On October 22, 2008, the Congressional Committee on Oversight and Government Reform held a hearing on the role of the credit rating agencies in the Wall Street crisis. In his opening statement, Chairman Henry Waxman referenced an October 2007 presentation by Moody’s CEO, Ray McDaniel: “Analysts and MD’s are continually pitched by bankers, issuers and investors,” as McDaniel described in a confidential address to the Board of Directors, and admitted that sometimes we “drank the kool-aid.”
The problem is compounded when rating agencies are paid consulting fees to help to design the structured finance deals in the first place. “Everyone is sitting on the same side of the table at that point,” says Graham Henley, a director at LECG who formerly served as director of mortgage-backed securitization at Societe Generale. “The fox is in the henhouse!”
Faulty Models
Garbage in, garbage out. When models are based on erroneous or insufficient data, they produce misleading results. One of the stumbling blocks for rating securitized instruments was the dearth of long term data for extrapolation. Although the ratings analysts assumed defaults would increase during an economic slowdown, recent history offered no such modeling data for innovations like CDO’s.
Indeed, many CDO’s were simply unratable on the basis of the home loan characteristics in the reshuffled pools of mortgages. In his testimony Chairman Waxman refers to exchanges between S&P employees describing the pressure on analysts to devise shortcuts, based on guesswork, for coming up with some rating, any rating at all. “It could be structured by cows, and we would rate it,” one analyst wrote.
