Credit ratings fueled subprime boom

This is the fourth in a five-part series on the subprime mortgage crisis.

As storm clouds gathered over New York on July 10, Standard & Poor's started a 10 a.m. conference call to discuss why the credit rating company was about to take its most dramatic action in more than two years.

S&P analysts said they might cut ratings on $12 billion of the world's worst-performing subprime mortgage bonds, some of them less than a year after they had been given investment-grade designations. Not since 2005, when it downgraded Ford Motor Co. and General Motors Corp., had S&P generated so much attention.

S&P chief economist David Wyss, 63, and managing director Thomas Warrack, 45, made a 20-minute presentation and then opened the line for questions from investors and analysts.

"I'd like to understand why now, when you could have made this move many, many months ago," said Steven Eisman, 45, who manages the $1.5 billion FrontPoint Financial Services hedge fund for Morgan Stanley in Greenwich, Conn. "The paper just deteriorates every single month."

Warrack and managing director Susan Barnes, 42, explained S&P's view of the time needed to accurately judge the performance of securities. Eisman cut them off. "You need to have a better answer," he said.

As the five-year real estate boom approached its peak in 2005, Wall Street marketed a new type of security backed by high-interest subprime mortgages issued to the least credit-worthy home buyers. Blessed by the biggest credit rating companies as safe investments, these instruments offered higher returns than government bonds with the same ratings.

Investment banks, including Bear Stearns Cos., Deutsche Bank AG and Lehman Brothers Holdings Inc., sold $1.2 trillion of these securities in 2005 and 2006, said Brian Bethune, director of financial economics for Global Insight Inc. in Waltham, Mass.

None of this could have happened without the participation of Wall Street's three biggest arbiters of credit -- Moody's Investors Service, S&P and Fitch Ratings. About 80 percent of the securities carried AAA ratings, the same designation given to U.S. Treasury bonds.

This implied that the investments couldn't fail, says Sylvain Raynes, 50, a former Moody's analyst who now is a principal at R&R Consulting, a structured securities valuation firm.

"The rating agencies had an almost godlike status in the eyes of some investors," Raynes says. "Now, that trust is gone. It's been replaced with a feeling of betrayal."

The companies' ratings underpinned Wall Street's expansion of the global market for securities based on high-risk subprime loans.

Issuers got guidance from rating companies on how to shape their subprime securities to win the ratings, says Joshua Rosner, managing director of the New York-based research firm Graham Fisher & Co. Investment banks used software distributed by the ratings companies to show them how to meet the requirements, then paid the companies to have the securities rated, he says.

"The idea that the rating agencies are impartial in the world of structured finance is a joke," Rosner says.

Distributing the criteria and discussing them with issuers is a matter of transparency, says Claire Robinson, Moody's senior managing director of asset finance and public finance.

"We do not structure transactions," Robinson says. "We do not provide consulting services in terms of assembling transactions or choosing assets or pools or anything of that nature. We comment on credit quality."

Moody's raised "credit enhancement" requirements for bonds in 2006 as analysts noted the deterioration of lending standards, she says.

One $720 million loan pool created by Tokyo-based Nomura Holdings Inc. was rated Baa3, an investment-grade rating, by Moody's when issued in 2006. Now, it's rated Caa1, seven levels deep into junk-bond territory, and priced at 32 percent of the original value after 29 percent of the mortgages defaulted.

Almost 40 percent of the loans in the pool were originated by Costa Mesa, Calif.-based Quick Loan Funding, run by Daniel Sadek, a broker who started the subprime company in 2002 with the motto: "You can't wait. We won't let you."

It wasn't the first misstep by Moody's, founded in 1900 by former Wall Street errand runner John Moody. Nor was it a first for Standard & Poor's, started in 1860 by Henry Poor, a Maine farm boy turned journalist known for citing "the investor's right to know."

The raters faced vitriol and lawsuits in 2001 when they were slow to downgrade Enron Corp. and WorldCom Inc. as accounting discrepancies emerged. In Enron's case a downgrade would have put the Houston-based energy company into default because of so-called rating triggers on its bonds. The rating companies were also criticized in 1994 for keeping bonds sold by Orange County, Calif., at investment grade even as the county filed the nation's largest municipal bankruptcy.

The lure of profits as the housing market began a run of five record-breaking years in 2000 fueled the change, says Graham Fisher's Rosner.

"They went from looking at companies that already existed to having a role in structuring securities," Rosner says.

S&P, a unit of New York-based McGraw-Hill Cos., issued ratings for about 98 percent of all new subprime mortgage bonds created last year, according to the industry newsletter Inside B&C Lending. Moody's, whose parent is New York-based Moody's Corp., provided ratings on 97 percent, while Fitch assessed 51 percent.

Fitch, owned by Paris-based Fimalac SA, declined to comment, according to spokesman James Jockle.

One regulator was issuing warnings. In a June 2006 speech at a Mortgage Bankers Association conference in Half Moon Bay, Calif., Susan Bies, the Federal Reserve governor in charge of regulation, urged the bankers to tighten credit standards for adjustable subprime mortgages. Bies said borrowers might default because of "payment shock" when interest rates rose.

The bankers didn't listen. The Fed's survey of senior loan officers issued the following month showed that 10 percent of U.S. lenders had lowered standards to qualify customers for mortgages.

In September 2006, Congress passed the Credit Rating Agency Reform Act, after hearings and investigations that began in the wake of the Enron meltdown. The measure gave authority to the Securities and Exchange Commission to designate, regulate and investigate rating companies.

"The essential conflict is they are being paid by the people that they rate, they are working with the people they rate," says Arthur Levitt, former SEC chairman, a Bloomberg LP board member and a senior adviser to the Carlyle Group, a Washington-based hedge fund.

S&P's president, Kathleen Corbet, resigned in August after lawmakers and investors criticized the company for failing to judge the risks of subprime securities.

FRIDAY: Subprime mortgage-related securities cripple world credit markets.