Rating Agency Lies!

Bloomberg today reports that the SEC is looking into whether issuers leaned on rating agencies to provide the desired ratings on structured credit transactions.

However, there may be less here than meets the eye. SEC chief Christopher Cox, along with senior executives from the rating agencies, are testifying before the Senate Banking Committee today. Query whether the SEC’s rating agency investigation is merely to forestall criticism from Congress.

Regardless, the rating agencies are making shameless claims:

Moody’s said it receives no fees for helping clients structure their securities.

“Moody’s does not structure, create, design or market securitization products,” {Michael] Kanef [group managing director, asset finance group] said. “We do not have the expertise to recommend one proposed structure over another, and we do not do so.”

Please. So what were these investment banks paying you for when they brought you in while they were structuring deals, the pleasure of your company?

Let’s hear from a recent Hudson Institute paper by Joseph Mason and Joshua Rosner, “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions.” This well researched report is required reading for anyone who wants to understand the rating agencies’ role in the structured credit mess.

As the authors noted:

The need for rating agencies to objectively assess and verify information rises in structured finance transactions since, unlike the traditional ratings process in which an enterprise can do little to change its risk characteristics in anticipation of an issuance, in structured finance, the rating agency is an active part of the structuring of the deal.28 In practice, arrangers will routinely use the rating agencies publicly available models to pre-structure deals and subsequently engage in a process that is “iterative and interactive,”29 informing the issuer of the requirements to attain desired ratings in different tranches and largely defining the requirements of the structures to achieve target ratings.30 31 32

Here are the citations:

28. Timothy J. Riddiough & Risharng Chiang, Commercial Mortgage-Backed Securities: An Exploration into Agency, Innovation, Information, and Learning in Financial Markets, 1 (2003), available at (http://scholar.google.com/scholar?hl=en&lr=&safe=off&q=cache:tgPHB82FijQJ:www.nchu.edu.tw/~Fin/03_research/fin2003/Commercial%2520Mortgage-Backed%2520Securities.pdf+riddiough+chiang+“Commercial+Mortgage-Backed+Securities. (“instead of assuming a passive credit quality certification role, the rating agency actively controls security architecture and are instrumental in determining product design standards.”).
29. Taiwan Ratings, http://www.taiwanratings.com/en/criteria/SF_ratingprocess.asp (last visited Apr. 30, 2007).
30. Letter from John R. Rutherford, to Nancy M. Morris, Secretary, Securities and Exchange Commission (Mar. 8, 2007), available at http://www.sec.gov/comments/s7-04-07/s70407-17.pdf. (“Normally sponsors of structured products seek to achieve specified rating levels for the various issues of securities (“tranches”) backed by the assets in the structure. They engage in iterative discussions with a rating agency. The sponsors propose specified assets and structures of seniority within the tranches to achieve the desired rating levels, and the rating agency indicates whether or not the specified assets and structures achieve those rating levels consistent with the methodologies of the rating agency… The most frequent situation where a rating agency does not rate the securities of a structured product is when the proposed assets and structures of the issuer and the proposed ratings of the sponsor do not meet the credit requirements of the rating agency following its specified methodologies. Normally, in this situation another credit rating agency, which may be an NRSRO, has concluded that the proposed ratings of the sponsor do meet the credit requirements of such agency. In this manner, sponsors of structured products “shop” for the ratings they desire.”);
31. Role of Ratings, supra note 11, at 2. (“What distinguishes the rating of structured finance transactions from the rating of traditional instruments is that the former requires the rating agencies to be involved in the deal’s structuring process. This is because a tranche rating reflects a judgment about both the credit quality of the underlying collateral asset pool and the extent of credit support that must be provided through the transaction’s structure in order for the tranche to receive the rating targeted by the deal’s arrangers. Deal origination thus involves obtaining implicit structuring advice by the rating agencies, at least to the extent that arrangers use rating agency models to pre-structure deals and subsequently engage in an iterative dialogue with the agencies in order to finalize these structures. As a result, ratings of structured finance instruments have a decidedly ex ante character. This contrasts with traditional bond ratings, where pre-rating discussions between issuers and agencies play a more limited role.”).
32. Authorite des Marches Financiers, Research Department, Is Rating an Efficient Response to the Challenges of the Structured Finance Market?, March 2007, at 6 (“Rating is an integral part of structuring securitization products. The agency is involved at an early stage, and the rating is not an outcome but a target for the arranger, with the agency indicating the factors that need to be addressed to obtain the desired rating. In particular, the agency has an indirect influence on how the tranches are configured to ensure that the senior issue obtains the highest possible rating.”) [hereinafter Authorite des Marches Financiers Report]

Let’s put it this way: if the SEC goes along with the rating agency party line that they had nothing to do with deal structuring, it’s a clear sign that its investigation is merely a matter of form.