Arthur Levitt, the SEC chairman, was one of those who had been told by Treasury that Born’s supposed stridency made her impossible to work with. Years later, though, he worked with her on a project and found her completely collegial. He later told the PBS documentary show Frontline that he felt Treasury had misled him. For his part, Greenberger believes that Rubin didn’t take her seriously because he didn’t view her as a bona fide member of the establishment like himself.
Even so, why should Brooksley Born’s personality or her background have been the deciding factor? Derivatives either were a problem or they weren’t. Rubin either understood the trouble they might someday cause or he didn’t. If, as he says, he did understand the problem, then allowing his position to pivot on whether or not Born showed him the proper deference would seem, in retrospect, a pretty serious dereliction of duty. Robert Rubin had spent most of his career affecting a kind of egoless management style. His treatment of Born—his willingness to put his personal irritation ahead of the important public policy issues that derivatives posed—suggests that he wasn’t quite as egoless as he let on.
It fell, finally, to Larry Summers to make sure that derivatives could never again be threatened by a regulator like Brooksley Born.
After Rubin left the Treasury Department, he took a position with Citigroup as “senior counselor,” where he had no operational responsibilities but was nonetheless paid around $15 million a year. Clinton named Summers as his replacement. A few months later, the President’s Working Group issued a long-awaited report on derivatives—a report that had been prompted by the furor over Born’s concept release. “A cloud of legal uncertainty has hung over the OTC derivatives markets in the United States in recent years,” read the cover letter accompanying the report. The report recommended that that uncertainty be remedied by Congress. It was: Phil Gramm pushed through the Commodities Futures Modernization Act in 2000, which Clinton—with Summers’s enthusiastic support—signed into law. The new law explicitly stated that derivatives were not futures and could not be regulated by the CFTC—or any other government regulator. It was the last bill Clinton signed before leaving office.
A year earlier, the president had signed a law that repealed Glass-Steagall, which had split commercial from investment banking so many years before. Gramm-Leach-Bliley, as the new law was called, also had Summers’s strong support. One of its nods to modern finance was a provision that “expressly recognized and preserved this authority for national banks to engage directly in asset-backed securitization activities,” as Comptroller of the Currency John Dugan would note many years later.
In most respects, though, the repeal of Glass-Steagall was largely symbolic, a recognition of changes that had already taken place. By 1999 all the big banks had investment banks and trading desks. And in any case, the real problem was not that the wall that had long separated commercial and investment banks had been torn down. Nor was it that the CFTC was not allowed to regulate derivatives. No, the core problem was that even as the old regulatory firmament was disappearing, nothing was being created to replace it. If Rubin and Summers deemed the CFTC as not the right agency to regulate derivatives, they should have given the task to some other agency they felt could handle it. Their defenders point out that the Republicans had firm control of both houses of Congress, and that is certainly true. But that wasn’t the only reason nothing was done to shore up the nation’s financial system. The other reason was that Bill Clinton’s Treasury was every bit as complacent as Alan Greenspan’s Fed.
After the financial crisis, one man who had worked closely with Rubin at Treasury would exclaim: “My God, I wish I had done more.”
8
Why Everyone Loved Moody’s
In September 2000, Dun & Bradstreet, a sleepy, 160-year-old business information company, spun off a sleepy subsidiary. The subsidiary was Moody’s, the credit rating agency, which Dun & Bradstreet had owned since 1962 and which had just hit the century mark itself.
Along with its two competitors, Standard & Poor’s and Fitch Ratings, Moody’s was in the business of gauging the possibility that a bond would be repaid on time and in full. It did so by using a series of letter grades known as ratings. Its highest “investment-grade” rating, triple-A, meant that the bond had the same risk of default as a Treasury bond: almost none. Bonds rated double-A to triple-B minus were also investment grade—riskier than triple-As, but still safe enough for widows and orphans. Anything below a triple-B minus was a “junk” bond, considered too risky to be bought by pension funds and other institutional investors that were legally bound to hold only safe investments.
The business of rating bonds was as steady as a thing could be. Everybody used the three rating agencies, and everybody understood what those letter grades represented on the risk spectrum. In the prospectus it issued prior to becoming a public company, Moody’s boasted that it rated $30 trillion of the world’s debt across one hundred countries.
“Steady,” however, is not the same as “fast growing.” Though it was immensely profitable, Moody’s 1999 revenues of $564 million would have barely dented the Fortune 2000, much less the Fortune 500. When its stock began trading, most investors yawned. Warren Buffett, who always liked to buy stocks others overlooked, took a 15 percent stake in Moody’s, but that was mainly because he liked the company’s impregnable market position and its steady cash flow.
As events would prove, though, Moody’s was poised to start growing faster—a lot faster. In addition to corporate and government bonds, Moody’s had begun rating “structured financial products,” Wall Street’s catchall euphemism for mortgage-backed securities, off-balance-sheet vehicles, derivatives, and the like. (S&P and Fitch were doing the same.) Although Moody’s had been reluctant to rate mortgage-backed securities when first approached by Lew Ranieri in the 1980s, that reluctance was long gone. By the time Moody’s became a stand-alone company, its structured finance business was growing much faster than its traditional bond rating business.
Structured financial products needed more than just a rating, though. They needed a high rating. The whole purpose of an asset-backed security was to take assets that could never merit a triple-A rating on their own and transform them into products safe enough to be rated that highly. Triple-A securities could be bought by investors like money market funds and pension funds. They could be used by banks to reduce capital requirements. The combination of tranching—with its cascading levels of risk that used the riskier tranches in the capital structure to protect the higher-rated tranches—and the other credit enhancement techniques that fortified the triple-As made that possible.
The rating agencies had always been stingy about bestowing triple-A status on corporate debt. In 2007, for instance, only six companies had a triple-A rating. Yet when it came to tranches of mortgage-backed securities, the rating agencies handed out triple-As like candy. Literally tens of thousands of mortgage-backed tranches were rated triple-A.
In the early years, the securities performed well. That was true even of the relatively small batch of asset-backed securities that used subprime mortgages. They had plenty of credit enhancements, and besides, housing prices were going up, the way they were “supposed” to, which kept defaults to a minimum. But the rating agencies continued to slap their triple-As on subprime securities even as the underwriting deteriorated—and as the housing boom turned into an outright bubble, waiting to burst. When it did burst, the rating agencies, and the investors who had depended on them, were caught flat-footed.
There were many reasons why the rating agencies continued to grant triple-As long after they should have stopped: an erosion of standards, a willful suspension of skepticism, a hunger for big fees and market share, and an inability to stand up to Wall Street. Not least, Moody’s and the other rating agencies turned their backs on their own integrity. “The story of the crisis,” says a former Moody’s executive, “is how Moody’s put its profits ahead of what was right.”
After an internal m
eeting held in the fall of 2007, as the financial crisis was gaining steam, a Moody’s employee complained that he would like more “candor” about the company’s “errors,” as he called them. “[They] make us look either incompetent at credit analysis or like we sold our soul to the devil for revenue, or a little bit of both.”
A little bit of both, indeed.
John Moody, the founder of Moody’s, was a muckraking journalist who in 1900 published something called Moody’s Manual of Industrial and Miscellaneous Securities. This publication, which investors took to immediately, formed the origins of Moody’s. At first, it offered statistical information about stocks. Then Moody began adding analysis, ranking stocks with letter grades. Finally, he shifted his focus from stocks to bonds. This was his eureka moment.
There has always been far less information available about bonds than stocks. Bonds don’t trade on public exchanges, and most of the information about them is held by the investment bankers and traders who are trying to sell them. Moody saw his manual as a means of leveling the playing field. As the circulation of his publication grew, others copied him. Henry Varnum Poor, who edited the American Railroad Journal, engaged his son to begin rating bonds in 1922; after a merger with Standard Statistics in 1941, the company became known as Standard & Poor’s.
The credit rating business didn’t change much until the 1970s, when two things happened. First, the rating agencies, which by then included a smaller upstart, Fitch Ratings, upended the way they generated revenue, abandoning the subscriber model in favor of charging issuers directly. The switch made undeniable business sense. Bond ratings had become important enough that many investors wouldn’t buy an unrated bond. Subscriptions were always going to be optional for the subscriber, but a rating had become mandatory for issuers.
The rating agencies’ new business model came with an obvious conflict: now that they were being paid by bond issuers, the rating agencies were potentially beholden to the same people whose bonds they were rating. For a long time, the potential conflict had kept Moody’s and S&P from taking that step. In 1957, for instance, a Moody’s executive told the Christian Science Monitor, “We obviously cannot ask payment for rating a bond. To do so would attach a price to the process, and we could not escape the charge, which would undoubtedly come, that our ratings are for sale… .” Now Moody’s was insisting it could manage this conflict.
The second change came in 1975, when the Securities and Exchange Commission began to use ratings to determine how much capital broker-dealers had to hold. The higher a bond’s rating, the less capital the broker-dealer had to hold against it. This made ratings even more important, but it also begged the question of whose ratings would count toward reducing capital. To prevent a proliferation of fly-by-night bond raters, the SEC decreed that Moody’s, S&P, and Fitch were nationally recognized statistical rating organizations, or NRSROs.
By the time mortgage-backed securities arrived on the scene, ratings were ingrained in the very fiber of the capital markets. Lenders put ratings triggers in bond agreements—stipulations that a ratings downgrade could cause a debt payment to accelerate or collateral to come due. The government had literally hundreds of rules based on ratings. One said that 95 percent of the bonds held by low-risk money market funds had to have an investment-grade rating. Another said that schools participating in government financial aid programs needed to maintain a certain rating. State regulators used ratings to determine the capital that insurers had to hold. “The resulting web of regulation is so thick that a thorough review would occupy hundreds, perhaps thousands of pages,” wrote Frank Partnoy, a professor at the University of San Diego School of Law and a longtime critic of the rating agencies.
As well intentioned as many of these rules were, they overlooked two problems. The first is that the bond market was essentially outsourcing its risk management to the rating agencies. The universal acceptance of the ratings resulted in almost no independent research by the fund managers who actually bought the bonds. They simply assumed that if the rating agency had given a bond a double-A or a triple-A, it must be safe. Nor was this some dark secret. As the Office of the Comptroller of the Currency put it in 1997, “Ratings are important because investors generally accept ratings … in lieu of conducting a due diligence investigation of the underlying assets… .”
Second, the rules imbued the rating agencies with an “almost Biblical authority,” to borrow a phrase first used in 1968 by New York City’s finance administrator, Roy Goodman. But that authority wasn’t remotely deserved. The agencies had charts and studies showing that their ratings were accurate a very high percentage of the time. But anyone who dug more deeply could find many instances when they got it wrong, usually when something unexpected happened. The rating agencies had missed the near default of New York City, the bankruptcy of Orange County, and the Asian and Russian meltdowns. They failed to catch Penn Central in the 1970s and Long-Term Capital Management in the 1990s. They often downgraded companies just days before bankruptcy—too late to help investors. Nor was this anything new: one study showed that 78 percent of the municipal bonds rated double-A or triple-A in 1929 defaulted during the Great Depression. To critics like Partnoy, the fact that ratings carried the force of law explained a troubling paradox: even as proof piled up that the agencies made mistake after mistake, their power continued to grow.
In retrospect, the surprise is not that the rating agencies would eventually be corrupted by their business model, but that it took so long to happen. For many years, whatever mistakes they made were the result of misguided analysis, not out-and-out cravenness. This was especially true of Moody’s, which had a reputation among bond issuers as a “hard-ass,” according to a former employee. The Moody’s culture, introverted and nerdy, was more akin to academia than Wall Street. Analysts would answer their phones after many rings, if at all. Moody’s analysts were standoffish toward the issuers who paid their salaries—a little like journalists during the heyday of newspapers, when they could thumb their noses at advertisers. Credit analysts at Moody’s didn’t worry about the revenue that might be lost if they refused to give an issuer the rating it sought. That was someone else’s problem. In the early 1990s, Moody’s actually refused to rate a then popular structured product, on the grounds that a rating might lead investors to expect more than they were likely to get.
This last anecdote was recounted in a 1994 article in Treasury and Risk Management magazine entitled “Why Everyone Hates Moody’s.” After polling ninety-nine corporate treasurers, the magazine concluded that “ingrained in Moody’s corporate culture is a conviction that too close a relationship with issuers is damaging to the integrity of the rating process.” Moody’s was actually proud of that characterization. A company executive responded by saying that the survey left out “our most important constituency … investors.”
What caused Moody’s to change were three things. The first was the inexorable rise of structured finance, and the concomitant rise of Moody’s structured products business. The second was the 2000 spin-off, which resulted in many Moody’s executives getting stock options and gave them a new appreciation for generating revenues and profits. And the final factor was the promotion of a former lawyer named Brian Clarkson within structured finance.
A Detroit native who had graduated from Ferris State University in Michigan and then practiced law at a tony New York firm, Clarkson joined Moody’s as an executive in 1991, without ever having worked as a credit analyst. One of his early tasks was to rate mortgage-backed securities issued by Guardian, the subprime mortgage originator founded by the Jedinaks in California. The bonds, needless to say, eventually blew up, but if there was a lesson in that, it was lost on Clarkson and his bosses. By 1995, he had become the co-head of the asset-backed finance group.
Clarkson went off like a bomb inside Moody’s. He developed a reputation for being nasty to those who couldn’t fight back and for never forgetting a slight. “At my level, any watercooler discussion of his mana
gement style included the words ‘fear and intimidation,’” a former Moody’s lawyer, Rich Michalek, later told the Senate Permanent Subcommittee on Investigations. Mark Froeba, another ex-Moody’s lawyer, told investigators that the company’s top executives “recognized in Brian the character of someone who could do uncomfortable things with ease, and they exploited his character to advance their agenda.” That agenda was using structured finance to boost revenues, market share, and—above all—Moody’s stock price.
Clarkson had no problem with this agenda. “We’re in a service business,” he once told the Wall Street Journal. “I don’t apologize for that.” But what exactly did that mean for a company that rated bonds? It wasn’t just a case of answering the phones on the first ring. Under Clarkson, former analysts say, it also meant caring about whether the issuers—meaning the small group of investment banks who mattered—were happy with the ratings they got.
Clarkson’s co-head of the asset-backed group was longtime Moody’s analyst Mark Adelson. Adelson was, in some ways, the opposite of Clarkson—a careful, cautious, somewhat skeptical analyst. He had been involved in structured finance seemingly forever; as a young lawyer in the 1980s, Adelson had worked on several of the early deals put together by Lew Ranieri and Larry Fink. Perhaps because of his long experience, he was always less willing to accept uncritically many of the arguments made for mortgage-backed securities. When underwriters began reducing their credit enhancements, claiming that the securities had proven themselves with their good performance, Adelson didn’t buy it. The fact that an asset class like housing had performed well in the past said nothing about how the same asset class was going to perform in the future, he believed. For a very long time, Moody’s backed Adelson, for which he would always be grateful. But his skepticism was out of sync with both the market and the new Moody’s. “My view wasn’t the most widely held one at Moody’s,” he says now. “You spend a lot of time doing soul-searching when you’re looking one way and everyone else is looking the other way.” As Clarkson was rapidly promoted, Adelson was eventually moved out of asset-backed securities. In 2001, he quit.
All the Devils Are Here Page 16