V. INFLATED CREDIT RATINGS: CASE STUDY OF MOODY's AND STANDARD & POOR's
C. Mass Credit Rating Downgrades
In the years leading up to the financial crisis, Moody's and S&P together issued investment grade ratings for tens of thousands of RMBS and CDO securities, earning substantial sums for issuing these ratings. In mid-2007, however, both credit rating agencies suddenly reversed course and began downgrading hundreds, then thousands of RMBS and CDO ratings. These mass downgrades shocked the financial markets, contributed to the collapse of the subprime RMBS and CDO secondary markets, triggered sales of assets that had lost investment grade status, and damaged holdings of financial firms worldwide. Perhaps more than any other single event, the sudden mass downgrades of RMBS and CDO ratings were the immediate trigger for the financial crisis.
To understand why the credit rating agencies suddenly reversed course and how their RMBS and CDO ratings downgrades impacted the financial markets, it is useful to review trends in the housing and mortgage backed security markets in the years leading up to the crisis.
The years prior to the financial crisis saw increasing numbers of borrowers buying not only more homes than usual, but higher priced homes, requiring larger and more frequent loans that were constantly refinanced. By 2005, about 69% of Americans had purchased homes, the largest percentage in American history. |1005| In the five-year period running up to 2006, the median home price, adjusted for inflation, increased 50 percent. |1006| The pace of home price appreciation was on an unsustainable trajectory, as is illustrated by the chart below. |1007|
Subprime lending fueled the overall growth in housing demand and housing price increases that began in the late 1990s and ran through mid-2006. |1008| "Between 2000 and 2007, backers of subprime mortgage - backed securities – primarily Wall Street and European investment banks – underwrote $2.1 trillion worth of [subprime mortgage backed securities] business, according to data from trade publication Inside Mortgage Finance ." |1009| By 2006, subprime lending made up 13.5% of mortgage lending in the United States, a fivefold increase from 2001. |1010| The graph below reflects the unprecedented growth in subprime mortgages between 2003 and 2006. |1011|
To enable subprime borrowers to buy homes that they would not traditionally qualify for, lenders began using exotic mortgage products that reduced or eliminated the need for large down payments and allowed monthly mortgage payments that reflected less than the fully amortized cost of the loan. For example, some types of mortgages allowed borrowers to obtain loans for 100% of the cost of a house; make monthly payments that covered only the interest owed on the loan; or pay artificially low initial interest rates on loans that could be refinanced before higher interest rates took effect. In 2006, Barron's reported that first-time home buyers put no money down 43% of the time in 2005; interest only loans made up approximately 33% of new mortgages and home equity loans in 2005, up from 0.6% in 2000; by 2005, 15% of borrowers owed at least 10% more than their home was worth; and more than $2.5 trillion in adjustable rate mortgages were due to reset to higher interest rates in 2006 and 2007. |1012|
These new mortgage products were not confined to subprime borrowers; they were also offered to prime borrowers who used them to purchase expensive homes. Many borrowers also used them to refinance their homes and take out cash against their homes' increased value. Lenders also increased their issuance of home equity loans and lines of credit that offered low initial interest rates or interest-only features, often taking a second lien on an already mortgaged home. |1013|
Subprime loans, Alt A mortgages that required little or no documentation, and home equity loans all posed a greater risk of default than traditional 30-year, fixed rate mortgages. By 2006, the combined market share of these higher risk home loans totaled nearly 50% of all mortgage originations. |1014|
At the same time housing prices and high risk loans were increasing, the National Association of Realtors' housing affordability index showed that, by 2006, housing had become less affordable than at any point in the previous 20 years, as presented in the graph below. |1015| The "affordability index" measures how easy it is for a typical family to afford a typical mortgage. Higher numbers mean that homes are more affordable, while lower numbers mean that homes are generally less affordable.
By the end of 2006, the concentration of higher risk loans for less affordable homes had set the stage for an unprecedented number of credit rating downgrades on mortgage related securities.
Although ratings downgrades for investment grade securities are supposed to be relatively infrequent, in 2007, they took place on a massive scale that was unprecedented in U.S. financial markets. Beginning in July 2007, Moody's and S&P downgraded hundreds and then thousands of RMBS and CDO ratings, causing the rated securities to lose value and become much more difficult to sell, and leading to the subsequent collapse of the RMBS and CDO secondary markets. The massive downgrades made it clear that the original ratings were not only deeply flawed, but the U.S. mortgage market was much riskier than previously portrayed.
Housing prices peaked in 2006. In late 2006, as the increase in housing prices slowed or leveled out, refinancing became more difficult, and delinquencies in subprime residential mortgages began to multiply. By January 2007, nearly 10% of all subprime loans were delinquent, a 68% increase from January 2006. |1016| Housing prices then began to decline, exposing more borrowers who had purchased homes that they could not afford and could no longer refinance. Subprime lenders also began to close their doors, which the U.S. Department of Housing and Urban Development marked as the beginning of economic trouble:
"Arguably, the first tremors of the national mortgage crisis were felt in early December 2006 when two sizeable subprime lenders, Ownit Mortgage Solutions and Sebring Capital, failed. The Wall Street Journal described the closing of these firms as ‘sending shock waves' through the mortgage-bond market. …By late February 2007 when the number of subprime lenders shuttering their doors had reached 22, one of the first headlines announcing the onset of a ‘mortgage crisis' appeared in the Daily Telegraph of London." |1017|
During the first half of 2007, despite the news of failing subprime lenders and increasing subprime mortgage defaults, Moody's and S&P continued to issue AAA credit ratings for a large number of RMBS and CDO securities. In the first week of July 2007 alone, S&P issued over 1,500 new RMBS ratings, a number that almost equaled the average number of RMBS ratings it issued in each of the preceding three months. |1018| From July 5 to July 11, 2007, Moody's issued approximately 675 new RMBS ratings, nearly double its weekly average in the prior month. |1019| The timing of this surge of new ratings on the eve of the mass downgrades is troubling, and raises serious questions about whether S&P and Moody's quickly pushed these ratings through to avoid losing revenues before the mass downgrades began.
In the second week of July 2007, S&P and Moody's initiated the first of several mass rating downgrades, shocking the financial markets. On July 10, S&P placed on credit watch, the ratings of 612 subprime RMBS with an original value of $7.35 billion, |1020| and two days later downgraded 498 of these securities. |1021| On July 10, Moody's downgraded 399 subprime RMBS with an original value of $5.2 billion. |1022| By the end of July, S&P had downgraded more than 1,000 RMBS and almost 100 CDO securities. |1023| This volume of rating downgrades was unprecedented in U.S. financial markets.
The downgrades created significant turmoil in the securitization markets, as investors were required to sell off RMBS and CDO securities that had lost their investment grade status, RMBS and CDO securities in the investment portfolios of financial firms lost much of their value, and new securitizations were unable to find investors. The subprime RMBS secondary market initially froze and then collapsed, leaving financial firms around the world holding suddenly unmarketable subprime RMBS securities that were plummeting in value. |1024|
Neither Moody's nor S&P produced any meaningful contemporaneous documentation explaining their decisions to issue mass downgrades in July 2007, disclosing how the mass downgrades by the two companies happened to occur two days apart, or analyzing the possible impact of their actions on the financial markets. When Moody's CEO, Raymond McDaniel, was asked about the July downgrades, he indicated that he could not recall any aspect of the decisionmaking process. |1025| He told the Subcommittee that he was merely informed that the downgrades would occur, but was not personally involved in the decision. |1026|
Although neither Moody's nor S&P produced documentation on its internal decisionmaking process related to the mass downgrades, one bank, UBS, produced an email in connection with a court case indicating that Moody's was meeting with a series of investment banks to discuss the upcoming downgrades. In an email dated July 5, 2007, five days before the mass downgrades began, a UBS banker sent an email to a colleague about a meeting with Moody's:
"I just got off the phone with David Oman …. Apparently they're meeting w/ Moodys to discuss impacts of ABS subprime downgrades, etc. Has he been in contact with the [UBS] Desk? It sounds like Moodys is trying to figure out when to start downgrading, and how much damage they're going to cause – they're meeting with various investment banks." |1027|
It is unclear how much notice Moody's or S&P provided to investment banks regarding their planned actions.
One senior executive at S&P, Ian Bell, the head of European structured finance ratings, provided his own views in a post-mortem analysis a few days after the initial downgrades. He expressed frustration and concern that S&P had mishandled its public explanation of the mass downgrades, writing:
"[O]ne aspect of our handling of the subprime that really concerns me is what I see as our arrogance in our messaging. Maybe it is because I am away from the center of the action and so have more of an ‘outsider's' point of view. …
I listened to the telecon TWICE. That guy [who asked a question about the timing of the mass downgrades] was not a ‘jerk'. He asked an entirely legitimate question that we should have anticipated. He then got upset when we totally fluffed our answer. We did sound like the Nixon White House. Instead of dismissing people like him or assuming some dark motive on their part, we should ask ourselves how we could have so mishandled the answer to such an obvious question.
I have thought for awhile now that if this company suffers from an Arthur Andersen event, we will not be brought down by a lack of ethics as I have never seen an organisation more ethical, nor will it be by greed as this plays so little role in our motivations; it will be arrogance." |1028|
In August 2007, Eric Kolchinsky, a managing director of Moody's CDO analysts, sent an urgent email to his superiors about the pressures to rate still more new CDOs in the midst of the mass downgrades:
"[E]ach of our current deals is in crisis mode. This is compounded by the fact that we have introduced new criteria for ABS CDOs. Our changes are a response to the fact that we are already putting deals closed in the spring on watch for downgrade. This is unacceptable and we cannot rate the new deals in the same away [sic] we have done before. ... [B]ankers are under enormous pressure to turn their warehouses into CDO notes." |1029|
Both Moody's and S&P continued to rate new CDO securities despite their companies' accelerating downgrades.
In October 2007, Moody's began downgrading CDOs on a daily basis, using the month to downgrade more than 270 CDO securities with an original value of $10 billion. |1030| In December 2007, Moody's downgraded another $14 billion in CDOs, and placed another $105 billion on credit watch. Moody's calculated that, overall in 2007, "8725 ratings from 2116 deals were downgraded and 1954 ratings from 732 deals were upgraded," which means it issued four times as many downgrades as upgrades. |1031| S&P calculated that, during the second half of 2007, it downgraded over 9,000 RMBS ratings. |1032|
The downgrades continued into 2008. On January 30, 2008, S&P took action on over 6,300 subprime RMBS securities and over 1,900 CDO securities—meaning it either downgraded their ratings or placed the securities on credit watch with negative implications. The affected RMBS and CDO securities represented issuance amounts of approximately $270.1 billion and $263.9 billion, respectively. |1033|
The rating downgrades affected a wide range of RMBS and CDO securities. Some of the downgraded securities had been rated years earlier; others had received AAA ratings less than 12 months before. For example, in April 2007, both Moody's and S&P gave AAA ratings to three tranches of approximately $1.5 billion in a cash CDO known as Vertical ABS CDO 2007-1. Six months later, the majority of the CDO's tranches were downgraded to junk status; in 2008, the CDO's ratings were withdrawn, it assets were liquidated, and the AAA rated securities became worthless. In another case, in February and March 2007, Moody's and S&P gave AAA ratings to 5 tranches of about a $1 billion RMBS securitization known as GSAMP Trust 2007-FM2. In late 2007, both credit rating agencies began downgrading the securities; by 2008, they began downgrading the AAA rated securities, and by August 2009 S&P had downgraded all its tranches to noninvestment grade or junk status.
One more striking example involved a $1.6 billion hybrid CDO known as Delphinus CDO 2007-1, Ltd., which was downgraded a few months after its rating was issued. Moody's gave AAA ratings to seven of its tranches and S&P to six tranches in July and August 2007, respectively, but began downgrading its securities by the end of the year, and by the end of 2008, had fully downgraded its AAA rated securities to junk status. |1034|
Analysts have determined that, by 2010, over 90% of subprime RMBS securities issued in 2006 and 2007 and originally rated AAA had been downgraded to junk status by Moody's and S&P. |1035|
Percent of the Original AAA Universe
Currently Rated Below Investment Grade
Source: BlackRock Solutions as of February 8, 2010.
Prepared by the U.S. Senate Permanent Subcommittee on Investigations, April 2010.
1005. See 3/1/2006 "Housing Vacancies and Homeownership Annual Statistics: 2005," U.S. Census Bureau. [Back]
1006. "Housing Bubble Trouble," The Weekly Standard (4/10/2006). [Back]
1007. 1/25/2010, "Estimation of Housing Bubble: Comparison of Recent Appreciation vs. Historical Trends," chart prepared by Paulson & Co. Inc., Hearing Exhibit 4/23- 1j. [Back]
1008. See 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, "Root Causes of the Foreclosure Crisis," at 36. See also "A Brief History of Credit Rating Agencies: How Financial Regulation Entrenched this Industry's Role in the Subprime Mortgage Debacle of 2007 – 2008," Mercatus on Policy (10/2009), at 2. [Back]
1009. "The Roots of the Financial Crisis: Who is to Blame?" The Center for Public Integrity (5/6/2009), http://www.publicintegrity.org/investigations/economic_meltdown/articles/entry/1286. [Back]
1010. 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, "Root Causes of the Foreclosure Crisis," at 7. [Back]
1011. 1/25/2010, "Mortgage Subprime Origination," chart prepared by Paulson & Co. Inc., PSI- Paulson&Co- 02- 0001- 21, at 4. [Back]
1012. "The No- Money- Down Disaster," Barron's (8/21/2006). [Back]
1013. 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, "Root Causes of the Foreclosure Crisis," at 8. [Back]
1014. Id. [Back]
1015. 11/7/2007 "Would a Housing Crash Cause a Recession?" report prepared by the Congressional Research Service, at 3- 4. [Back]
1016. 1/25/2010 "60 Day+Delinquency and Foreclosure," chart prepared by Paulson & Co. Inc., PSI- Paulson&Co- 02- 0001- 21, at 15. Subcommittee interview of Sihan Shu (2/24/2010). [Back]
1017. 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, "Root Causes of the Foreclosure Crisis," at 2 [citations omitted]. [Back]
1018. 6/24/2010 supplemental response from S&P to the Subcommittee, at 12, Hearing Exhibit 4/23- 108. [Back]
1019. Data compiled by the Subcommittee using 6/14/2007 "Structured Finance New Ratings: May 28, 2007 through June 13, 2007," Moody's; 6/28/2007 "Structured Finance New Ratings: June 11, 2007 through June 27, 2007," Moody's; 7/5/2007 "Structured Finance New Ratings: June 18, 2007 through July 4, 2007," Moody's; and 7/12/2007 "Structured Finance New Ratings: June 25, 2007 through July 11, 2007," Moody's. [Back]
1020. 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit H, Hearing Exhibit 4/23- 108 (7/11/2007 "S&PCORRECT: 612 U.S. Subprime RMBS Classes Put On Watch Neg; Methodology Revisions Announced," S&P RatingsDirect (correcting the original version issued on 7/10/2007)). [Back]
1021. 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit I, Hearing Exhibit 4/23- 108 (7/12/2007 "Various U.S. First- Lien Subprime RMBS Classes Downgraded," S&P's RatingsDirect). [Back]
1022. 7/30/2010 supplemental response from Moody's to the Subcommittee, Hearing Exhibit 4/23- 106 (7/12/2007 Moody's Structured Finance Teleconference and Web Cast, "RMBS and CDO Rating Actions," at MOODYSPSI2010- 0046899- 900). The $5.2 billion also included the original value of 32 tranches that were put on review for possible downgrade that same day. [Back]
1023. 6/24/2010 supplemental response from S&P to the Subcommittee, at 3, 6, Hearing Exhibit 4/23- 108. According to this letter, the July downgrades were not the first to take place during 2007. The letter reports that, altogether in the first six months of 2007, S&P downgraded 739 RMBS and 25 CDOs. These downgrades, however, took place on multiple days over a six- month period. Prior to July, Moody's had downgraded approximately 480 RMBS during the first six months of 2007 (this figure was calculated by the Subcommittee based on information from Moody's "Structured Finance: Changes & Confirmations" reports for that time period). [Back]
1024. See 3/19/2007 "Subprime Mortgages: Primer on Current Lending and Foreclosure Issues," report prepared by the Congressional Research Service, Report No. RL33930; 5/2008 "The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown," report prepared by CCH, at 13. [Back]
1025. Subcommittee interview of Ray McDaniel (4/6/2010). [Back]
1026. Id. At S&P, no emails were produced that explained the decision- making process, but a few indicated that, prior to the mass downgrades, the RMBS Group was required to make a presentation to the chief executive of its parent company about "how we rated the deals and are preparing to deal with the fallout (downgrades)." 3/18/2007 email from Michael Gutierrez to William LeRoy, Hearing Exhibit 4/23- 52a; 3/2007 S&P internal email chain, "Preempting bad press on the subprime situation," Hearing Exhibit 4/23- 52c. [Back]
1027. 7/5/2007 email from David Goldsteen (UBS) to Dayna Corlito (UBS), "ABS Subprime & Moody's downgrades," UBS- CT 021485, Hearing Exhibit 4/23- 94o. [Back]
1028. 7/13/2007 internal S&P email from Ian Bell to Tom Gillis and Joanne Rose, Hearing Exhibit 4/23- 54a. [Back]
1029. 8/22/2007 email from Moody's Eric Kolchinsky, "Deal Management," Hearing Exhibit 4/23- 42. [Back]
1030. 7/30/2010 supplemental response from Moody's to the Subcommittee, at 9, Hearing Exhibit 4/23- 106. In an email sent in the midst of these CDO downgrades, one Moody's analyst commented to a colleague: "You ' re right about CDOs as WMD – but it's only CDOs backed by subprime that are WMD." 11/27/2007 email from William May to Deepali Advani, Hearing Exhibit 4/23- 58. [Back]
1031. 2/2008 "Structured Finance Ratings Transitions, 1983- 2007," Credit Policy Special Comment prepared by Moody's, at 4. [Back]
1032. 6/24/2010 supplemental response from S&P to the Subcommittee, at 6, Hearing Exhibit 4/23- 108. [Back]
1033. 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit N, Hearing Exhibit 4/23- 108 (1/30/2008 "S&P Takes Action on 6,389 U.S. Subprime RMBS Ratings and 1,953 CDO Ratings," S&P's RatingsDirect). [Back]
1034. For more details about these three examples, see "Fact Sheet for Three Examples of Failed AAA Ratings," prepared by the Subcommittee based on information from S&P and Moody's websites. [Back]
1035. See "Percent of the Original AAA Universe Currently Rated Below Investment Grade," chart prepared by the Subcommittee using data from BlackRock Solutions, Hearing Exhibit 4/23- 1i. See also 3/2008 "Understanding the Securitization of Subprime Mortgage Credit," report prepared by Federal Reserve Bank of New York staff, no. 318, at 58 and table 31 ( "92 percent of 1 st - lien subprime deals originated in 2006 as well as … 91.8 percent of 2 nd - lien deals originated in 2006 have been downgraded." ). See also "Regulatory Use of Credit Ratings: How it Impacts the Behavior of Market Constituents," University of Westminster - School of Law International Finance Review (2/2009), at 65- 104 (citations omitted) ( "As of February 2008, Moody's had downgraded at least one tranche of 94.2% of the subprime RMBS issues it rated in 2006, including 100% of the 2006 RMBS backed by second- lien loans, and 76.9% of the issues rated in 2007. In its rating transition report, S&P wrote that it had downgraded 44.3% of the subprime tranches it rated between the first quarter of 2005 and the third quarter of 2007." ) [Back]
Back to Contents B. Background D. Ratings Deficiencies
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