Credit rating agencies had doubts by 2006

By Sewell Chan
New York Times / April 23, 2010

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WASHINGTON — As the housing market began to falter in 2006 and the risks embedded in Wall Street’s giant collective bet on subprime mortgages became apparent, a sense of omen filled the corridors of Standard & Poor’s and Moody’s, the two big credit rating agencies.

“Rating agencies continue to create an even bigger monster — the CDO market,’’ one S&P employee wrote in an internal e-mail message that December, referring to the collateralized debt obligations that emerged at the heart of the financial crisis. “Let’s hope we are all wealthy and retired by the time this house of card falters.’’

Another S&P employee wrote in an instant message the following April: “We rate every deal. It could be structured by cows and we would rate it.’’

A Senate panel will release 550 pages of exhibits today — including these and other internal messages — at a hearing scrutinizing the role the two rating agencies played in the 2008 financial crisis. The panel, the Permanent Subcommittee on Investigations, released excerpts of the messages yesterday.

“I don’t think either of these companies have served their shareholders or the nation well,’’ said Senator Carl Levin, Democrat of Michigan and the subcommittee’s chairman.

In response to the Senate findings, Moody’s said it had “rigorous and transparent methodologies, policies, and processes,’’ and S&P said it had “learned some important lessons’’ and taken steps “to increase the transparency, governance, and quality of our ratings.’’

The investigation, which began in November 2008, found that S&P and Moody’s used inaccurate rating models from 2004-07 that failed to predict how high-risk residential mortgages would perform; allowed competitive pressures to affect their ratings; and failed to reassess past ratings after improving their models in 2006.

The companies failed to assign adequate staff to examine exotic investments, and neglected to take mortgage fraud, lax underwriting, and “unsustainable home price appreciation’’ into account, the inquiry found.

By 2007, when the companies admitted their failures and downgraded the ratings to reflect the true risks, it was too late.

Large-scale downgrades over the summer and fall of that year “shocked the financial markets, helped cause the collapse of the subprime secondary market, triggered sales of assets that had lost investment-grade status, and damaged holdings of financial firms worldwide,’’ according to a panel memo.

While many of the rating agencies’ failures have been documented, the Senate investigation provides perhaps the most vivid accounting of the failures.

Although the agencies were supposed to offer objective and independent analysis of the securities they rated, the documents released by Levin’s panel showed the pressures the companies faced from their clients, the same banks that were assembling and selling the investments.

“I am getting serious pushback from Goldman on a deal that they want to go to market with today,’’ a Moody’s employee wrote in an internal e-mail message in April 2006.

In an August 2006 message, an S&P employee likened the unit rating residential mortgage-backed securities to hostages who have internalized the ideology of their kidnappers.