The top executive of Moody’s warned his board in 2007 that the quality of credit ratings was in danger due to trends that could “place the entire financial system at risk.”
The confidential briefing was among documents obtained by congressional investigators for a hearing Wednesday into the role of rating agencies in the worst economic crisis since the 1930s.
Executives of Moody’s Corp., McGraw-Hill Cos Inc.’s Standard & Poor’s, and Fimalac SA’sFitch Ratings were blasted by lawmakers for giving high ratings to mortgage-linked securities, which later collapsed in value and helped spread chaos through the global financial system.
Mutual fund company Vanguard said rating agencies were letting debt issuers “get away with murder,” according to another document released by the U.S. House of Representatives Oversight and Government Reform Committee.
Rep. Henry Waxman, the California Democrat who chairs the committee, said the credit rating agency story was one of “colossal failure.”
Moody’s Chief Executive Raymond McDaniel told directors in October 2007 that Moody’s was facing a dilemma in trying to maintain both market share and quality in the ratings paid for by issuers of the securities.
“The real problem is not that the market… underweights ratings quality but rather that in some sectors, it actually penalizes quality,” he said, according to the documents.
“It turns out that ratings quality has surprisingly few friends: issuers want high ratings, investors don’t want ratings downgrades, short sighted bankers labor shortsightedly to game the ratings agencies.”
McDaniel said analysts and managing directors are continually pitched by bankers, issuers and investors and sometimes “we drink the Kool-Aid.”
Waxman’s committee is holding a series of hearings to examine the genesis of the financial crisis. Securities and Exchange Commission Chairman Christopher Cox and former Federal Reserve Chairman Alan Greenspan are among Thursday’s witnesses.
“The rating agencies broke this bond of trust, and federal regulators ignored the warning signs and did nothing to protect the public,” said Waxman. “The result is that our entire financial system is now at risk.”
Rep. Tom Davis of Virginia, the top Republican on the committee, said the credit rating firms’ triple-A credit ratings are meant to insulate investors against nasty shocks. “Many are asking how and why … they got it so wrong.”
A former S&P executive, Frank Raiter, said that the rating agencies focused on maximizing short-term profits and that money from rating asset-backed securities became so great that managers lost focus.
Raiter, S&P’s managing director and head of residential mortgage-backed securities ratings from March 1995 to April 2005, said S&P failed to implement a model that could have given earlier warnings about many new products. He said cost was one reason the model was not kept current.
RATERS ADMIT SOME MISTAKES
The rating agencies themselves acknowledged some responsibility. “We did not … anticipate the magnitude and speed of the deterioration in mortgage quality or the suddenness of the transition to restrictive lending,” Moody’s McDaniel said.
Fitch Ratings Chief Executive Stephen Joynt said Fitch did not foresee the magnitude of the decline in the U.S. housing market or the dramatic shift in borrower behavior.
“I believe we’ve introduced significant conservatism into the models now,” he said at the hearing.
S&P President Deven Sharma said it is now clear that a number of assumptions used in preparing ratings on mortgage-backed securities issued between 2005 and mid-2007 did not work.
U.S. and European regulators are crafting rules to rein in credit raters and have already proposed a series of reforms, such as forcing raters to disclose more information about their underlying assumptions used to rate products.
Since the subprime mortgage market collapsed, credit raters have come up with some of their own solutions.
S&P is implementing more safeguards against potential conflicts of interest by establishing an office of the ombudsman and is increasing the amount of information it publishes about the stress tests for ratings.
Moody’s and Fitch also say they are working to insulate themselves from conflicts of interest.
Rating agencies agreed on Wednesday that much needed to be done to win back investor confidence.
(Editing by John Wallace, Gerald E. McCormick, Tim Dobbyn)
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