The New Robber Barons Read online

  "You're a young guy, early in your career. You should think long and hard before issuing the report. We are the largest guarantor of New York state and New York City bonds. In fact, we're the largest guarantor of municipal debt in the country. Let's put it this way: We have friends in high places." Confidence Game: How a Hedge Fund Manager Called Wall Street's Bluff, Christine Richard, P. 6, (Wiley, 2010).

  Ackman published the report on his fund's web site: "Is MBIA Triple-A?" Among other issues, Ackman questioned MBIA's foray into credit derivatives and synthetic CDOs.

  Here's some ironic background you won't find in Confidence Game. In 2003, Jack Caouette, then Vice Chairman of MBIA,* wrote a blurb for my book on the dangers posed by credit derivatives and synthetic CDOs, Collateralized Debt Obligations & Structured Finance (Wiley, 2003):

  "Caveat Emptor! Never in the history of finance has this warning been more appropriate. With the development of esoteric structured finance techniques, the savvy as well as the novice are exposed to a bewildering array. An outstanding mixture of exposition, mathematics and skepticism."

  Ackman's concern was reasonable. Structured finance is easily gamed, and fraud was common.

  Ackman's early bet didn't pay-off, and he was not just ignored, the financial media raked him over the coals. Moreover, Ackman was correct about several other accounting issues unrelated to synthetic CDOs.

  Ackman persisted, MBIA protested, and in early 2003, the SEC and New York Attorney General's office investigated him. The NY AG's office, then headed by Eliot Spitzer, grilled Ackman for six days. Ackman's activism eventually led to a two-year investigation of MBIA resulting in its restating seven years of earnings and a $75 million fine.

  Ackman didn't stop. He hired a top forensic accounting expert and several times brought evidence of fraudulent accounting to Moody's, the leading credit rating agency. Meanwhile, MBIA restated its numbers twice. At the end of 2005, Ackman wrote Moody's board of directors:

  "Moody's Aaa rating is so powerful and credible that investors don't do any due diligence on the underlying credit. Every day that Moody's incorrectly maintains an Aaa rating on MBIA, these extremely risk-averse investors unwittingly buy bonds that are not deserving of Moody's Aaa rating." Confidence Game, P. 137.

  MBIA escalated its risk. MBIA wrote credit derivatives on new "Triple-A" risk backed by malignant mortgage loans, including built-to-fail mezzanine CDOs. It didn't matter how much "confidence" Wall Street, rating agencies, bond insurers, and regulators had in maintaining a collective financial lie, MBIA was unstable.

  In February 2008, MBIA cut its dividend and suspended structured finance activities. Jay Brown wrote MBIA's investors that Ackman's "campaign" was an attempt to destroy his business. Ackman's shorts weren't the problem. MBIA could have used some shorts of its own, since it was long with too little coverage. MBIA had insured rotting mortgage risk with too little capital to maintain even an investment grade rating.

  By June 2008, MBIA and Ambac, the largest municipal bond insurers, lost their "AAA" ratings and slid fast from there. At the end of 2008, Ackman took $1.1 billion in gains for Pershing Square, enough to offset losses in other investments, some of which subsequently rebounded.

  Bankers Get Bonuses, USA Gets the Great Recession

  Wall Street banks with financial ties to mortgage lenders fueled bad--and often fraudulent--mortgage lending, created phony mislabeled securities, and off-loaded the temporarily disguised risk on bond insurers (MBIA, Ambac, AIG, FGIC, and more) and naïve investors to keep the Ponzi scheme going. A housing bubble fueled by corrupt finance damaged the U.S. economy, and taxpayers bailed out the chief culprits. ("Goldman Sachs: Spinning Gold," HuffPost, April 7, 2010)

  Those with "friends in high places" did the most damage to the nation's economy and personally profited the most. It's also noteworthy that Ackman's outrage was not directed at investment banks with whom he traded and that underwrote fraudulent value-destroying CDOs, fed him internal CDO data, internal CDO models, and information on MBIA's and Ambac's positions, all of which bolstered his confidence to continue with his short positions. The high pay of Wall Street and its cronies doesn't reflect efficient markets or individual brilliance; it's a market failure.

  The Great Bailout protected debt holders and some shareholders in corrupt financial institutions. Culprits involved in phony securitizations that damaged the economy have windfall gains and are now heavily subsidized with taxpayer dollars. Bill Ackman's ordeal shows us how much endurance will be required to reverse these mistakes and reform the financial system.

  In the interest of full disclosure, I attended Bill Ackman's book launch party and am quoted in the book.

  * Jack Caouette retired from MBIA in early 2005 and is now Chairman of Channel Capital Group.

  Tavakoli Structured Finance Revokes Credit Rating Agencies’ NRSRO Designation: Issues and Solutions for Restoring Credibility to the Credit Rating Agencies and Rehabilitating the Alternative Banking System

  July 26, 2011

  I. REVOCATION OF THE NRSRO DESIGNATION

  Ten rating organizations are designated Nationally Recognized Statistical Rating Organizations: Moody’s Corporation; Standard & Poor’s Ratings Services (S&P, part of McGraw-Hill Cos., Inc.), Fitch, Inc., Best Company, Inc., DBRS Ltd., Egan-Jones Rating Company, Japan Credit Rating Agency, Ltd., Kroll Bond Rating Agency, Inc. (f/k/a LACE Financial Corp.), Rating and Investment Information, and Realpoint LLC. Moody’s and S&P are the most influential and have the most market share. Ratings, particularly those of Moody’s and S&P, are built into the global regulatory and market framework.

  Ostensibly the U.S. Securities and Exchange Commission (SEC) qualifies the NRSRO designation. The SEC’s series of failures to check the creation and sale of hundreds of billions of dollars of blatantly misrated securitizations leading up to the financial crisis are beyond the scope of this report. It’s worth noting, however, that if the Food and Drug Administration failed to check the sale of tainted meat that repeatedly sickened a large segment of the population, we would demand a top to bottom overhaul of the organization and its methods.

  In February 2007, the SEC sought comments about the steps it should take to regulate the rating agencies. In my letter to the SEC dated February 13, 2007, I called for the SEC to revoke the rating agencies’ designation as Nationally Recognized Statistical Rating Organizations (NRSRO). Ratings for structured products were based on smoke and mirrors. (APPENDIX I.)

  In upholding the NRSRO designation the SEC and Congress are as irrelevant to the truth as Galileo’s inquisitors when they forced him to recant his upholding of Copernicus’ idea that the earth moves around the sun. Fundamental truths are not changed by arbitrary legislation like Congress’s Credit Agency Reform Act of 2006, meant to improve ratings quality, or by the SEC’s regulation. Since the SEC failed to act, I now revoke the NRSRO designation for all credit rating agencies for every class of credit rating with the exception of corporations not engaged in structured finance in a meaningful way. Specifically, this revocation is for the following rating classes: structured financial products including, but not limited to, structured credit products, asset backed securities, and synthetic securitizations; financial institutions (including brokers or dealers and hedge funds), insurance companies, and sovereigns that have bailed out their banking systems and continue to fund them.

  This report provides further background on this action focusing on the top two rating agencies, Moody’s and S&P, and suggests a multi- year process required to restore a credible NRSRO designation for the rating agencies.

  A. Rating Agencies’ Role in the Financial Collapse: The Sovereign Effect

  The U.S. and European economies are experiencing credit turmoil that is a side effect of the collapse of the alternative banking system, sometimes referred to as the “shadow” banking system. This is the financial system created using a combination of structured finance techniques employed over more than twenty years including special purpose vehicles,
securitization, interest rate derivatives, commodity derivatives, currency derivatives, and credit derivatives.

  At its best, the alternative banking system was a financial growth engine that provided a mechanism for efficient financing and risk distribution for borrowers that otherwise found it difficult to access traditional bank financing. The downfall of this system was due to a series of failures, chiefly the role of the largest banks that underwrote phony securitizations and failed to follow established laws governing the underwriting of the securities they sold. This was abetted by failures at the rating agencies, regulators, monoline insurers, and ancillary finance partners of investment banks: mortgage lenders, mortgage servicers, legal advisors, accountants, student loan providers, auto loan providers, credit card issuers, and academic consultants.

  Most of the market for ratings is dominated by Moody’s and Standard & Poor’s, especially the U.S. market, where these two U.S.-based rating agencies have been entrenched and have most of the historical data. Fitch has played a more minor but significant role as both a primary and swing provider in the rating of structured financial products.

  In the run up to the current crisis, the rating agencies misrated mortgage securitizations called Residential Mortgage-Backed Securities (RMBS) that included loans with poor underwriting standards and fraudulent loans; this risk wasn’t captured in the ratings. (APPENDIX II.) As mortgage lenders failed, new investors had to be found to pay off old investors i.e., mortgage lenders and the banks that funded them. When the business model became unsustainable, it devolved into a Ponzi scheme. (APPENDIX III.) The errors compounded with misrated Collateralized Debt Obligations (CDOs) and CDO-squared products that were securitizations of misrated tranches. (APPENDICES IV. and V.) Credit derivatives technology added hidden risks and amplified problems. From the start "AAA"-rated tranches of these deals showed the high probability of significant principal loss. (See Section VI. for a more detailed discussion.) These were just a few of the rating agencies’ egregious debacles. This report will discuss a few more, but it is still a partial list.

  In a July 2011 report, The Joint Forum at The Bank for International Settlements' (BIS) Committee on Banking Supervision issued a report titled: “Report on Asset Securitisation Incentives.” Characteristic of most central banks and regulators in the global financial system, it did not identify the key rating agency issues and when it comes to other aspects of securitization, the word “fraud” is not mentioned anywhere in the report. This sort of denial enables repeat offenders.

  This is ironic, because BIS enabled “super senior” tranches, supposedly the top-most “AAA” tranches of CDOs that used credit derivatives technology, since it awarded lower regulatory capital requirements for these tranches. The “super senior” tranches of synthetic CDOs, securitizations that use credit derivatives technology, made up most of each deal. This will be discussed in more detail later in this report.

  The BIS report noted that from 1990 to 2006, the peak year for ABS issuance, “AAA” rated assets ballooned from 20 percent of rated fixed-income issuance to almost 55 percent. Many of these came at the tail end of this period when the “AAA” ratings were unwarranted, in fact many warranted a junk rating at the outset, but BIS didn’t mention that part. It also left out that in the first half of 2007, virtually every “AAA” of ABS CDOs warranted junk ratings.

  Prior to the effective halt of private label securitizations in the latter part of 2007, the alternative banking system provided an outlet for more than 70% of bank loans. By June, 2008, just three months before the September 2008 financial meltdown, CDOs in default already exceeded $200 billion. More troubles were subsequently exposed in CDOs and a variety of other products. Investors included insurance companies, bank investment portfolios, mutual funds, pension funds, hedge funds, and other money managers. Every sector of society was affected as misrated products caused actual principal losses combined with loss in value due to declining market prices and illiquidity.

  The perceived ability to remove ever increasing risk from the balance sheets of the largest banks through misrated securities backfired as risk boomeranged back onto the balance sheets of underwriters. Liquidity—coming up with needed cash—is now a global problem, since investors are wary of lending money (by investing) against potentially misrated assets.

  Advance hedging and raising capital requirements would only have helped mitigate some of the failures of risk transference: failure of credit default swap counterparties, consolidation of assets of flawed-at-creation special purpose vehicles, and consolidation of failed “independent hedge fund” assets.

  The general financial meltdown experienced in September 2008 was accompanied by the suppression of facts and self-serving misinformation by many of the key players. Capital buffers and hedges were insufficient, and the controversial choice was made to recapitalize the banks without inquiry into the causes and culprits. Unfortunately, the bailout was also done without conditions and no meaningful steps have been taken that will prevent a similar global financial catastrophe.

  As of 2009, “AAA” issuance from Sovereigns that still have that rating ballooned to outstrip the “AAA” ABS issuance of 2006. This is no surprise. Government bailouts to recapitalize the banks meant that new sovereign debt had to be issued. Capital spending, the biggest driver of economic growth was starved of funds.

  As a result of the enormous bailouts, sovereign debt ballooned imperiling the “AAA” ratings of many sovereign entities while debt issuance continued to expand. “AAA” asset issuance stood at around $5 trillion in 2006, and in 2009 it was around $6 trillion. A significant chunk had shifted from imploded ABS CDOs to “AAA” sovereign debt. (APPENDIX VI.) Sovereign ratings are lagging indicators of risk and are readjusted by the rating agencies only after the damage is already blindingly obvious and well-reported by other more reliable sources.

  Dodd-Frank will not avert a future crisis any more than Sarbanes-Oxley was effective in averting the last crisis. Banks can appear to take mortgage loan risk on balance sheet, but can lay it off through derivatives or through structural games. The provisions in Dodd-Frank are easily thwarted through opaque structured finance. Another problem is that risks have ramped up in other opaque areas: currency derivatives, credit derivatives, interest and market-linked derivatives, and commodities derivatives and speculation. This report, however, will continue to focus on the rating agencies.

  This report deals with only one critical aspect of what it will take to rehabilitate the alternative banking system. It is a necessary—but not sufficient condition—to address the various issues that have contributed to the credit rating agencies’ history of failure.

  B. Rating Agencies’ Current Practice Is Junk Science

  One cannot understand the strengths and weaknesses of any model unless one understands the risk characteristics of the target portfolios’ assets. This is accomplished by examining the underwriters’ due diligence, and demanding even more thorough due diligence from the underwriter, if it is warranted. Since this granular work wasn’t properly done by any reasonable professional standard, the rating agencies computer models employed inputs that were simply guesses (or worse, deliberate masks of the risk) instead of a rational assessment of value.

  Rating agencies correctly point out that deal sponsors and investment bank underwriters are responsible for due diligence on the underlying collateral. Although the rating agencies do not perform due diligence for investors, they can demand evidence that proper due diligence has been performed before attempting to apply their respective ratings methodologies. In fact, it is not possible to perform a sound statistical analysis without it.

  Statistics is the mathematical study of the probability and likelihood of events. Known information can be taken into account, and likelihoods and probabilities are inferred by taking a statistical sampling. The rating agencies have not lived up to the NRSRO designation by any reasonable professional standard.

  For example, in the mortgage loan sec
uritization market, a statistical sampling of the underlying mortgage loans should verify the integrity of the documentation, the identity of the borrower, the appraisal of the property, the borrower’s ability to repay the loan, and so on. Rating agencies should take reasonable steps to understand the character of the risk they are modeling. Yet, they seemingly rated risky deals without demanding evidence of thorough due diligence, or if they did, they ignored or didn’t understand the implications.

  It seems the rating agencies either did not refuse to “rate” securitizations that lacked this evidence, or they ignored reports that revealed fatal asset flaws for many structured finance transactions. In more colloquial language, the rating agencies just made stuff up.

  When rating agencies use old data for obviously new risks, it’s financial astrology. When rating agencies guess at “AAA” ratings (without the data to back it up), it’s financial alchemy. When rating agencies evaluate no-name CDO managers without asking for thorough background checks, it’s financial phrenology. In other words, the rating agencies practice junk science. The result is that junk, i.e., non –investment grade tranches of securitized assets routinely got “AAA” ratings prior to the meltdown of 2008. So-called super-safe “super seniors” were junk.