Ratings Agencies 2007 = Equity Analysts 2000 ?

Way back in the late 1990s into the early 2000s, a previously well regarded group — stock analysts — subtly shifted the objectives of their work. Previously, they plied their skills looking for stocks their clients and trading desks could make money buying and selling.

But things change, commissions shrunk from 10 cents per share to 6 to 3 to mere half pennies today. The old business model no longer applied. What rose in its place was a new model that emphasized not the trading of equities, but the investment banking fees that accompanied IPOs. Many analysts compromised their objectivity on the altar of banking fees. This was especially true in the Internet/Technology/Telecom space.

Thus, they went from being somewhat valued allies of the investor class to the guys helping to dump the dogs into an unknowing public’s portfolios. Since then, many of this crowd has been vilified (Jack Grubman, Henry Blodgett, etc.), and the securities industry got Spitzerized to the tune of some $$1,387.5 Million dollars in fines (a deal I suspect they would do all over again if they could).

Fast forward to the early 2000s. Interest rates are at 46 year lows, and this time around, another group of shameless whores analysts are following the same playbook: The ratings agencies that gave their AAA blessings to the now defaulting alphabet soup of RMBS, CDOs, CLOs, ABX structured products that has so recently seized up the credit markets.

It was a simple case of pay-to-play to get rated. Portfolio’s Jesse Eisinger goes into the ugly details of a surprisingly familiar story:

"Moody’s and S&P dominated for decades, and their business model was straightforward: Investors bought a subscription to receive the ratings, which they used to make decisions. That changed in the 1970s, when the agencies’ opinions were deemed a “public good.” The Securities and Exchange Commission codified the agencies’ status as self-regulatory entities. The agencies also changed their business model. No longer could information so vital to the markets be available solely by subscription. Instead, companies would pay to be rated. “That was the beginning of the end,” says Rosner.

It might come as a surprise, but rating credit is a heck of a business to be in. In fact, Moody’s has been the third-most-profitable company in the S&P 500-stock index for the past five years, based on pretax margins. That’s higher than Microsoft and Google. Little wonder that Warren Buffett’s Berkshire Hathaway is the No. 1 holder of Moody’s stock.

McGraw-Hill’s most recent financial report shows that S&P has profit margins that would put it in the top 10. Fitch Ratings, owned by the French firm Fimalac, is a distant third in market share but nevertheless has an operating margin above 30 percent, about double the average for companies in the S&P 500.

In 2006, nearly $850 million, more than 40 percent of Moody’s total revenue, came from the rarefied business known as structured finance. In 1995, its revenue from such transactions was a paltry $50 million. . ."

The entire article is well worth your time to read in full.

Yes, Moody’s, S&P, and Fitch were complicit in what is slowly coming to be viewed as widespread fraud. However, there is more than enough blame for the failure of the credit markets to spread around. The ratings agencies fraudulent ratings — I won’t even bother with the word alleged — are merely the tip of the iceberg.

As much as the whores credit agencies have a large share of responsibility in this mess, do not forget to save some blame for an even greater ethically challenged industry: those clever folks who work at Wall Street’s biggest iBanks. As related by Reuter’s Patrick Rucker, it seems that Wall Street often shelved damaging subprime reports. (Sweet!) Here are the details:

"Investment banks that bundle and sell home mortgages often commissioned reports showing growing risks in sub-prime loans to less credit-worthy borrowers but did not pass on much of the information to credit rating agencies or investors, according to some of those who prepared the reports.

The mortgage consultants, known as due-diligence firms, were hired by investment banks to make sure blocks of mortgages conformed to the mortgage seller’s own standards. The studies provided a first glimpse of loan quality for ratings agencies and investors who do not normally see the full reports.

As the U.S. housing boom reached its crescendo in 2006 and investors showed a strong appetite for mortgages, lenders relaxed their underwriting standards, and millions of borrowers with poor credit records were able to obtain subprime mortgages as a result.

Default rates on many of those subprime mortgages are now rising, some borrowers face foreclosure on their homes, and investors in the mortgages face losses." (emphasis added)

At this point, we should expect to see a flurry of investigations into the rating agencies and the same slew of Wall Street firms that were involved in the last analyst scandal.   

The saving grace for Wall Street maybe (emphasis maybe) that this was less of a "systemic fraud" than the 1998-2002 scandal. They may perhaps escape by merely jettisoning these bad actors, throwing them under the bus to save their own skins. Perhaps.

We will also find out if the S.E.C. has developed the cojones to go after their own, a shortcoming sadly lacking last go round.

Finally, if the S.E.C. fumbles, we may learn if NYS Attorney General Andrew Cuomo is willing to do what his predecessor, Eliot Spitzer did: challenge Wall Street’s God given right to do anything it can regardless of consequences to earn banking fees.

I suspect the next 24 months are going to be quite intriguing . . .


UPDATE: August 15, 2007 7:15am

The WSJ also has a page 1 column on the subject: How Rating Firms’ Calls Fueled Subprime Mess >


The subprime-mortgage meltdown could— finally—end the credit-ratings racket.
Jesse Eisinger
Portfolio, August 14, 2007 (September 2007 Print Issue)

Wall Street often shelved damaging subprime reports
Patrick Rucker
Reuters, July 27, 2007
Mirror (IHT)

How Rating Firms’ Calls  Fueled Subprime Mess Benign View of Loans Helped Create Bonds, Led to More Lending
WSJ, August 15, 2007; Page A1

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  1. SINGER commented on Aug 15

    mad lawsuits….

  2. Aldous Orwell commented on Aug 15

    Mr Ritholtz,

    I read your website daily and I enjoy your satirisation of the various market players. But today, I really think that you went too far. To equate whores with credit anaylysts is very insulting to whores; and not even slightly accurate.

    Whores provide a valuable service to society and my personnal experience is that they are honest professionals. I would rather trust my money, and have done, to a whore, than to a credit analyst.

    Whereas credit analyst, plus their close relations investment analyst, stock brokers and investment bankers, are only interested money earned dishonestly. In fact the more elaborate the deceit the better. A whore provide an honest and enjoyable service.

    The trillions of dollars wasted on credit analysts and ilk would have been better spent on whores. And I might add, much more enjoyably too!!!

    So please stop this slanderous comparision of whores to credit analyst or to any of the other disgusting financial swindlers that dispoil our financial centres.

    Yours sincerly
    Aldous Oscar Orwell


    BR: My apologies to the ladies of the evening who work in the “comfort” industry . . .

  3. ari5000 commented on Aug 15

    I think it’s funny how ‘rating’ agencies are now screwing people the other way.

    Take home appraisers. They are now (this from WSJ) being very very stringent in their appraisals — obviously — so people trying to refi are discovering — suprise — their home is worth a lot less than their current mortgage and so they not only can’t extract cash, they can’t even get a better rate.

    Now that these dipwads are finally doing what they should have done all along… they’re screwing people over once again.

    I assume the new strict standards — like the banks not accepting that MBS crap as collateral is going to hurt the hedge funds in the same way — although deservedly so.

  4. Ross commented on Aug 15

    If I understand this correctly: The owner, the handicapper and the jockey were in on the fix. How did they get the horse to co- operate? Oh, now I see. The horse is just a bunch of meat with legs!

  5. SPECTRE of Deflation commented on Aug 15

    The difference being that this time around it will be the so called “smart money’ that takes it in the shorts as well. There is very little difference between the poor sap home debtor, and all the companies who believed in the various Rating Agencies prognostications. In both cases they thought you actually could spin Gold from Straw forever. Nothing lasts forever.

  6. Metroplexual commented on Aug 15

    This outcome is what we were all prognosticating at least a year ago. Even myself, a non-economist with a smattering of econ classes could see the handwriting on the wall, unlike the lenders, borrowers, and the appraisers who had lemming like behavior.

    But I have to agree with the consensus here the comparison to whores is maligning a decent and honest profession which in the US had some respect before the 1920’s. It seems ironic though that when we started stigmatizing prostitution we sarted glorifying economists. (No insult intended toward you Mr. Ritholtz) No I see thenm more as pimps.

  7. Idaho_Spud commented on Aug 15

    The markets may be disillusioned by this news, but I doubt that anyone who reads this blog regularly is.

    ps I agree with Aldous. Comparing the two professions is like comparing afterglow and bankruptcy.

  8. W.Edwards commented on Aug 15

    Speaking of iBanks, just saw the newswire where Goldman is reducing their fees on the GEO fund now taking only 10% of the profit and eliminating the 2% asset managment fee. They appear desperate for cash inflow given that today is Redemption Day! Sounds like a sucker’s bet to me!!

  9. Louis commented on Aug 15

    Barry, did you mean $1.387 Billions in fines? (vs 1,387)


    BR: Ooops! I better fix that . . . Its either $1,387.5 million, or $1.3875 billion!

  10. Rob Levinson commented on Aug 15

    Why are the buyers not to blame? What responsible and sensible portfolio manager would buy this drek? Doesn’t that person have a fiduciary responsibility to understand the assets he manages? No one purchased these securities under duress so why are the buyers not to blame? Whatever happened to “caveat emptor”?

  11. barlow commented on Aug 15

    the correct spelling is “altar”

  12. ECONOMISTA NON GRATA commented on Aug 15

    I’m sorry but I don’t agreee with you equation… However you’re on the right path. The acrual equation is more like….

    RATING AGENCIES 2007 = EQUITY ANAILYSTS 3 (cubed) 2000…!

    This is a lot worse and it will play out a lot worse.

    Best Regards,


  13. michael schumacher commented on Aug 15

    Market closes up today…after all you would’nt want to panic people into filling out those redemption papers today now would you?

    Market spoke to that yesterday…..


  14. Marcus Aurelius commented on Aug 15

    Bill Regardie, prior to the S&L debacle:

    The time to get out is when the bull shitters start believing their own bull shit.

  15. Sven commented on Aug 15

    With regard to the redemption reckoning day at hand…the actual selling to raise cash would occur between now and the end of the quarter, right?

    It’s not like all the hedge funds are going to announce the number of redemptions they received. If they received a lot of redemptions, they are just going to have continue to dump stuff until the end of the Q, no?

  16. michael schumacher commented on Aug 15

    I do not expect any announcement but I gather enough information will leak to someone who can reasonably put together a snapshot of what we could expect.

    The second answer is yes.


  17. SPECTRE of Deflation commented on Aug 15

    But I have to agree with the consensus here the comparison to whores is maligning a decent and honest profession which in the US had some respect before the 1920’s. It seems ironic though that when we started stigmatizing prostitution we sarted glorifying economists. (No insult intended toward you Mr. Ritholtz) No I see thenm more as pimps.

    Posted by: Metroplexual | Aug 15, 2007 8:48:05 AM

    I agree completely. Whores must actually work for a living, and when it’s over everyone in the transaction is happy. The Ratings Agencies can’t say that same thing.

  18. Mike commented on Aug 15

    Thornburg: “Out of our 38,000 mortgages only 58 loans are 60 days past due”

    Their stock was down by 80% and it is still trading below the book value (based on marking it to market yesterday).

    The market is trading based on irrational fear and panic, completely ignoring the fundamentals.

    The market transformation from extreme euphoria (market top) to extreme pessimism with panicky fear (market bottom) is almost complete.

  19. W.Edwards commented on Aug 15

    Re: redemptions

    Typically people wouldn’t hear about the size of redemptions taking place. Personally, I expect to hear quite a bit more this time around when the hedgies come out and say that they won’t honor those redemptions for fear of being forced to sell assets at below their “fundamental” value.

    All this talk will of course generate additional fear in a weak marketplace causing a downdraft in asset prices ultimately forcing them to sell.

  20. rappraisal commented on Aug 15

    “Take Home Appraisers…they are now being very stringent….screwing people all over again”

    To Ari5000:

    I have been in the appraisal business for over 20 years. I entered the profession because of the ethical values it encompassed as well the ability to be “independent” in my analysis. I took my role of being the only party to the transaction without self-interest. I protected the lender, as well as the buyer, with an independent opinion of value. What happened to our profession in this debacle, is too many “bad apples” were allowed into the field. The other part of the story is the mortgage brokers. If your appraisal didn’t make the deal fly, they went to another appraiser who was willing to “hit the number”. What you have now valueing property is the “good” appraisers — the bad apples have all left the party.

    BTW many appraisers who have been in the profession 10 + years and did “stick to their ethical practices” are now so disheartened by the industry they are leaving. I’ve been mulling it over myself. What was all the regulation after the S&L crises for????

  21. KP commented on Aug 15

    To Mike:


    Is that you??

  22. ari5000 commented on Aug 15

    more selling:

    Even during today’s weak rally — QIDs have been up strong — even when the QQQQs were up.

    and there’s good volume. Someone is obviously anticipating carnage…

  23. Philippe commented on Aug 15

    A revelatory example of the difficulties of being an analyst with integrity or a CEO on a marketing alley?
    The analyst may well be RIGHT The Russian information recently admitted that 1/3 of the Russian corporations were showing negative operating profits.
    All banks are not deemed to lend to the major oil and gas cies.

  24. BDG123 commented on Aug 15

    Where there is a will there is a way. Wall Street seemingly finds ways to skirt regulation or create these shell games while leaving someone else holding the bag. This time, I suspect we will all be left holding the bag. I wonder how many centuries it will take for legislators to quit accepting PAC and election money from “The Crew” and realize that those who are chosen to protect our money (banks), need to be held to a higher standard and de-regulation has no place in institutions which are meant to be protecting our wealth.

  25. Norman commented on Aug 15

    The title from one of W. C. Fields’s movies says it best:

    “You Can’t Cheat an Honest Man”

  26. Andres commented on Aug 15

    This is a classic collective action problem. Ideally, investors should be the ones paying the rating agencies rather than issuers. But how do you get them to pony up?

    That might have been true when individual investors ruled the markets. But today, it’d make a lot of sense for large institutional investors to form an independent consortium to fund independent ratings research.

    Why hasn’t this happened?

  27. SPECTRE of Deflation commented on Aug 15

    Barry, here’s another fine read concerning the Rating Agencies:

    A ratings charade?


    By Richard Tomlinson and David Evans
    Bloomberg News

    The numbers looked compelling. Buy this investment-grade CDO (collaterized debt obligation) and you’ll get a return of up to 10 percent, Credit Suisse Group said.

    That was almost 25 percent more than the average yield on a similarly rated corporate bond.

    Investors snapped up the $340.7 million CDO, a collection of securities backed by bonds, mortgages and other loans, within days of the Dec. 12, 2000, offering. The CDO buyers had assurances of its quality from the leading credit rating companies — Standard & Poor’s, Moody’s Investors Service and Fitch Group. Each blessed most of the CDO with the highest rating, AAA or Aaa.

    Investment-grade ratings on 95 percent of the securities in the CDO gave no hint of what was in the debt package — or that it might collapse. It was loaded with risky debt, from junk bonds to subprime home loans.

    During the next six years, the CDO plummeted as defaults mounted in its underlying securities. By the end of 2006, losses totaled about $125 million. The failed Credit Suisse CDO may be an omen of far worse to come in the booming market for these investments. Sales of CDOs worldwide have soared since 2004, reaching $503 billion last year, a fivefold increase in three years, according to data compiled by Morgan Stanley.

    CDO holdings have already declined in value between $18 billion and $25 billion because of falling repayment rates by subprime U.S. mortgage holders, Lehman Brothers Holdings estimated April 13. In many cases, investors don’t even know that values have dropped.

    In this secretive market, there is no easy way for investors to find out what their CDOs are worth.

    The slide of the Credit Suisse CDO points to the critical and little-understood-role played by rating companies in assessing risk and acting as de facto regulators in a market that has no official watchdogs.

    Many of the world’s CDOs are owned by banks and insurance companies, and the people who regulate those firms rely on the raters to police the CDOs.

    “As regulators, we just have to trust that rating agencies are going to monitor CDOs and find the subprime,” says Kevin Fry, chairman of the Invested Asset Working Group of the U.S. National Association of Insurance Commissioners.

    “We can’t get there. We don’t have the resources to get our arms around it.”

    The three leading rating companies, all based in New York, say that policing CDOs isn’t their job. They just offer their educated opinions, says Noel Kirnon, senior managing director at Moody’s.

    “What we’re saying is that many people have the tendency to rely on [the ratings], and we want to make sure that they don’t,” says Kirnon, whose firm commands 39 percent of the global credit-rating market by revenue.

    S&P, which controls 40 percent, asks investors in its published CDO ratings not to base any investment decision on its analyses. Fitch, which has 16 percent of the worldwide credit-rating field, says its analyses are opinions and investors shouldn’t rely on them.

    The rating companies apply disclaimers about their analyses. S&P says in small print: “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.”

    Joseph Mason, a finance professor at Philadelphia’s Drexel University and a former economist at the U.S. Treasury Department, says the ratings are undermined by the disclaimers.

    “I laugh about Moody’s and S&P disclaimers,” he says. “The ratings giveth and the disclaimer takes it away. Once you’re through with the disclaimers, you’re left with very little new information.”

    Credit raters participate

    When it comes to CDOs, rating companies do much more than give them letter grades. The raters play an integral role in putting the CDOs together in the first place.

    Banks and other financial firms typically create CDOs by wrapping together 100 or more bonds and other securities, including debt investments backed by home loans.

    Credit-rating companies help the financial firms divide the CDOs into sections known as tranches, each of which gets a separate grade, says Charles Calomiris, the Henry Kaufman professor of financial institutions at Columbia University.

    Credit raters participate in every level of packaging a CDO, says Calomiris, who has worked as a consultant for Bank of America, Citigroup, UBS and other major banks. The rating companies tell CDO assemblers how to squeeze the most profit out of the CDO by maximizing the size of the tranches with the highest ratings, he says.

    “It’s important to understand that unlike in the corporate bond market, in the securitization market, the rating agencies run the show,” Calomiris says.

    S&P charges as much as 12 basis points of the total value of a CDO issue compared with up to 4.25 basis points for rating a corporate bond, company spokesman Chris Atkins says. (A basis point is 0.01 percentage point.)

    That means S&P charges as much as $600,000 to rate a $500 million CDO. Fitch charges 7-8 basis points to rate a CDO, more than its 3-7 basis point fee to rate a bond, based on the company’s fee schedule. Moody’s doesn’t publish its pricing for any ratings.

    “CDOs are the cash cow for rating agencies. They’re clearly a gold mine,” says Frank Partnoy, a former bond trader, now a University of San Diego law professor and author of a book on the financial markets.

    That euphoria has blinded investors — and the rating companies — to the true risk of CDOs, Partnoy says.

    The subprime connection

    As homebuyers and investors grapple with the subprime-mortgage crisis, many haven’t yet realized the extent to which that turbulence is spilling into CDOs.

    Foreclosure filings in the U.S. surged to 147,708 in April, up 62 percent from April 2006, as subprime borrowers stopped making mortgage payments.

    As foreclosures increase, the subprime-backed securities in CDOs begin to crumble. Subprime-mortgage securities make up about $100 billion of the $375 billion of CDOs sold in the U.S. in 2006. Investors have little idea how toxic some of these CDOs are, Drexel’s Mason says.

    “We compose CDOs with a bunch of this stuff,” he says. “Now we just jack up the risk, jack up the misunderstanding. We’re throwing our money to the wind. We now know the defaults are in the mortgage pools and it’s only a matter of time before they accumulate to levels that will threaten the CDO market.”

    Hearst invests in Fitch

    Ask Victor Ganzi, chief executive of The Hearst Corp. (and owner of the Seattle Post-Intelligencer) why the private New York-based media company bought 20 percent of Fitch Group last year for $593 million and he talks about collateralized debt obligations.

    “That’s where the opportunities lie for Fitch,” Ganzi said.

    Fitch has shot ahead of smaller competitors in the past decade to become the world’s third-largest rating firm.

    Fimalac, the company’s owner, has bought up smaller rivals. Ganzi and Stephen Joynt, Fitch’s chief executive, say structured finance, such as CDOs, is the fastest-growing source of credit-rating revenue and gives Fitch the chance to compete on level ground with its two rivals, Standard & Poor and Moody’s.

    Hearst eventually wants to buy control of the rating company, Ganzi said. But it won’t be easy. Ladreit de Lacharriere, the French investor who controls Fimalac, said he has no plans to sell any more of Fitch.

    “We’re very patient in that regard,” Ganzi said.

    The first CDOs

    Michael Milken, the junk-bond king, created the first CDO in 1987 at now-defunct Drexel Burnham Lambert, says Satyajit Das, a former Citigroup banker who has written 10 books on debt analysis.

    Until the mid-1990s, CDOs were little known in the global debt market, with issues valued at less than $25 billion a year, according to Morgan Stanley.

    Drexel and other investment banks realized that by bundling high-yield bonds and loans and slicing them into different layers of credit risk, they could make more money than they could from holding or selling the individual assets.

    Investment-grade CDOs that include subprime assets offer debt returns that exceed yields on junk bonds. In May, BBB-rated portions of CDOs — the lowest investment grade — paid 7-9 percentage points above the London interbank offered rate (Libor), according to Morgan Stanley.

    That amounted to an annual return of about 13 percent, based on May bank-lending rates. Most CDO tranches promise returns at a fixed spread over Libor.

    That means their value isn’t affected by changes in interest rates the way the value of a fixed-rate bond would be, says Arturo Cifuentes, a managing director at R.W. Pressprich, a New York-based fixed-income brokerage that buys and sells CDOs.

    “CDOs offer you a possibility to invest in risk which you cannot do in any other way,” he says. Cifuentes says CDOs have been good for investors and financial markets.

    Former banker Das wonders why few people are probing the potential dangers for CDO investors. “I think the regulators seem to be fairly sanguine about all of this. The thing that I find quite bewildering is the lack of urgency and focus.”

    He says subprime-mortgage defaults have just started to soar.

    “The fuse has been lit,” Das says. “Somebody should be trying to find where this wire is running to.”

  28. Cate commented on Aug 16

    Hi and thanks for this great post on the credit rating agencies…

    I’ve written a fair amount about the new law, the Credit Ratings Agency Reform Act of 2006 and the SEC rules implementing the law…

    Here is a summary of the new law which was essentially laid out by the Senate Banking Committee… (Senators Shelby and Sarbanes et al…)


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