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The Financial Crisis Inquiry Committee (FCIC) grilled executives from Moody's on Wednesday, June 2, in New York about the pressure on analysts to produce ratings that would help investment banks pump out mortgage-backed securities. These securities were often AAA-rated initially, and then often downgraded to junk status during the housing debacle which led to the ongoing economic crisis.
Revenue and margin pressure was so great on managing directors at Moody's that their performance evaluations depended on the market share of securities deals they rated. We "could not turn a deal down," testified Eric Kolchinsky, a former team managing director at Moody's.
The veritable alphabet soup being thrown about during this hearing, the fifth in a series by the Congressionally appointed FCIC, includes residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), collateralized debt obligations (CDOs), and credit default swaps (CDS).
All of these securities affected the economic swoon in part by supplying available credit to fuel the housing bubble, and by deflating after purchase as the underlying mortgages collapsed. This led to the inability of banks and other investors that bought these securities, often with massive amounts of leverage, such as hedge funds and institutions, to mark them to market or sell much of what remained on--or off--their books.
Some of these types of securities are part of an ongoing investigation by the SEC and its charges of fraud against Goldman Sachs's Abacus deal. Some observers have asked whether the buyers did proper research on the underlying mortgage securities selected by a third party hedge fund--which took a short position on that deal--on the basis that they were most likely to fail.
Testimony at the June 2 hearing sheds a little light on due diligence on mortgage-backed securities. FCIC Commissioner Doug Holz-Eakin asked Dr. Gary Witt, Moody's former team managing director, U.S. derivatives, if his team ever "looked through" to the underlying mortgages themselves. Witt explained that his team did not typically look at the underlying securities of CDOs: there would often be a "security with 100 RMBS tranches," which would mean "looking through 100,000 underlying mortgages for each deal." Instead, Witt admitted, they "took the rating assigned by the RMBS group."
Witt's testimony raises the question: If the rating agencies don't look through to the huge numbers of underlying mortgages, and because these securities are so complex, how could institutions or advisors stand a chance of doing their own due diligence?
The early session concluded with the question from Commission Vice Chairman Bill Thomas: "What was the major cause of the crisis?" All four current or former Moody's managers testifying--Witt, Kolchinsky, Jay Siegel, and Nicholas Weill, said the "housing market decline" caused the crisis. But when prodded by Thomas, Witt added, "accessability of financing and inappropriate ratings."
For more on the hearings, including Warren Buffet's testimony, follow Kate McBride's live Twitter updates.
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