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Generational Dynamics Web Log for 5-Feb-08
Moody's and other rating agencies made big money overrating CDOs

Web Log - February, 2008

Moody's and other rating agencies made big money overrating CDOs

No direct evidence of negligence or fraud yet, but a huge conflict of interest, according to CNBC's reporter Charlie Gasparino on Tuesday.

Gasparino went through publicly available information and found the following:

"The margins in rating CDOs were much higher than anything else out there. The profit margins for rating a CDO for a typical bond rater was three times higher than it was to rate, say, a municipal bond."
Bond rating agencies, like Standard & Poor's, Moody's Investors Service and Fitch Ratings, do not just sit by themselves and publish ratings of bonds. The companies issuing the bonds pay the rating agencies to do the ratings. A bond issuer can choose whichever rating agency he wants, and can select the ratings agency that's most likely to provide a high rating. So there's a big incentive for ratings agencies to overrate.

Charlie Gasparino (top) and Vince Farrell (Source: CNBC)

So a ratings agency makes money by getting issuers to pay them to compute ratings. For CDOs and other structured finance bonds, they make THREE TIMES MORE than for "ordinary" bonds.

"In 2006 - that's the last year we have publicly available information for -- Moody's derived nearly 50% of its revenues from the structured finance area.
That means that the amount of revenue from structured finance nearly doubled over a 10-year period. I should point out that in 1998 you made as much money from corporate finance - that's rating plain old vanilla corporate bonds -- as you did from structured finance."
Because of the huge fees that ratings agencies can charge to rate CDOs, structured finance is responsible for half the company's revenues. Moody's CANNOT AFFORD to lose the CDO business, and so it CAN'T RISK even losing a customer, which means it has to provide high ratings to keep the customer happy.

There's "a pretty interesting sentence" from Moody's 10-K filing for 2007: "Increasingly complex collateralized debt obligations ('CDO's) have been introduced, which should continue to support growth."
Gasparino adds: "What they're talking about is their own growth in revenues. ... This was a huge growth area for bond rating companies. We forget that bond rating companies make money by rating these complex products, and it may have been one of the reasons why they didn't catch it sooner."
And so we have a pretty damning picture: Moody's was charging extremely fat fees to provide high ratings to CDOs that turned out to be near-worthless, was deriving half its revenue from it, and was expecting this business to be a major growth area, because of the increasing complexity of the CDOs themselves.

In the discussion that followed, commentator Vince Farrell of Scotsman Capital Management said:

"What these ratings agencies did is absolutely deplorable. They took the issuers' money and gave them a good rating back. I can understand how the complexity of this thing can throw you, but there were very smart people who were scratching their head at the time, saying, "How do you take triple B subprime stuff, and through financial alchemy, turn it into triple A stuff. It just doesn't make any sense. And now they're paying the price. I think this story is going to play out over a long period of time. I think there was negligence here."

And Gasparino responded:

"I have no direct evident of negligence. But there is clearly one issue here that not even the people at S&P, Moody's, the bond raters talk about, and that's the conflict of interest, where you have the issuers -- municipalities, corporations, companies -- and in this case when you package together these CDOs, it's like Bear Stearns and Merrill Lynch paying the rating agencies to rate the bond. Whenever you have that sort of disincentive -- why would Moody's want to piss off Bear Stearns, when Bear Stearns is essentially pitting Moody's against other bond rating agencies? That's one of the incentives to give higher ratings.

On top of that, these numbers show that structured finance was a HUGE moneymaker for these guys. These guys needed structure finance to make bucks."

To which Farrel replied, "These guys all marched off the cliff together. It's unbelievable."

This is just one more of many examples of retribution closing in on various of the scam artists in the "subprime" scandal. I've said repeatedly that all of these financial engineers might be able to claim that they didn't know what they were doing in 2002, or 2003, or 2004, or 2005, but by 2006 they must have known that the were defrauding investors and the public. By 2007, when Moody's was projecting this kind of fraud as a "growth" business, there is no plausible excuse whatsoever.

These rating agencies made huge amounts of money by issuing fraudulent ratings. The "marched off the cliff together," as Farrell says, and now retribution is getting closer. (5-Feb-08) Permanent Link
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Generational Dynamics Web Log for 5-Feb-08 Moody's and other rating agencies made big money overrating CDOs

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Generational Dynamics Web Log for 5-Feb-08
Moody's and other rating agencies made big money overrating CDOs