Politics & Government

Senate to ask Moody's chief why bad bonds got good ratings

A familiar sign during the financial meltdown
A familiar sign during the financial meltdown George Macdonald / Merced Sun-Star

WASHINGTON — Following the nation's financial crisis, which culminated in the near collapse of Wall Street in September 2008, the heads of most major firms involved have stepped aside, been removed by the government or were forced out by corporate boards.

However, the chief executive of Moody's Investors Service, a key player in the crisis, remains a notable exception.

On Friday, Moody's CEO Raymond McDaniel Jr. will face the Senate Permanent Subcommittee on Investigations, which is looking into the role the credit-rating agencies played in the nation's worst financial crisis since the Great Depression. The agencies rate the quality of financial products such as bonds and serve as guides trusted by investors. Many bonds they rated as top-quality in the recent crisis turned out to be junk.

McDaniel has yet to face the kind of congressional grilling already suffered by bank executives. However, an earlier hearing revealed a transcript in which McDaniel told his board of directors that his firm was constantly pressured to inflate ratings — and that sometimes Moody's "drank the Kool-Aid."

The ratings agencies are under attack on many fronts. Legislation to revamp financial regulations threatens to leave them more open to lawsuits for bad ratings, although not as open as consumer advocates hoped. They already face class-action suits from investors who lost money when top-rated bonds turned out not to be.

In addition, on Monday California Attorney General Jerry Brown brought court action trying to force Moody's to answer questions raised in a subpoena he issued seven months ago.

"The ratings are the linchpin of the entire financial meltdown. Without the ratings, the toxic assets could never have been sold," Brown, a Democratic candidate for governor in California, told McClatchy in an interview.

Brown wants details about who developed the methodology for the rating of complex securities, and how far up the chain of command these decisions flowed. What most irks him is that Wall Street actors refuse to accept responsibility.

"It's kind of like this has been an immaculate deception. Everyone is deceived, but nobody is at fault," Brown told McClatchy. "I've listened to high officials from these private firms and the Federal Reserve, it seems no one is to blame and no one stands up and recognizes their accountability. And over $11 trillion in wealth has been destroyed."

Friday will be McDaniel's turn to be accountable.

The special role of the ratings agencies was underscored last Friday when the Securities and Exchange Commission brought civil fraud charges against Goldman Sachs. The SEC alleges that Goldman failed to disclose vital information to investors about a complex deal that received investment-grade ratings from both Moody's and Standard & Poor's.

Hedge fund mogul John Paulson paid Goldman to let him help assemble a package of investment bonds that he was going to bet would fail, and which Goldman then sold to investors without telling them of Paulson's involvement. The bonds failed, and Paulson's firm pocketed $1 billion, which investors lost.

Goldman's alleged deception of investors may have extended to the ratings agencies. A former ratings agency analyst told McClatchy that Goldman didn't reveal to his firm that it allowed Paulson to influence the selection of bonds in the deal, nor that Paulson was wagering that the securities would default.

"Goldman didn't tell us anything about this," said the analyst, who demanded anonymity because the deal is subject to litigation. "I had no idea. What they kept from investors, they kept from us as well."

However, even if the ratings agencies were duped, their participation in these complex deals gives the appearance of complicity. At minimum, Goldman and its competitors had a symbiotic relationship with the ratings agencies.

When Goldman Sachs Chief Executive Lloyd Blankfein recently testified before the congressionally mandated Financial Crisis Inquiry Commission, which is looking into the causes of the financial crisis, he suggested that Wall Street banks were at the mercy of the ratings agencies.

However, in a McClatchy investigation late last year, former Moody's officials recounted how Wall Street investment powers like Goldman played the three major ratings agencies off each other to get the ratings they needed to attract investors.

The carrot for the ratings agencies was a big reward, $1 million or more, for providing an investment grade to a complex deal.

Moody's dominated the rating of "structured-finance products," the general term for complex financial instruments concocted by Wall Street. Chief among these were collateralized debt obligations and mortgage-backed securities.

Both involve pools of loans, most often mortgages, which were packaged into bonds that were sold to investors. Institutional investors such as pension funds and endowments are often restricted to purchasing only investment-grade securities, so Wall Street worked feverishly to win investment grades from Moody's or its competitors, Standard & Poor's and Fitch.

McClatchy's investigation documented how McDaniel promoted officials from the highflying structured finance division, and how he installed its architect Brian Clarkson as president and chief operating officer of Moody's.

Officials who oversaw the process of giving top ratings to some of the worst deals were given top executive suites and jobs heading regulatory affairs and compliance.

During this era, former Moody's executives said, ratings quality eroded as analysts were under intense pressure from Clarkson and McDaniel to maintain market share and a "business-friendly" environment.

One former executive making that charge was Eric Kolchinsky, who's scheduled to testify on Friday. He's alleged that he was pushed out for questioning the integrity of the ratings process for complex securities. His direct supervisor, Yuri Yoshizawa, also will appear.

Former senior directors of structured finance groups and other related divisions at Moody's and S&P are also scheduled to talk before McDaniel testifies alongside former S&P President Kathleen Corbet.

Corbet stepped down as president of S&P in August 2007 as ratings on securities backed by risky U.S. mortgages unraveled. Clarkson stepped down in July 2008.

Still, McDaniel and several other key players at Moody's remain in their jobs, including chief counsel John Goggins and the head of regulatory affairs, Michael Kanef.

McDaniel became president of Moody's Investors Service in 2001, rising to president of parent Moody's Corp. and later its chief executive officer in 2005. A year later, he added chairman of the board to his list of titles.


Brown's complaint

Moody's response to subpoenas

Where was Moody's board when top-rated bonds blew up?


To ask a question about this story or any economic question, go to McClatchy's economy Q&A

Message to Wall St. in Goldman case: SEC 'back on the job'

Congress, administration may finally crack down on Wall Street, Cantwell says

Now it's the Senate's turn to take on Goldman, Moody's

Next player in financial crisis to not take blame for it: Citi

Where was Moody's board when top rated bonds blew up?

How Moody's sold its ratings — and sold out investors

Related stories from McClatchy DC