UPDATE: 5:45 PM - Moody's Former Execs: Firm Lusted After Profits
More former top executives at Moody's Investors Service testified Wednesday that a change in the firm's culture led it to switch its focus from providing investors with conservative ratings to one that craved market share and profits, cultivating lucrative relationships with the megabanks and broker-dealers whose securities it was supposed to objectively rate.
Mark Froeba, who spent 10 years in the Moody's unit that oversaw collateralized debt obligations before leaving in 2007 as a senior vice president, told the panel created by Congress to investigate the roots of the financial crisis that the culture change, which occurred around the time the firm was split from the Dun & Bradstreet Corporation in 2000, had disastrous results.
"Moody's simply gave up its analytical distinctiveness," he told the panel.
Prior to that culture shift -- had "something like the subprime bubble" arisen -- the old Moody's "had the stature (and maybe even the power) to stop [it]," Froeba said.
Collateralized debt obligations are securities not based on actual home mortgages, but rather on the bonds into which they were sliced and diced. Moody's is onehalf of the "duopoly" that effectively controls the market for rating the creditworthiness of securities, companies and governments, legendary investor Warren Buffett said Wednesday before his appearance in front of the Financial Crisis Inquiry Commission. Buffett's investment firm, Berkshire Hathaway, is the largest shareholder in Moody's parent company, Moody's Corporation.
"The story of Moody's role in the financial crisis does not begin in the years immediately preceding the financial crisis, viz., in 2006 or 2007. It begins sometime in the year 2000. This was the year that Dun & Bradstreet Corporation and Moody's Corporation became separate independent publicly-traded companies and, I might add, that Moody's senior managers were first able to begin receiving compensation in the form of stock options and other stock compensation, interests directly in Moody's Corporation. Before that, Moody's had been a very profitable but somewhat neglected subsidiary of Dun & Bradstreet.
"Until this time, Moody's had an extremely conservative analytical culture. Moody's analysts were proud to work for what they believed was by far the best of the rating agencies. They viewed Moody's competitors as a very distant second in quality and ratings integrity. Moody's was a place that outsiders loved to hate (as the title of one article at the time put it). Everyone understood that for any new product that was unusual or complex, the Moody's rating was the one to get and that without it, it would be difficult or even impossible to market the new product. In short, the Moody's of that time had the stature (and maybe even the power) to stop something like the sub,prime bubble had it arisen then.
"Unfortunately, by the time the bubble arrived, Moody's had deliberately abandoned its stature and surrendered this power. Moody's simply gave up its analytical distinctiveness. How did it happen?
"Under the guise of making Moody's more business friendly, making it more responsive to clients -- e.g., making sure that analysts would return telephone calls etc., -- Moody's senior managers set in motion a radical change in Moody's analytical culture that not only changed the rating process but also profoundly affected Moody's ratings."
Froeba then provided an example illustrating how the culture had changed between the time he joined the firm and the time he left.
"When I joined Moody's in late 1997, an analyst's worst fear was that he would contribute to the assignment of a rating that was wrong, damage Moody's reputation for getting the answer right and lose his job as a result," he said.
"When I left Moody's [in 2007], an analyst's worst fear was that he would do something that would allow him to be singled out for jeopardizing Moody's market share, for impairing Moody's revenue or for damaging Moody's relationships with its clients and lose his job as a result."
Phil Angelides, chairman of the bipartisan financial crisis panel, described how much the firm's revenue had grown.
"To be blunt, the picture is not pretty," he began. "From 1998 to 2007, Moody's revenues from rating complex financial instruments like mortgage securities grew by a whopping 523 percent. From 2000 to its peak in 2007, the company's stock price climbed more than sixfold. Moody's did very well. The investors who relied on Moody's ratings did not fare so well.
"From 2000 through 2007, Moody's slapped its coveted Triple-A rating on 42,625 residential mortgage backed securities. Moody's was a Triple-A factory. In 2006 alone, Moody's gave 9,029 mortgage backed securities a Triple-A rating. That means they put the Triple-A label on more than 30 mortgage securities each and every working day that year. To put that in perspective, Moody's currently bestows its Triple-A rating on just four American corporations. Even Berkshire Hathaway, with its more than $20 billion cash on hand, doesn't make that grade.
"We know what happened to all those Triple-A securities. In 2006, $869 billion worth of mortgage securities were Triple-A rated by Moody's. Eighty-three percent went on to be downgraded. Investors -- from university endowments to teachers and police officers relying on pension funds -- suffered heavy losses."
Froeba said that in both cultures -- pre- and post-2000 -- analysts feared losing their jobs.
"But in the former case it was theoretical and rare -- you did not really know of anyone who had been fired for getting the answer wrong but it provoked a healthy anxiety that you had better be careful not to miss anything," Froeba said. "Moody's decades-old reputation for accuracy and integrity was in your hands.
"In the latter case, the fear was real, not rare and not at all healthy. You began to hear of analysts, even whole groups of analysts, at Moody's who had lost their jobs because they were doing their jobs, identifying risks and describing them accurately," he said.
The reason for this, Froeba explained, was the credit rating agency's lust for ever-increasing profits. This even affected the firm's ratings of securities -- grades that theoretically should be objective and immune to revenue pressures.
"As long as market share and revenue were at issue, Moody's best answer could never be much better than its competitors' worst answers," he described. "But arriving at an accurate answer was never objectionable, so long as that answer did not threaten market share and revenue.
"For this reason, there are some structured finance securities where Moody's ratings continue to be accurate and of high quality. This is not evidence of rating integrity; it is simply evidence that, for these types of securities, Moody's was not exposed to rating competition.
"Wherever Moody's encountered material market share pressure (rating competition), we can expect to see that its ratings become indistinguishable from the ratings of its competitors," Froeba added.
Among the ways Moody's cultural changes resulted in poor ratings were the firm's attempts to intimidate its own analysts while encouraging bankers, he said.
Top managers threatened to (and actually did) fire independent-minded analysts. Investment bankers, representing the world's biggest banks and broker-dealers, were allowed to single out the analysts that gave them the most problems.
"They came to understand that Moody's would cooperate with them whenever they complained about a particular analyst," Froeba said. "As Richard Michalek recently confirmed in testimony before the Senate Permanent Subcommittee on Investigations, Moody's began to allow bankers to request that particular analysts be prohibited from working on any of the bank's deals.
"More important, the banks learned that Moody's would allow them to ask that all of the bank's deals be assigned to the same particularly 'flexible' analyst or team of analysts.
"Finally, they learned well that they could go over the heads of analysts (even of rating committees despite Moody's policies to the contrary) if they should ever really need to do so by appealing directly to Moody's managers and senior managers," Froeba concluded.
READ Froeba's full prepared remarks below:
UPDATE: 3:17 PM - Moody's CEO Refuses To Say He's Sorry
The chairman and chief executive of Moody's Corporation joined the long list of top Wall Street executives who have refused to apologize for their role in causing the worst financial crisis and resulting economic collapse since the Great Depression.
Appearing on Wednesday before the panel created by Congress to investigate the roots of the financial crisis, Raymond W. McDaniel, the head of the corporate parent of Moody's Investors Service, said that while the credit rating agency's disastrous performance has been "deeply disappointing" and that the firm is "certainly not satisfied" with it, after more than two hours of testimony he didn't say the one thing much of America may have been looking for: I'm sorry.
Moody's is one-half of the "duopoly" that effectively controls the market for rating the creditworthiness of securities, companies and governments, legendary investor Warren Buffett said Wednesday before his appearance in front of the Financial Crisis Inquiry Commission, a panel he shared with McDaniel. Buffett's investment firm, Berkshire Hathaway, is the largest shareholder in Moody's.
McDaniel repeated that he was "deeply disappointed" in the firm's performance, which caused "injuries [to the] reputation [of the] firm and its long-term value."
"The regret is genuine and deep with respect to our ratings in the housing sector," McDaniel added.
No similar apology, though, for the effect of his firm's now-discredited ratings in helping to exacerbate -- if not cause -- the financial crisis, a sentiment voiced by legislators, policymakers, academics and former top Moody's executives.
By comparison, Charles "Chuck" Prince, Citigroup's CEO from 2004 to 2007, told the financial crisis panel in April that he was "deeply sorry that our management -- starting with me -- was not more prescient and that we did not foresee what lay before us."
McDaniel said that "the performance of our credit ratings for U.S. residential mortgage-backed securities and related collateralized debt obligations over the past several years has been deeply disappointing.
"Moody's is certainly not satisfied with the performance of these ratings. Indeed, over the past few years, there has been an intense level of self evaluation within our organization.
"To this end, I and members of my management team have been open to ideas, questions and differing perspectives, from both inside and outside of the company, for two purposes: better understanding the reasons for the poor performance in this sector... [and] raising the bar in assessing credit risk in a fast-changing and less predictable market environment."
McDaniel cautioned, though, that "neither we -- nor most other market participants, observers or regulators -- fully anticipated the severity or speed of deterioration that occurred in the U.S. housing market or the rapidity of credit tightening that followed and exacerbated the situation."
Federal regulators at the Federal Reserve, Securities and Exchange Commission, Federal Deposit Insurance Corporation, Office of Thrift Supervision, Office of the Comptroller of the Currency, various regional Federal Reserve banks like the New York Fed and the Treasury Department have all said the same thing, more or less.
Treasury Secretary Timothy Geithner, who headed the New York Fed in the years preceding and during the height of the crisis, as well as Federal Reserve chairmen Alan Greenspan and Ben Bernanke also have made similar remarks explaining how unprepared they were when the crisis hit.
To reform his firm, McDaniel said that Moody's is "continuing our communication with market participants, public sector authorities and market commentators to better understand various concerns and recommendations."
Moody's also has implemented various internal reforms, he said.
Regarding reforms mandated by Congress and federal regulators, McDaniel said that he "welcome[s] reform." The two examples he listed were moves that would lead to "increased transparency in the rating process and reducing the use of credit ratings in regulation."
His firm is under investigation by the Securities and Exchange Commission, Moody's disclosed last month in its most recent quarterly filing with the SEC. It also faces other investigations by Congressional panels and various other entities.
Over the past year, the value of Moody's Corp. shares have declined by 31 percent. The Dow Jones Industrial Average is up 16 percent. The S&P 500 Index is up 15 percent. The NASDAQ Composite Index is up 23 percent.
UPDATE: 2:10 PM - Warren Buffett: I Use Derivatives -- But Not Like AIG
(Scroll down for video)
Commission member Peter Wallison had a hilarious exchange with Buffett over derivatives, in which Wallison compared the Oracle of Omaha to AIG.
Wallison began, "You are quite famous for saying... that credit default swaps are "financial weapons of mass destruction and yet it's recently come to light that you actually participate in that market."
(Buffett actually said that derivatives are weapons of mass destruction.) "Used improperly," Buffett responded, "I think that they pose system-wide problems."
From there, the exchange got a little odd:
Wallison: What do you use them for?
Buffett: I use them to make money. If i think they're mispriced, I buy them....We sell insurance We sell it on municipal bonds..."
Wallison: "This is much like what AIG did."
Buffett: "I don't think I'd put it that way [Laughs] But we sell credit insurance. We sell auto insurance and AIG sold auto insurance too."
Buffett went on to warn that credit default swaps, futures and other derivatives are currently not subject to adequate capital requirements -- investors are still able to buy many of these securities without much money down.
WATCH the exchange:
UPDATE 1:11 PM - Warren Buffett 'Entire American Public' Made The Same Mistake The Rating Agencies Made
NEW YORK (BY STEVENSON JACOBSON, AP) - Billionaire investor Warren Buffett on Wednesday defended credit rating agencies that gave overly positive grades to mortgage-related investments before the housing bust. He said the agencies were among many who missed warnings signs of the crisis.
"They made the wrong call," Buffett acknowledged.
But he said he counted himself among those who failed to foresee the collapse of the housing bubble. Buffett called it the "greatest bubble" he had ever seen.
"The entire American public was caught up in a belief that housing prices could not fall dramatically," Buffett told a congressionally chartered panel investigating the financial crisis. Had he known how bad it would get, Buffett said he would have sold his company's stake in Moody's.
Buffett is testifying before Financial Crisis Inquiry Commission alongside Moody's Corp. CEO Raymond McDaniel. Buffett's investment firm is Moody's largest shareholder.
Rating agencies have been criticized for giving high ratings to complex investments backed by risky mortgages. When homeowners defaulted, the agencies downgraded billions of dollars of investments at once. That helped spark the financial crisis.
Lawmakers have accused the industry of having a conflict of interest because the agencies are paid by the banks whose investments they rate.
McDaniel told the panel that "Moody's is certainly not satisfied with the performance of these ratings" and is taking steps to improve its rating process.
Still, McDaniel says in prepared testimony that investors should use ratings as a tool, "not a buy, sell or hold recommendation."
Despite his company's stake in Moody's, Buffett has said he never relies on credit ratings when making investment decisions because he makes his own judgments on companies.
In opening remarks, FCIC chairman Phil Angelides Angelides noted that Moody's profited greatly from rating mortgage-backed securities. Revenue soared from $600 million in 2000 to $2.2 billion in 2007, just as the housing bubble peaked.
But as the company profited, "the investors who relied on Moody's ratings didn't do very well," Angelides said.
Credit Rating Agency Exec: We Couldn't Say No To Wall Street - Shahien Nasiripour
A former top director at Moody's Investors Service painted a dreadful picture of how one of the nation's two biggest and most influential credit rating agencies miserably failed to do the job with which it was entrusted: adequately rate the creditworthiness of securities.
Eric Kolchinsky, a managing director overseeing the unit that rated subprime mortgage-backed collateralized debt obligations, said in testimony Wednesday before the panel investigating the roots of the financial crisis that the rating agencies acted to the benefit of Wall Street's megabanks and broker-dealers rather than in the public interest. Subprime-backed CDOs are securities not based on actual subprime home mortgages, but rather on the bonds they were sliced and diced into.
Driven by an insatiable lust for ever-increasing market share and profits, which ramped up during the housing boom, Moody's questionable ratings of exotic financial securities caused it to nearly commit securities fraud, Kolchinsky said.
"[T]he rating agencies faced the age old and pedestrian conflict between long-term product quality and short-term profits," Kolchinsky said in prepared remarks. "They chose the latter.
"These asymmetric incentives caused a shift of the culture at Moody's from one resembling a university academic department to one which values revenue at all costs," he said.
As Congress prepares to launch a fresh round of negotiations over how best to reform the nation's broken financial system, the testimony provided Wednesday by former Moody's executives could remind legislators of the key role the agencies played in enabling Wall Street's pre-crisis excess.
Kolchinsky told the Financial Crisis Inquiry Commission, meeting at The New School, a New York-based university, that it was "very clear" that his future at the firm and his compensation depended on the revenue his team generated, rather than on the quality of their ratings.
Regarding rating questionable deals, he said that it was "harder to say no" to a securities issuer "than to say yes."
Moody's "couldn't say no in any case," he said. This created the "worst incentives" because megabanks and broker-dealers knew that Moody's would always rate their offerings, regardless of how crappy they may have been. "It went downhill from there," Kolchinsky said.
To illustrate, Kolchinsky offered two anecdotes.
"Upon first joining Moody's in 2000, I was asked to opine on a new transaction backed only by telecommunication loans. After doing my research, I reported to my managers that I did not believe the deal could be rated.
I felt no pressure to reverse my decision and was complimented for my work even though we lost out on a lucrative piece of business. The decision not to rate was a sound one -- shortly thereafter, as a result of the dot‐com collapse, many telecom loans defaulted.
However, by 2007, the culture at Moody's changed dramatically. It was now a major public company with revenues of over $2 billion. It had been one of the best equity performers in the S&P 500. Managers received a significant portion of their compensation in restricted stock and options.
The products rated by my group had grown from a financial backwater to a profit leader. In 2001, a total of $57 billion of CDOs were rated. By 2006, the number had reached $320 billion -- a nearly six-fold increase. In the first half of 2007, our revenues represented over 20% of the total rating agency revenues earned by Moody's.
The growth was the result of surging structured finance origination and focus on increasing and maintaining market share. Senior management would periodically distribute emails detailing their departments' market share. Even if the market share dropped by a few percentage points, managers would be expected to justify 'missing' the deals which were not rated. Colleagues have described enormous pressure from their superiors when their market share dipped.
For senior management, concern about credit quality took a back seat to market share. While therewas never any explicit directive to lower credit standards, every missed deal had to be explained and defended. Management also went out of its way to placate bankers and issuers. For example, and contrary to the testimony of a Moody's senior managing director, banker requests to keep certain analysts off of their deals were granted.
The focus on market share inevitably lead to an inability to say "no" to transactions. It was well
understood that if one rating agency said no, then the banker could easily take their business to another. During my tenure at the head of US ABS CDOs, I was able to say no to just one particularly questionable deal. That did not stop the transaction -- the banker enlisted another rating agency and received the two AAA ratings he was looking for.The poor performance of structured finance ratings is primarily the result of senior management's directive to maintain and increase market share. Leverage during negotiations can only be gained if the one side has the ability to walk away (or the opposing party believes they can walk away). Without this leverage, the power to extract meaningful concessions from bankers ceased to exist. Instead, analysts and managers rationalized their concessions since the nominal performance of the collateral was often quite exceptional."
That drive for profits also affected the resources Moody's allocated to grade the securities it was entrusted to rate by investors and regulators.
Despite the increasing number of deals and the increasing complexity, our group did not receive adequate resources," Kolchinsky said. "By 2007, we were barely keeping up with the deal flow and the developments in the market. Many analysts, under pressure from bankers and their high deal loads, began to do the bare minimum of work required.
We did not have the time to do any meaningful research into all the emerging credit issues. My own attempts to stay on top of the increasingly troubled market were chided by my manager. She told me that I spent too much time reading research."
Kolchinsky's remarks regarding resources were backed up by a former Moody's colleague.
Gary Witt, now a professor at the Fox School of Business at Temple University, was a managing director in the firm's U.S. derivatives group. He left the CDO team in the fall of 2005.
During his time in the unit, Witt said it was "always under-resourced."
"We were definitely under-resourced," Witt told the commissioners.
But it wasn't due to the firm's inability to pay for talent and new tools, he said. Rather, it was to preserve its profits.
"The profit margins were so wide," Witt said, "and yet management really stinted on hiring staff. "I didn't understand it then and I don't understand it now."
Kolchinsky also detailed how he believes Moody's came dangerously close to committing securities fraud.
"As the market began to falter after the [2007] collapse of the Bear Stearns hedge funds, I was asked to post senior management on the developments in the markets," Kolchinsky said. "There appeared to be little concern regarding credit quality.
According to my manager, the CEO, Ray McDaniel, was asking for information on our potential deal flow prospects: 'obviously, they're getting calls from [equity] analysts and investors'.
I believe that this mindset helps to explain how in the fall of 2007, Moody's nearly committed securities fraud.
During the course of that year, the group which rated and monitored subprime bonds did not react to the deterioration in their performance statistics. During the summer of 2007, a relatively small batch of subprime bonds was downgraded. However, by early September, during an impromptu meeting with Mr. Nicolas Weill [who's testifying today], I was told that the ratings on the 2006 vintage of subprime bonds were about to be downgraded broadly and severely. While the understaffed group needed time to determine the new ratings, I left the meeting with the knowledge that the then-current ratings were wrong and no longer reflected the best opinion of the rating agency.
The rating methodology for CDOs backed by subprime bonds relied on the latter ratings to access credit risk," Kolchinsky explained. "The worse the sub‐prime ratings, the more subordination would be required for any particular CDO rating. If the underlying ratings were no longer correct, then the ratings on the CDOs would also be wrong. I believed that to assign new ratings based on assumptions which I knew to be wrong would constitute securities fraud.
Since we still had a handful of CDOs in our pipeline, I immediately notified my manager and proposed a solution to this problem. My manager declined to do anything about the potential fraud, so I sought advice from Gary Witt, my colleague and former manager. He suggested that I take the matter up with the managing director in charge of credit policy.
As a result of my intervention, a procedure for lowering sub‐prime bond ratings going into CDOs was announced on September 21, 2007. I believe that this action saved Moody's from committing securities fraud."
His action, though, was not without consequence.
"About a month and a half after my intervention, I was asked to leave the CDO group and offered a transfer and demotion to a lower position in another department at Moody's," he said.
Kolchinsky is no longer with the firm.
READ Kolchinsky's prepared remarks: