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Moody's — before the big crisis

WASHINGTON — As the housing market collapsed in late 2007, Moody's Investors Service, whose investment ratings were widely trusted, responded by purging analysts and executives who warned of trouble and promoting those who helped Wall Street plunge the country into its worst financial crisis since the Great Depression.

A McClatchy investigation has found that Moody's punished executives who questioned why the company was risking its reputation by putting its profits ahead of providing trustworthy ratings for investment offerings.

Instead, Moody's promoted executives who headed its "structured finance" division, which assisted Wall Street in packaging loans into securities for sale to investors. It also stacked its compliance department with the people who awarded the highest ratings to pools of mortgages that soon were downgraded to junk. Such products have another name now: "toxic assets."

As Congress tackles the broadest proposed overhaul of financial regulation since the 1930s, however, lawmakers still aren't fully aware of what went wrong at the bond rating agencies, and so they may fail to address misaligned incentives such as granting stock options to midlevel employees, which can be an incentive to issue positive ratings rather than honest ones.

The Securities and Exchange Commission issued a blistering report on how profit motives had undermined the integrity of ratings at Moody's and its main competitors, Fitch Ratings and Standard & Poor's, in July 2008, but the full extent of Moody's internal strife never has been publicly revealed.

Moody's, which rates McClatchy's debt and assigns it a quite low value, disputes every allegation against it. "Moody's has rigorous standards in place to protect the integrity of ratings from commercial considerations," said Michael Adler, Moody's vice president for corporate communications, in an e-mail to McClatchy.

Insiders, however, say that wasn't true before the financial meltdown.

"The story at Moody's doesn't start in 2007; it starts in 2000," said Mark Froeba, a Harvard-educated lawyer and senior vice president who joined Moody's structured finance group in 1997.

"This was a systematic and aggressive strategy to replace a culture that was very conservative, an accuracy- and quality-oriented (culture), a getting-the-rating-right kind of culture, with a culture that was supposed to be 'business-friendly,' but was consistently less likely to assign a rating that was tougher than our competitors," Froeba said.

After Froeba and others raised concerns that the methodology Moody's was using to rate investment offerings allowed the firm's profit interests to trump honest ratings, he and nine other outspoken critics in his group were "downsized" in December 2007.

"As a matter of policy, Moody's does not comment on personnel matters, but no employee has ever been let go for trying to strengthen our compliance function," Adler said.

Moody's was spun off from Dun & Bradstreet in 2000, and the first company shares began trading Oct. 31 that year at $12.57.

Executives set out to erase a conservative corporate culture.

To promote competition, in the 1970s ratings agencies were allowed to switch from having investors pay for ratings to having the issuers of debt pay for them. That led the ratings agencies to compete for business by currying favor with investment banks that would pay handsomely for the ratings they wanted.

Wall Street paid as much as $1 million for some ratings, and ratings agency profits soared. This new revenue stream swamped earnings from ordinary ratings.

'Exploding profits'

"In 2001, Moody's had revenues of $800.7 million; in 2005, they were up to $1.73 billion; and in 2006, $2.037 billion. The exploding profits were fees from packaging ... and for granting the top-class AAA ratings, which were supposed to mean they were as safe as U.S. government securities," said Lawrence McDonald in his recent book, "A Colossal Failure of Common Sense." He's a former vice president at now defunct Lehman Bros., one of the high- flying investment banks that helped create the global crisis.

From late 2006 through early last year, however, the housing market unraveled, poisoning mortgage finance, then global finance. More than 60 percent of the bonds backed by mortgages have had their ratings downgraded.

"How on earth could a bond issue be AAA one day and junk the next unless something spectacularly stupid has taken place? But maybe it was something spectacularly dishonest, like taking that colossal amount of fees in return for doing what Lehman and the rest wanted," McDonald wrote.

Ratings agencies thrived on the profits that came from giving the investment banks what they wanted, and investors worldwide gorged themselves on bonds backed by U.S. car loans, credit card debt, student loans and, especially, mortgages.

Before granting AAA ratings to bonds that pension funds, university endowments and other institutional investors trusted, the ratings agencies didn't bother to scrutinize the loans that were being pooled into the bonds. Instead, they relied on malleable mathematical models that proved worthless.

"Everyone else goes out and does factual verification or due diligence. The credit rating agencies state that they are just assuming the facts that they are given," said John Coffee, a finance expert at Columbia University. "This system will not get fixed until someone credible does the necessary due diligence."

Nobody cared about due diligence so long as the money kept pouring in during the housing boom. Moody's stock peaked in February 2007 at more than $72 a share.

One Moody's executive who soared through the ranks during the boom years was Brian Clarkson, the guru of structured finance. He was promoted to company president just as the bottom fell out of the housing market.

Fear of being fired

Several former Moody's executives said he made subordinates fear they'd be fired if they didn't issue ratings that matched competitors' and helped preserve Moody's market share.

Froeba said his Moody's team manager would tell his team that he, the manager, would be fired if Moody's lost a single deal. "If your manager is saying that at meetings, what is he trying to tell you?" Froeba asked.

In the 1990s, Sylvain Raynes helped pioneer the rating of so-called exotic assets. He worked for Clarkson.

"In my days, I was pressured to do nothing, to not do my job," said Raynes, who left Moody's in 1997. "I saw in two instances — two deals and a rental car deal — manipulation of the rating process to the detriment of investors."

When Moody's went public in 2000, midlevel executives were given stock options. That gave them an incentive to consider not just the accuracy of their ratings, but the effect they'd have on Moody's — and their own — bottom lines.

"It didn't force you into a corrupt decision, but none of us thought we were going to make money working there, and suddenly you look at a statement online and it's (worth) hundreds and hundreds of thousands (of dollars). And it's beyond your wildest dreams working there that you could make that kind of money," said one former midlevel manager who requested anonymity to protect his current Wall Street job.

Moody's spokesman Adler insisted that compensation of Moody's analysts and senior managers "is not linked to the financial performance of their business unit." Clarkson couldn't be reached to comment.

Moody's wasn't alone in ignoring the mounting problems. It wasn't even first among competitors. The financial industry newsletter Asset-Backed Alert found that Standard & Poor's participated in 1,962 deals in 2006 involving pools of loans, while Moody's did 1,697. In 2005, Standard & Poor's did 1,754 deals to Moody's 1,120. Fitch was well behind both.

The ratings agencies were under no legal obligation because technically their job is only to give an opinion, protected as free speech, in the form of ratings.

"As an analyst, I wouldn't have known there was a compliance function," said Eric Kolchinsky, a managing director in Moody's structured finance division from January 2007 to November 2007. "There was an attitude of carelessness, or careless ignorance of the law. I think it is a result of the mentality that what we do is just an opinion, and so the law doesn't apply to us."


McCLATCHY: Having spoken to a large number of Moody’s managers, midlevel and higher, who were present in the 06-08 period, they all paint a picture in which the bottom is beginning to fall out of the housing market. In this time frame, Moody’s let go most of its compliance department and people who had raised questions about business/market share concerns encroaching on ratings quality, and replaced them all with executives from structured finance. During this period, the top jobs also went to people from structured finance who had brought in great quantities of revenue, now shown to be unsustainable revenue.

Against that backdrop, was there a conscious decision by top management at Moody’s to replace compliance officials with people from structured finance, who lacked a background in compliance? If so, why was this decision made? If not, is it coincidence that this happened, or what explanation does Moody’s have?

MOODY’S: Our Compliance team is led by an individual with more than 20 years of compliance experience, including with the SEC and the Justice Department.

(Editor’s note: This person, Jeff Schwartz, isn’t listed in Moody’s public filings with the SEC, but according to his profile on the online site LinkedIn, he joined Moody’s from Nomura Securities last August, and he’s a former SEC attorney. The most recent SEC filing on Moody’s Web site still lists David Teicher as the designed compliance officer. A spokesman confirmed that Schwartz is new to the job but couldn’t say when he began.)

Moody’s has more than doubled the number of employees in its oversight and other control functions over the last two years, and they include extremely capable professionals with diverse backgrounds and experience, which of course must include knowledge and experience from our various businesses. Additionally, Moody’s has in fact taken significant steps over the last two years to bolster the strength and composition of its Compliance department in response to evolving business and global regulatory changes, and this has resulted in staffing changes within the department.”

McCLATCHY: Were Scott McCleskey and his team let go for trying to erect a firewall between business/market share and ratings quality? If not, why were he and several others with compliance backgrounds replaced by people from structured finance?

MOODY’S: Moody’s has rigorous safeguards in place to protect the integrity of ratings from commercial considerations. As a matter of policy, Moody’s does not comment on personnel matters, but no employee has ever been let go for trying to strengthen our compliance function.

As noted above, the company has taken significant steps over the last two years to bolster the strength and composition of its Compliance department in response to evolving business and global regulatory changes, and this has resulted in staffing changes within the department. Our Compliance team is extremely capable and well staffed and led by an individual with more than 20 years of diverse compliance experience, including with the SEC and the Justice Department.

McCLATCHY: Numerous executives at Moody’s there at the time describe Brian Clarkson as a bully who threatened to fire anyone who couldn’t match a competitor’s ratings and lost market share. In July 2008, Moody’s acknowledged that some workers rated complex European securities incorrectly. Were any complex U.S. securities, i.e. CDOs and RMBS improperly rated during the highly competitive period of 2005 to late 2007? Former managers say they were pressured to match ratings, did this happen and does it constitute incorrect ratings?

MOODY’S: Moody’s is extremely confident in the analytical integrity of its ratings and ratings process. We have always had a rigorous, disciplined, and transparent ratings process — and we do not take commercial considerations into account when developing our methodologies or assigning a rating.

McCLATCHY: After Moody’s went public in Oct 2000, midlevel employees were given stock options, and some have acknowledged that these options eventually came to cloud their decision making, as they were under pressure both to preserve market share or risk losing their job, but they also now had a personal wealth stake in the outcome given the huge run-up in Moody’s stock prices. Do midlevel employees at Moody’s still receive stock options, and how do you guard against an analyst having a personal stake in the outcome of ratings?

MOODY’S: Moody’s maintains strong policies and procedures to manage potential conflicts of interest and to protect the quality and independence of our ratings. We are fully transparent regarding the basis for our ratings. Among other things, Moody’s has long disclosed publicly the methodologies on which we base our ratings, and our adherence to those methodologies on any given security can be easily assessed by market participants. Furthermore, the compensation of Moody’s analysts and senior managers is not linked to the financial performance of their business unit.

McCLATCHY: Three ex-employees — Scott McCleskey, Eric Kolchinsky and Mark Froeba — have all testified before Congress about alleged wrongdoing at Moody’s. All three said they were punished for expressing opinions internally that clashed with a new culture of reaping the profits from structured finance. Is there anything Moody’s would like to say about these three men, are they malcontents, bad employees fired for insubordination? Was there anything in their record to suggest they were problem employees? How would you characterize these employees? I believe Mr. Cantor (Richard Cantor, Moody’s chief risk officer) testified that they were disgruntled employees, is this a correct characterization?

MOODY’S: Moody’s has a culture that promotes rigorous and open debate of diverse opinions among its analysts. None of these employees were disciplined, suspended or terminated because of the opinions they expressed. Indeed, Moody’s has a strict policy of nonretaliation.

Because Mr. Kolchinsky raised questions about Moody’s own review of the evolving claims he made, Moody’s commissioned an outside law firm to conduct an independent investigation of all of Mr. Kolchinsky’s assertions. Those investigating lawyers have been given unfettered access to Moody’s personnel and documents. Indeed, the only person who has declined to cooperate with the independent investigation is Mr. Kolchinsky. The preliminary findings of the independent investigators are completely consistent with Moody’s own compliance review — namely, that Mr. Kolchinsky’s claims of misconduct are unfounded. Moody’s is confident in the integrity of its people and its processes.

McCLATCHY: I e-mailed yesterday about whether Moody’s was still footing the legal bills for class action suits brought against Michael Kanef, who I believe is still employed by Moody’s, and Brian Clarkson, who is not. Can you confirm that Clarkson’s legal representation is in fact paid for by Moody’s, as we are unable to reach him through family and all public records. His former underlings said some unflattering things that we would not like to let go without a response. Does Moody’s believe he was tyrannical and an executive who bullied and terrorized employees? This is how your former president and COO is described.

MOODY’S: As a matter of policy, Moody’s does not comment on personnel matters or former employees of the firm.

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