Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [64]
Moody’s documents showed that after it corrected the “bug,” it changed its methodology, resulting in the ratings staying AAA until January 2008, when the market fell apart and the original ratings seemed ludicrous.The CPDOs were downgraded several notches.
The part about Moody’s changing its methodology was not news to me. I had included that information in a letter to the SEC on proposed regulations in February 2007, and I specifically objected to the AAA rating on this product. I do not even 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.
The news is that the 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.”13 This suggests that there may be a cause and effect—the inconvenient lower ratings may have been masked by the methodology change. Chairman of the House Financial Services Committee, Barney Frank, said: “Moody’s alleged conduct in this matter raises questions not only about its competence, but more importantly its integrity.”14
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 at an approximate 90 percent loss to investors.”15 The CPDOs were projected to have a 90 percent loss from the rating agency that claims its AAA rating is based on expected loss.
Standard & Poor’s had also rated CPDOs AAA. In fact, it was the first to do so, and Moody’s followed suit. S&P vigorously defended their ratings methodology, even after it downgraded CPDOs. In the wake of the negative news, it put Moody’s commercial paper on credit watch. 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 and was caught and remedied by our ratings process.”16 Now we all feel better.
In February 2007, Bear Stearns research analyst Gyan Sinha wrote a report encouraging investors to take a long position in the ABX.HE.06-2 BBB- index (an index based on the value of BBB- rated residential mortgage-backed securities backed by subprime home equity loans).17 Simultaneously, I wrote a letter to the SEC recommending it revoke the NRSRO designation for the credit rating agencies with respect to structured financial products, asserting “ratings are based on smoke and mirrors.”18
On February 20, 2007, Gyan Sinha appeared on CNBC with Susan Bies, a Fed governor who had recently tendered her resignation. Bies thought it could take a year or two for housing inventory to be worked out, and housing had further to fall. She was concerned that hidden inventory was high, houses built for investors were vacant, and the numbers did not reflect the problem. She was surprised that subprime mortgages originated in 2006 had gone bad so quickly. It usually took a couple of years for loan delinquencies and defaults to peak, but 2006 vintage loans were delinquent in just a few months. It seemed to her that loans were made that never should have been made. She echoed Warren Buffett’s 2002 complaint about mortgage lenders in the manufactured housing market.
Gyan Sinha agreed with Susan Bies’s assertion that subprime delinquencies could reach 20 percent or a bit higher. He too was concerned about the early delinquency trends, but said that based on his research, at 6 to 7 percent cumulative losses, only 1 of the 20 residential mortgage-backed securities in the ABX index would experience a write-down. Furthermore, he stressed that 75 percent of the capital structure of a CDO is AAA rated.19
It seemed to me Sinha only had part of the story. He did not mention that ersatz AAA rated tranches did not deserve that rating, or that