Credit-Rating Firms Grilled Over Conflicts
Risks Were Known, Documents Show

By Amit R. Paley
Washington Post Staff Writer
Thursday, October 23, 2008

Executives at the country's leading credit-rating companies, whose optimistic assessments of risky investments helped fuel the financial meltdown, have privately acknowledged for more than a year that conflicts of interest contributed to the industry's failures, according to internal company documents released yesterday.

The disclosures emerged at a heated congressional hearing where lawmakers grilled the heads of the three major rating companies, accusing them of betraying the public by letting corporate greed trump their responsibility to provide unbiased appraisals for investors.

"The story of the credit-rating agencies is the story of a colossal failure," said Rep. Henry A. Waxman (D-Calif.), chairman of the House Oversight and Government Reform Committee. "Millions of investors rely on them for independent, objective assessments. The ratings agencies broke this bond of trust, and federal regulators ignored the warning signs."

In one of the confidential documents obtained by the committee, Raymond W. McDaniel, chief executive of ratings firm Moody's, said analysts and executives are "continually 'pitched' by bankers, issuers, investors . . . whose views can color credit judgment."

"we 'drink the kool-aid,' " he wrote in a Oct. 21, 2007, memo to the board. "Unchecked, competition on this basis can place the entire financial system at risk."

The three major credit-rating companies -- Standard & Poor's, Moody's and Fitch -- assigned some of their highest ratings to mortgage-backed securities whose risks were grossly underestimated. As homeowners began defaulting on subprime mortgages, it became clear that many of those securities were overvalued. The companies finally downgraded thousands of those securities over the past year, contributing to the collapse of major firms and heightening the economic crisis.

Lawmakers are looking at whether the business model of these companies was a key factor in their failure to accurately predict the risk of the securities. The big credit-raters are paid by the issuers of the securities they evaluate, creating what executives acknowledge is an inherent conflict of interest. Some industry critics advocated banning the practice and replacing it with a model in which companies are paid by investors.

"When the referee is being paid by the players, no one should be surprised when the game spins out of control," said Rep. Christopher Shays (R-Conn.), reflecting the committee's unanimous bipartisan criticism of the industry. "You have so screwed up the ratings as to not be believable."

All three executives acknowledged their firms had badly erred in assessing the mortgage-backed securities and said those mistakes had contributed to the financial meltdown. But they said the errors were not intentional or malicious, adding that they had made their procedures more transparent and implemented safeguards to prevent additional mistakes.

"We have to earn our credibility back," said Deven Sharma, president of Standard & Poor's.

Before the firm chiefs testified, the committee heard from two former high-ranking credit-rating executives who described their frustrations in dealing with conflicts of interest and pressure on analysts to gloss over problems.

Frank L. Raiter, who had been head of residential mortgage-backed securities ratings at Standard & Poor's for 10 years, said that he developed a new model for better assessing loan performance in 2001 but that it was not implemented because of budgetary constraints.

"Profits were running the show," he said.

Sharma said that the model was not adopted because Raiter's colleagues thought it was not effective and that models have been repeatedly updated since Raiter left the company in 2005.

Raiter also clashed with colleagues at Standard & Poor's when he was asked to rate a security by Richard Gugliada, an S&P managing director. After Raiter asked for detailed loan information to assess the creditworthiness of the security, Gugliada refused.

"Any request for loan level tapes is TOTALLY UNREASONABLE!!!" Gugliada wrote in 2001. "It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so."

Raiter responded: "This is the most amazing memo I have ever received in my business career." He told the lawmakers that he never rated the security.

Gugliada said in an interview that he was following company policy and that Raiter's department was the only one that refused to provide ratings without the detailed data.

Other internal documents suggested that analysts knew they were overrating the securities. In an April 2007 instant-message exchange between two S&P analysts, one wrote, "that deal is ridiculous."

"i know right . . . model def does not capture half of the . . . risk," responded the other.

"we should not be rating it," the first replied.

"we rate every deal," the second wrote. "it could be structured by cows and we would rate it."

Standard & Poor's said the deal discussed by the employees was later restructured and then rated by the firm. The company said the rating has held up and that the exchange did not reflect the firm's professional standards.

One high-ranking executive at Moody's expressed concern about the morality of its policies in September 2007. "We had blinders on and never questioned the information we were given," the unnamed managing director said. "These errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue, or a little bit of both."

Other credit-raters took a more whimsical tone in describing the risks of mortgage-backed securities. "Let's hope we are all wealthy and retired by the time this house of cards falters," a high-ranking official at Standard and Poor's wrote in December 2006.

The sentence concludes with a smiley face.

Staff researchers Madonna A. Lebling and Lucy Shackelford contributed to this report.

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