wildly popular until the 2000s, were a kind of asset-backed securities on steroids. A CDO is a collection of just about anything that generates yield—bank loans, junk bonds, emerging market debt, you name it. The higher the yield, the better. Just as with a typical mortgage-backed security, the rating agencies would run the CDO’s tranches through their models and declare a large percentage of them triple-A. There would also be a triple-B or triple-B-minus slice, which was called the mezzanine portion, as well as an unrated equity tranche, which got paid only after everyone else had collected their returns. One astonishing fact is that the CDO managers didn’t always have to disclose what the securities contained because those contents could change. Even more astonishing, investors didn’t seem to care. They would buy CDOs knowing only the broad outline of the loans they contained. So why were they willing to do so? Because the way they viewed it, they weren’t so much buying a security. They were buying a triple-A rating. That’s why the triple-A was so key.
Like so many of the other financial products bursting onto the scene, CDOs weren’t necessarily a bad idea. Done correctly, they could give investors broad exposure to different kinds of fixed-income assets at whatever level of risk they desired. But CDOs were fraught with risks and conflicts. Debt was being used to buy debt. CDO managers were paid a percentage of the money in the CDO, meaning they had an incentive to find stuff to buy—good, bad, or indifferent. Wall Street firms, who usually worked hand in glove with the managers, could earn hefty fees. According to one hedge fund manager who became a big investor in CDOs, as much as 40 to 50 percent of the cash flow generated by the assets in a CDO went to pay the bankers, the CDO manager, the rating agencies, and others who took out fees.
What’s more, CDOs could also give banks and Wall Street securities firms both the means and the motive to move their worst assets off their balance sheets and into a CDO instead. And since the rating agencies could be counted on to rate a big chunk of the CDO triple-A, nobody would be the wiser.
Is it a surprise to learn that just as the rating agencies had failed to sniff out Enron and WorldCom, they also drastically misjudged the first batch of CDOs? Perhaps not. Sure enough, in 2002 and 2003 the rating agencies were forced to downgrade hundreds of CDOs—in no small part because they contained the bonds of certain companies the agencies had also woefully misjudged. A handful of investors sued the CDO managers and the firms that had underwritten them. But because the CDO issuance was still small, neither the lawsuits nor the losses made headlines. For a short while, CDO volume declined.
And how did Wall Street respond? By devising a new type of CDO, one that would be backed not by corporate loans, but by mortgage-backed securities. The idea, says one person who was prominent in the CDO business, was that the original rationale for CDOs—loan diversification—had proven to be flawed. But if you bought real estate, he said, “you