Given all of this, why would top analysts from both Moody's and Standard & Poor's rate such a massive deal like Cheyne without any science to back it up? The answer was simple: money. In the old days, ratings agencies lived on subscriptions sold to investors, meaning they were compensated – indirectly, incidentally – by the people buying the financial products.
But over time, that model morphed into the current "issuer pays" model, in which a company like Moody's or Standard & Poor's is paid directly by the "issuer" – i.e., the company that is actually making the financial product.
For Cheyne, for instance, the agencies were paid in the area of $1 million to $1.5 million to rate the deal by Morgan Stanley, the very company with an interest in getting a high rating. It's the ultimate in negative incentives, and was and continues to be a major impediment to honest analysis on Wall Street. Michigan Sen. Carl Levin, one of the few lawmakers to focus on reforming the ratings agencies after the crash, put it this way: "It's like one of the parties in court paying the judge's salary."
Thanks to this model, ratings-agency business soared during the bubble era. A Senate report found that fees for the "Big Three" doubled between 2002 and 2007, from $3 billion to $6 billion. Fees for rating mortgage-backed securities at both Moody's and S&P nearly quadrupled.
So there were powerful incentives to whitewash deals like Cheyne. The eventual president of Moody's, Brian Clarkson, actually copped to this awful truth in writing, in a 2004 internal e-mail. "To put it bluntly," he wrote, "the issuer could take its business elsewhere unless the rating agency provides a higher rating."
Both Moody's and Standard & Poor's employees described complex/exotic new financial products like CDOs and SIVs as "cash cows," and behind closed doors, executives talked openly about the financial pressure to give scientifically unfounded analysis to products the banks wanted to sell.
The minutes from a 2007 conference of Standard & Poor's executives show that the raters knew they were in way over their heads. Admitting that it was virtually impossible to accurately rate, say, a synthetic derivative loan deal with underlying assets in China and Russia, one executive candidly admits, "We do not have the capacity nor the skills in house to rate something like this." Another counters, "Market pressures have significantly risen due to 'hot money.'" The first retorts that bankers are pushing boundaries, asking the raters to help them play the highly cynical hot-potato game, in which bad loans are originated en masse and then instantly passed off to suckers who will take on all the risk. "Bankers say why not originate bad loans, there is no penalty," the executive muses.
Hilariously – or tragically, depending on your point of view – an S&P executive at the conference even tossed off a quick visual sketch of their company's moral quandary. The picture is atrociously drawn (it looks like a junior high school student's rendering of a ganglion cell) and comes across like the Wall Street version of Hamlet, showing the industry traveling down a road and reaching a "Choice Point" crossroads, where the two options are "To Rate" and "Not Rate."
The former – basically taking the money and just rating whatever crap the banks toss their way – is crudely depicted as a wide, "well marked super highway." Meanwhile the honorable thing, not rating shitty investments, is shown to be a skinny little roadlet, marked "Dark and narrow path less traveled."
Obviously, the ratings agencies like S&P ultimately decided to take the road more traveled, choosing profits over scruples. Not that there wasn't some token resistance at first. For instance, some at S&P hesitated to allow the use of a questionable technique called "grandfathering," in which old and outdated rating models were used to rate newly issued investments.
In one damning e-mail chain in November 2005, a Morgan Stanley banker complains to an S&P executive named Elwyn Wong that S&P was preventing him from putting S&P ratings on Morgan Stanley deals that used this grandfathering technique. "My business is on 'pause' right now," the banker complains.
Wong took the news that S&P was holding up deals over the grandfathering issue badly. "Lord help our fucking scam," he said. "This has to be the stupidest place I have worked at." Wong, incidentally, was later hired by the U.S. Office of the Comptroller Currency, our top federal banking regulator.
The purists, however, couldn't hold out for long. In the Cheyne case, when one of the "quants" tried to hold the line, Morgan Stanley went over their heads to someone on the business side at the company to get the rating it wanted.
In July 2004, for instance, analyst Lapo Guadagnuolo sent an e-mail to Morgan Stanley's point man on the Cheyne deal, Gregg Drennan, and told him that the best he could do for the "mezzanine capital notes" or "MCN" piece of the SIV – a piece that Drennan wanted at least an A rating for – was BBB-plus. Drennan responded in an e-mail that CC'd Guadagnuolo's boss, Perry Inglis, telling him that Morgan Stanley "believe[s] the position the committee is taking is very inappropriate."
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