The New Robber Barons Page 19

  The model results were arbitrary. As part of its ongoing due diligence – and in particular due to a senior Chase credit officer’s concerns that CFS presented “a classic situation for fraud,” Chase Securities failed to validate the model at the outset or at any other time in its relationship with CFS, and S&P failed to ask for any validation.

  These problems occurred throughout a three year period, yet Chase Securities and the rating agencies did not uncover problems or publicly reveal red flags, of which there were many. Only Moody’s withdrew from rating further securities after CFS evolved to a new structure, but Moody’s did not downgrade securities it had already rated. Instead, issues became public due to the charity of a stranger. In the early fall of 1998, the rating agencies received an anonymous letter concerning the cash flows of the securitizations issued by CFS. The letter alleged that about 20 percent of cash collections on assets for the securitizations came from asset sales, even though the securitizations were supposed to be static pools from which only assets on which collections were zero or not cost effective could be sold. Furthermore, the sales were made to a newly incorporated company and the officers of the company were unknown.

  On October 21, 1998, Duff & Phelps Credit Rating Co. (DCR) downgraded CFS’s securitizations six notches from single A to BB—from solidly investment grade to well below investment grade. DCR cited CFS’s reliance on sales of the securitizations’ assets to make payments due to investors. A couple of days later, Fitch IBCA lowered the rating of CFS’s securitized transactions to CC, 10 notches below investment grade. It claimed it relied on CFS’s representations that assets sales did not represent a significant amount of monthly collections, yet Fitch IBCA had apparently done no independent investigation of sales of which it was already aware. Moody’s and S&P also downgraded the transactions below investment grade. Shortly thereafter, all of the rating agencies stopped rating CFS’s securitizations.

  On December 11, 1998, CFS filed for bankruptcy protection in the U.S. Bankruptcy Court for the Northern District of Oklahoma after its unsecured creditors threatened to file an involuntary bankruptcy petition. Jay L. Jones, then an executive officer of CFS and owner of the mysterious company that bought loans at inflated prices from CFS, pleaded guilty to a single count of conspiracy as part of a plea agreement in exchange for testimony against Bartmann, who was later acquitted. Jones was eventually convicted, sentenced to five years in prison for his role, and was released in January 2007. In a separate lawsuit, Chase Securities settled out of court for an undisclosed amount.

  While rating agencies may not be responsible for performing due diligence, they need to see evidence of appropriate due diligence in order to rely on data used to perform a fundamental statistical analysis. As circumstances change and a growing stream of red flags are revealed, due diligence standards become more stringent. The fundamental bases for value in CDOs are the value of the underlying assets and the cash flow. The timing, frequency, magnitude, and probability of receipt of the cash flows are affected by a variety of factors. Just as in any financial transaction, common sense, checks on the character of securitization managers, and one’s ability to grasp the fundamentals of what is happening with the cash flows are key. Yet, time and again, rating agencies fail to follow fundamental principles of statistical analysis and make the same mistakes.

  V. CONSTANT PROPORTION DEBT OBLIGATION SCANDAL 2006-2008: LEVERAGED CREDIT BETS

  Securitizations are not the only area where rating agencies doled out phony “AAA” ratings. Ratings on leveraged synthetic credit products are often misleading. A recent example is the "AAA" rating achieved by products like the constant proportion debt obligation (CPDO), which is largely a leveraged bet on the credit quality and market spreads of indexes based on U.S. and European investment-grade companies. Besides credit risk, there is a substantial amount of financial engineering risk. Potential losses are due to defaults or market value changes (when spreads widen). The high leverage puts investors' principal at risk, since it acts as first-loss protection on the leveraged exposure to the indexes.

  A. CPDOs: Phony “AAA” Ratings for New Structured Credit Products

  Constant Proportion Debt Obligations appeared on the market in 2006. I immediately flagged CPDOs as deserving a non-investment grade, i.e., junk rating. Yet, Moody’s and S&P awarded CPDOs “AAA” ratings. These leveraged bets on the credit quality and market spreads of indexes based on U.S. and European investment-grade companies put investors' principal at significant risk.

  Investors essentially took the risk of the first losses on leveraged exposure to the indexes, and there was no margin of safety. Scenario analysis revealed the flaws. I told the Financial Times in November 2006, “rating agencies have proved that when it comes to some structured credit products, a rating is meaningless. All AAAs are not created equal, and this is a prime example.”

  The rating agencies careless enabling of this product through phony “AAA” ratings had an important side effect. U.S. pension funds found that the distortions in the market created by CPDOs caused them to lose money on both their investments and their hedges.

  After rating an early CPDO transaction “Aaa,” Moody’s was criticized by industry professionals, including me. Moody’s then changed its rating methodology applying a different standard for subsequent transactions. Investors were attracted by the “Aaa” rating and the high coupons. The investment banks selling them were attracted to upfront fees of 1 percent plus annual servicing fees of up to 0.1 percent.

  In May 2007, the Financial Times reported that Moody’s original “Aaa” ratings for CPDO were the result of a computer “bug,” and the ratings should have been (according to Moody’s) four notches lower.

  It is difficult to tell whether Moody’s was taking half-measures to try to cover for its previously indefensible position, or whether it is really that flat out incompetent. In any case, four notches was inadequate, since that still left CPDOs with an investment grade rating. In February 2007, I had already written the SEC (and copied officers of all three rating agencies) that CPDOs had substantial principal risk, i.e., CPDOs merited junk ratings, and this was soon proved correct.

  B. Moody’s Is Exposed Having Changed CPDO Rating Methodology

  Moody’s documents showed that after it corrected the “bug,” it changed its methodology resulting in the ratings staying “Aaa” until January 2008, when credit spreads moved and proved the original ratings were ludicrous. The CPDOs were then downgraded several notches. As previously noted, even this was inadequate. Moody’s seemed to be floundering.

  The part about Moody’s changing its methodology was not news to me. I had included that information in the letter to the SEC on proposed regulations in February 2007. I do not recall who told me about the change. If it was a secret, it was an open secret. All three rating agencies’ models have more patches than Microsoft software.

  C. Moody’s: Both Methodology and Integrity Were Questionable

  Moody’s “Aaa” rating seemed to be due to something more than a serious disagreement with my opinion. Moody’s internal memo said that the bug’s impact had been reduced after “improvements in the model.” This suggests that there may be a cause and effect. The initial reality of inconvenient lower ratings may have been covered up by the methodology change.

  D. CPDO Investors Lost Most of Their Principal on New “Aaa” Rated Products

  By January 2008, just under a year after my written comments to the SEC, Moody’s analysts wrote that two of the originally “Aaa” rated CPDOs would unwind and investors would lose approximately 90 percent of their principal.” The irony is that Moody’s is the rating agency that claims its “Aaa” rating is based on expected loss.

  E. Standard & Poor’s Also Claimed a Model Error and Defended Its Unsound Methodology

  Standard & Poor’s had also rated CPDOs “AAA.” In fact, it was the first to do so, and Moody’s later followed suit. S&P vigorously defended its ratings methodology, even after it dow
ngraded CPDOs. S&P later disclosed that it too found an error in its computer models, but said: “This error did not result in a ratings change.”

  S&P claimed its error was caught and remedied by its ratings process. Yet S&P’s ratings process didn’t catch the fact that the “AAA” products were incompetently rated at the outset when in fact the products deserved a junk rating.

  In other words, S&P admitted to a model error while defending an unsound methodology. Its methods were in fact so unsound it initially awarded the “AAA” rating (as did Moody’s, so one should again question the “independence” of the rating agencies), admitted to a model error while temporarily defending an indefensible rating, and within a few months experienced the public humiliation of high principal losses on what was now obviously a product that merited a junk rating from the beginning.

  VI. RATING AGENCIES’ ROLE IN THE FINANCIAL MELTDOWN

  In a repeat of the failings of previous debacles such as the previously noted CFS scandal, and despite examples of fraud and misconduct in mortgage loan origination revealed in the FAMCO and Ameriquest scandals, the rating agencies once again failed to live up to a reasonable professional standard in rating hundreds of billions of securities backed by mortgages, all of the products derived from them, all of the entities that issued them, and the entities that invested in them.

  Although the subprime crisis has been a euphemism for the financial meltdown, various other financial products were overrated. Banks that created them and held them in inventory were also overrated. Banks that engaged in leveraged structured credit transactions and credit derivatives—all the major banks—were overrated. Sovereigns that these banks called home were also overrated.

  The following examples focus on the problems of misrated mortgage backed securities or multi-sector CDOs that included mortgaged backed securities, since the housing market is such a large part of the U.S. economy and the implosion of these products affected banks, monoline insurers, insurance companies, pension funds, individual retirement accounts, mutual funds, and foreign investors.

  The financial implosion of 2008 was not a “black swan” event or an unforeseeable problem. The following examples are not meant to be comprehensive or cover every institution in every category. Rather, I offer examples that typify preventable events and the ongoing failure of regulators to reign in the instigators of the collapse. The banks that ran the alternative banking system played a starring role while the rating agencies played a key supporting role.

  A. Misrated From the Start: RMBSs, CDOs, CDO-Squared

  Banks gave corrupt mortgage lenders with unsustainable business models large credit lines (similar to credit card debt) and packaged the loans into overrated private-label Residential Mortgage Backed Securities (RMBS). (APPENDIX II.) Most of the RMBS was rated “AAA,” since subordinated investors absorbed the risk of a pre-agreed amount of loan losses. But many RMBSs were backed by portfolios comprising risky fraud-riddled loans. Moreover, portfolios of mortgage loans often included loans for which the representations and warranties were breached. Most of the “AAA” investment was imperiled, and subordinated (lower rated) “investment grade” components were worthless. 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. (See APPENDIX III.)

  The worst of the subprime loans were among the cohort originated from the end of 2004 through 2007, and these entities were primarily funded through credit lines and private label securitizations engineered by Wall Street banks including JPMorgan Chase, Citigroup, Bank of America, Merrill Lynch (now part of Bank of America), Lehman Brothers (now bankrupt), Morgan Stanley (now a bank that can borrow from the Fed), Goldman Sachs (now a bank that can borrow from the Fed), Bear Stearns (now a part of JPMorgan Chase), and others.

  The rating agencies misrated Collateralized Debt Obligations (CDOs) that were re-securitizations of tranches of RMBSs. (APPENDICES IV. and V.) These so-called CDOs of Asset Backed Securities (CDOs of ABS), often used credit derivatives technology to transfer risk in a way that amplified risk to investors. These CDOs of ABS were often “multi-sector” deals and assets included not only misrated tranches of RMBSs but misrated tranches of other asset backed securities including student loans, auto loans, credit card receivables, consumer loans, and other tranches of misrated CDOs (which had other misrated CDO tranches in their asset portfolios). (APPENDIX IX.)

  These errors compound when tranches of securitizations with flawed ratings are used as collateral in other CDOs. From the start "AAA"-rated tranches of these deals showed a high probability of significant principal loss. A product called CDO-squared included the mezzanine (middle-risk but still investment grade) tranches of misrated CDOs (which had other misrated CDO tranches in their asset portfolios) that were virtually worthless. The result was that “AAA” tranches of CDOs had enormous risk of principal loss at creation and merited non-investment grade, i.e., junk ratings.

  The problem was magnified further when hedge funds applied leverage to these products, virtually guaranteeing eventual disaster. Flawed products purchased at par with the use of leverage are on a one-way trip down net asset value's slippery slope. Yet rating agencies handed out “AAA” ratings on vehicles like structured investment vehicle "lites," also known as SIV-lites. These vehicles employed short-term financing on long-dated assets that had flawed ratings. Structured Investment Vehicles (SIVs) and Asset Backed Commercial Paper Conduits (ABCP) were created to further temporarily offload “highly rated” tranches of CDOs. Real Estate Mortgage Investment Conduits (REMICs and Re-REMICs) were plagued with similar problematic ratings as RMBS and CDO products.

  B. Credit Derivatives: Documentation Risk Not Captured By Ratings

  Credit derivatives allowed the multiplication of risk. A fraud-riddled loan could be used over-and-over again in deal-after-deal, since the physical asset did not need to be part of the portfolio. The same was true of tranches of securitizations backed by fraud riddled loans. Instead, it was referenced as a “notional” asset. The notional risk could be transferred more than once. This seemed to happen only with the worst loans and worst tranches. Some RMBSs and CDOs were built to fail. This was very convenient for short sellers.

  Credit derivatives and total return swaps added “financial engineering” risk to securitizations, and this risk was not captured by the ratings. These over-the-counter products at times included “documentation risk” detrimental to the investor.

  C. 2006 Onward: Tail End of a Ponzi Scheme

  HSBC took a $6 billion subprime write-off for the fourth quarter of 2006. None of the U.S. banks followed suit, although they should have. Many (including me) publicly challenged the failure to account for losses. By 2007, there was no excuse for the rating agencies, the SEC, and the banks that brought corrupt deals to market.

  Instead, toxic securitization accelerated in the first half of 2007—classic malfeasance as a Ponzi scheme collapses. I projected hundreds of billions in principal losses for mortgage loans alone—not counting other troubled asset classes, derivative duplication, and leverage.

  By 2006, to keep what had now devolved into a Ponzi scheme going, more loans and securitizations were required. This is the classic end play of a Ponzi scheme. (APPENDIX III.) Lending standards plummeted and fraud by mortgage lenders accelerated to attract more borrowers. Collapsing mortgage lenders paid high dividends to shareholders (old investors) and interest on credit lines to Wall Street (old investors) with money raised from new investors in built-to-fail CDOs. New money allowed Wall Street to temporarily hide losses and pay enormous bonuses.

  While this business at first may not have appeared to be Ponzi scheme, it crossed the breakeven point and the cover-ups began prior to 2007. By the end of 2006, public reports of implosions of large mortgage lenders eliminated CEOs’ and rating agencies’ plausible deniability, albeit problems were manifest well before then.
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  In August 2007, I explained to the Wall Street Journal, which reported the matter, that AIG had materially mismarked a more than $19 billion “super senior” credit default swap position that it was required to mark-to-market (market prices determine value). AIG said it would never experience a loss and took no accounting loss whatsoever. AIG’s market price loss was already material, and the underlying CDOs would soon have substantial principal loss (leading to losses for AIG) on just this one position alone. It also had other problematic positions on its balance sheet. A few months later auditors said AIG showed material weakness in its accounting. By September 2008, AIG was bailed out unjustly enriching its credit default swap and securities lending counterparties, including Goldman Sachs. Henry Paulson was CEO of Goldman at the time the problematic trades were put on, and he was Treasury Secretary with influence over the AIG bailout that enriched Goldman Sachs without conducting an investigation.

  This is particularly poignant, because under Hank Paulson’s leadership, Goldman Sachs Alternative Mortgage Products, or GSAMP, was alleged to have created Garbage Sold At Mythical Prices. A complaint of alleged fraud on the part of Goldman Sachs detailed its close relationships with troubled mortgage lenders, Countrywide, New Century, and Fremont. A complaint showed Goldman knew of "an accelerating meltdown for subprime lenders such as New Century and Fremont." Despite known serious loan problems, Goldman continued to securitize the loans and sell them in packages of residential mortgage backed securities.