A little bit Moody about investing

A long article in the New York Times today looks into one significant factor in the credit market collapse: bond rating agencies' going too easy on their evaluations of the risks surrounding a slew of mortgage backed securities. In the abstract, it's interesting reading. In real life, it's cause for rage.

The article focuses on Moody's, one of the big rating agencies on Wall Street, and on its role in facilitating the housing bubble (the others are Standard and Poor's and Fitch). Basically, it goes like this: Mortgage originators securitized the mortgages they produced into various financial instruments like bonds, collateralized debt obligations, etc. so they could sell these instruments to investors eager to get a good return on their money. The sale of the instruments produced cash which loan originators could then use to generate more mortgages. It's the job of a company like Moody's to assess the risk associated with the securities and assign a grade to them based on an estimation of the quality of the underlying debt. In the words of a Moody's spokesman quoted in the Times:

“Moody’s credit ratings play an important but limited role in the financial markets — to offer reasoned, independent, forward-looking opinions about relative credit risk, based on rigorous analysis and published methodologies...”

Nice spin with that "but limited" bit, eh?

Whatever.

Let's look at the "reasoned, independent, forward-looking" part of the statement. Financial instruments built out of mortgages and other sorts of debt are often divided into slices called "tranches" (tranche = slice in French) with a heirarchy of risk and reward assigned to each slice. Higher tranches get paid before lower ones. When all the debts in the security are paying as they should everybody gets a piece of the action. But as mortgage holders get behind in their payments or (worse) default, the lower tranches get nothing while the upper guys still get paid. I know that's horribly complex, but that's the way they do things. And complexity can be profitable.

So the Times reports:

Consider a residential mortgage pool put together in summer 2006 by Goldman Sachs. Called GSAMP 2006-S5, it held $338 million of second mortgages to subprime, or riskier, borrowers.

The safest slice of the security held $165 million in loans. When it was issued on Aug. 17, 2006, Moody’s and S.& P. rated it triple-A. Just eight months later, Moody’s alerted investors that it might downgrade the top-rated tranche. Sure enough, it dropped the rating to Baa, the lowest investment-grade level, on Aug. 16, 2007.

Then, on Dec. 4, 2007, Moody’s downgraded the tranche to a “junk” rating. On April 15 of this year, Moody’s downgraded the tranche yet again; today, it no longer trades. The combination of downgrades and defaults hammered the securities.

Millions in debt were rated an excellent risk in 2006. The same -- exactly the SAME -- debt gets a not so good score in a year, and four months later it's junk. Now nobody wants any of it at any price. This one example of a scenario that has been repeated untold times since the boom went bust and would appear to be what passes for "forward-looking" in the world of risk assessment.

Then there's the issue of "independent" opinions. Used to be that Moody's got paid by the people who bought securities, not the guys selling them. That changed in the 70s. Now the issuers of credit instruments pay rating agencies for the rating service, and the conflict of interest is just about inescapable. Add to that the pressures to maximize shareholder profits (Moody's went public in 2000) and you get a real problem. From the Times:

By the time Moody’s became a public company in 2000, structured finance had become its top source of revenue. Employees in this unit rated bundles of assets like credit card receivables, car loans and residential mortgages. Later they rated collateralized debt obligations, or C.D.O.’s, yet another combination of various bundles of debt.

Moody’s could receive between $200,000 and $250,000 to rate a $350 million mortgage pool, for example, while rating a municipal bond of a similar size might have generated just $50,000 in fees, according to people familiar with Moody’s fee structure.

A standard of profitability at many companies is its operating margin, which measures how much of its revenue is left over after it pays most expenses. While operating margins at Moody’s were always enviable — in 2000 they stood at 48 percent — they climbed even higher as revenue from structured finance rose. From 2000 to 2007, company documents show, operating margins averaged 53 percent.

Even thriving companies like Exxon and Microsoft had margins of 17 and 36 percent respectively in 2007. But Moody’s and its counterparts were not founded to be profit machines.

Structured finance is a generic term for all those complex securities we've heard so much about as the financial markets spazzed out. The more complex the financial instrument, the more a rating agency could charge to assess its risk. A huge amount of money was on the line with each rating. This is what passes for "independence" in the world of risk assessment.

As to "reasonable," if we are to apply a pragmatic test -- say, looking at whether or not their ratings accurately reflected the realities of the products under scrutiny -- the verdict can't be kind. How could anybody claim that reasonable opinions about risk ended up with a global financial meltdown? As with the tech bubble before it, the housing bubble was irrational, and Moody's was integral to the irrationality.

There is ample blame for this mess. Subprime lenders who asked nothing regarding the credit worthiness of people who were buying houses they couldn't afford, government regulators who allowed big banks and other financial institutions to value their assets according to the "reasonable" opinions of rating agencies and didn't regulate like they should have, banks that leveraged every buck they had on deposit 30 times in reckless bids to maximize profits, doofus home buyers picking up properties on spec so they could flip them quick in an ever-rising tulip mania of a market -- all those guys and others had a big share in the mess.

But credit rating agencies like Moody's enabled a baseless boom by propping up false assessments of the underlying value of the securities that kept the credit flowing beyond any reasonable limit.