How S&P, Moody's failed to guard subprime debt
"I knew it was wrong at the time,'' says the S&P official who approved letting investment banks "sell more top-rated, subprime mortgage-backed bonds" and still get top credit ratings.
Now they tell us:
Standard and Poor's "thought they had discovered a machine for making money that would spread the risks so far that nobody would ever get hurt,'' former S&P managing director Frank Raiter told Bloomberg News.
Part One and Part Two of Bloomberg's investigation show how S&P and rival Moody's watered down credit standards so they could get more business, leaving banks and investors stuck with low-value junk when borrowers stopped paying the riskiest loans.
"I knew it was wrong at the time,'' said another former S&P managing director, Richad Gugliada, who approved a policy giving investment banks' mortgage bonds top ratings even when they had lots of high-risk subprime loans.
According to Bloomberg: "S&P outlined the alchemy of structured finance in a March 2002 paper for clients entitled `Global Cash Flow and Synthetic CDO Criteria.'... The authors said ``the goal'' was to create a capital structure with a higher credit rating than the underlying assets would qualify for without financial engineering.
"By estimating the percentage of a debt pool that would pay off, the raters could assign AAA grades to the safest portion of the investment and lower marks on the rest. About 85 percent of structured finance CDOs qualified for the top grade, according to Moody's.
That meant the bond issuers could qualify to buy bond insurance from Ambac or MBIA. "This way, subprime mortgages with elevated default risks could be pooled into (collateralized debt obligation securities) with top ratings. As lending standards fell, earlier deals performed better than later ones."
One example: "Stragegos Capital Management LLC, an affiliate of Philadelphia-based Cohen & Co., which manages more than $30 billion in CDOs and other investments, packaged three Kleros Real Estate CDO Ltd. investments between June and November of 2006.
"All three Kleros CDOs defaulted after credit downgrades last year. While Strategos liquidated Kleros III, the most recent of the investment pools, in June, it still manages the two earlier ones for investors."
Credit markets depend on the rating agencies to tell them what's safe and what's risky. But nobody was watching the watchers, except maybe their customers -- the bond issuers and salesmen -- who had little incentive to urge stricter standards.