long been suspected that ratings agencies like Moody's and Standard
& Poor's helped trigger the meltdown. A new trove of embarrassing
documents shows how they did it
The Last Mystery of the Financial Crisis
hat about the ratings agencies?
That's what "they" always say about the financial crisis and the
teeming rat's nest of corruption it left behind. Everybody else got
plenty of blame: the greed-fattened banks, the sleeping regulators, the
unscrupulous mortgage hucksters like spray-tanned Countrywide ex-CEO
But what about the ratings agencies? Isn't it true that almost none
of the fraud that's swallowed Wall Street in the past decade could have
taken place without companies like Moody's and Standard & Poor's
rubber-stamping it? Aren't they guilty, too?
Man, are they ever. And a lot more than even the least generous of us suspected.
Thanks to a mountain of evidence gathered for a pair of major
lawsuits by the San Diego-based law firm Robbins Geller Rudman &
Dowd, documents that for the most part have never been seen by the
general public, we now know that the nation's two top ratings companies,
Moody's and S&P, have for many years been shameless tools for the
banks, willing to give just about anything a high rating in exchange for
In incriminating e-mail after incriminating e-mail, executives and
analysts from these companies are caught admitting their entire business
model is crooked.
"Lord help our fucking scam . . . this has to be the stupidest place I
have worked at," writes one Standard & Poor's executive. "As you
know, I had difficulties explaining 'HOW' we got to those numbers since
there is no science behind it," confesses a high-ranking S&P
analyst. "If we are just going to make it up in order to rate deals,
then quants [quantitative analysts] are of precious little value,"
complains another senior S&P man. "Let's hope we are all wealthy and
retired by the time this house of card[s] falters," ruminates one more.
Ratings agencies are the glue that ostensibly holds the entire
financial industry together. These gigantic companies – also known as
Nationally Recognized Statistical Rating Organizations, or NRSROs – have
teams of examiners who analyze companies, cities, towns, countries,
mortgage borrowers, anybody or anything that takes on debt or creates an
Their primary function is to help define what's safe to buy, and what
isn't. A triple-A rating is to the financial world what the USDA seal
of approval is to a meat-eater, or virginity is to a Catholic. It's
supposed to be sacrosanct, inviolable: According to Moody's own reports,
AAA investments "should survive the equivalent of the U.S. Great
It's not a stretch to say the whole financial industry revolves
around the compass point of the absolutely safe AAA rating. But the
financial crisis happened because AAA ratings stopped being something
that had to be earned and turned into something that could be paid for.
That this happened is even more amazing because these companies
naturally have powerful leverage over their clients, as they are part of
a quasi-protected industry that enjoys massive de facto state
subsidies. Largely that's because government agencies like the
Securities and Exchange Commission often force private companies to
fulfill regulatory requirements by retaining or keeping in reserve
certain fixed quantities of assets – bonds, securities, whatever – that
have been rated highly by a "Nationally Recognized" ratings agency, like
the "Big Three" of Moody's, S&P and Fitch. So while they're not
quite part of the official regulatory infrastructure, they might as well
It's not like the iniquity of the ratings agencies had gone
completely unnoticed before. The Financial Crisis Inquiry Commission
published a case study in 2011 of Moody's in particular and discovered
that between 2000 and 2007, the agency gave nearly 45,000
mortgage-backed securities AAA ratings. One year Moody's doled out AAA
ratings to 30 mortgage-backed securities every day, 83 percent of which
were ultimately downgraded. "This crisis could not have happened without
the rating agencies," the commission concluded.
Thanks to these documents, we now know how that happened. And showing
as they do the back-and-forth between the country's top ratings
agencies and one of America's biggest investment banks (Morgan Stanley)
in advance of two major subprime deals, they also lay out in detail the
evolution of the industrywide fraud that led to implosion of the world
economy – how banks, hedge funds, mortgage lenders and ratings agencies,
working at an extraordinary level of cooperation, teamed up to disguise
and then sell near-worthless loans as AAA securities. It's the black
box in the American financial airplane.
April, Moody's and Standard & Poor's settled the lawsuits for a
reported $225 million. Brought by a diverse group of institutional
plaintiffs with King County, Washington, and the Abu Dhabi Commercial
Bank taking the lead, the suits accused the ratings agencies of
conspiring in the mid-to-late 2000s with Morgan Stanley to fraudulently
induce heavy investment into a pair of doomed-to-implode subprime-laden
deals, called Cheyne and Rhinebridge.
Stock prices for both companies soared at the settlement, with
markets believing the firms would be spared the hell of reams of
embarrassing evidence thrust into public view at trial. But in a quirk,
an earlier judge's ruling had already made most of the documents in the
case public. Although a few news outlets, including The New York Times
took note at the time, the vast majority of the material was never
reported, and some was never seen by reporters at all. The cases
revolved around a highly exotic and complex financial instrument called a
SIV, or structured investment vehicle.
The SIV is a not-so-distant cousin of the special purpose entity, or
SPE, which was the main weapon of destruction in the Enron scandal. The
corporate scam du jour in those days was mass accounting fraud, in which
a company would create an ostensibly independent corporate structure
that would actually be controlled by its own executives, who would then
move their company's liabilities off their own books and onto the
remote-controlled SPE, hiding the firm's losses.
The SIV is a similar concept. They first started showing up in the
late Eighties after banks discovered a loophole in international banking
standards that allowed them to create SPE-like repositories full of
assets like mortgage-backed securities and keep them off their own
These behemoths operated on the same basic concept as an ordinary
bank, which borrows short-term cash from depositors and then lends money
long-term in the form of things like mortgages, business loans, etc.
The SIV did the same thing, borrowing short-term from investors and then
investing long-term on things like student loans, car loans, subprime
mortgages. Like banks, a SIV made money on the spread between its
short-term debt and long-term investments. If a SIV borrowed on the
commercial paper market at 3 percent but earned 6.5 percent on subprime
mortgages, that was an easy 3.5 percent profit.
The big difference is a bank has regulatory capital requirements. A
SIV doesn't, and being technically independent, its potential
liabilities don't show up on the books of the megabank that created it.
So the SIV structure allowed investment banks to create and take
advantage of, without risk, billions of dollars of things like subprime
loans, which became the centerpiece of the new trendy corporate scam –
creating and then selling masses of risky mortgage-backed securities as
AAA investments to institutional suckers.
Ratings agencies helped this game along in two ways. First, banks
needed them to sign off on the bogus math of the subprime era – the math
that allowed banks to turn pools of home loans belonging to people so
broke they couldn't even afford down payments into securities with
higher credit ratings than corporations with billions of dollars in
assets. But banks also needed the ratings agencies to sign off on the
safety and reliability of these off-balance-sheet SIV structures.
The first of the two SIVs in question was dreamed up by a
London-based hedge fund called Cheyne Capital Management (pronounced
like Dick "Cheney"), run by an ex-Morgan Stanley banker duo who hired
their old firm to build and stock this vast floating Death Star of
Morgan Stanley had multiple motives for putting together the Cheyne
deal. For one thing, it earned what the bank's lead structurer
affectionately called "big fat upfront fees," which bank executives
estimated would eventually add up to $25 million or $30 million. It was a
lucrative business, and the top dogs wanted the deal badly. "I am very
focused on . . . getting this deal done to get NY to stop freaking out"
and "to make our money," said Robert Rooney, the senior Morgan Stanley
executive on the deal. A spokesman for Morgan Stanley, however, told Rolling Stone
, "Our sole economic interest was in the ongoing success of the SIV."
But that wasn't Morgan Stanley's only motive. Not only could the bank
make the "big fat upfront fees" for structuring the deal, they could
also turn around and sell scads of their own mortgage-backed securities
to the SIV, which in turn would be marketed to investors like Abu Dhabi
and King County. In Cheyne, 25 percent of the original assets in the
deal came from Morgan Stanley – over time, $2 billion of the SIV's $9
billion to $10 billion portfolio of assets came from the bank as well.
Internal Morgan Stanley memorandums show that the bank knowingly
stuffed mortgages in the SIV whose borrowers were, to say the least,
highly suspect. "The real issue is that the loan requests do not make
sense," complained a Morgan Stanley employee back in 2005. He noted
loans had been made to a "tarot reading house" operator who claimed to
make $12,000 a month, and a "knock off gold club distributor" who
claimed to make $16,000 a month. "Compound these issues," he groaned,
"with the fact that we are seeing what I would call a lot of this type
No matter – into the soup it went! Morgan sold mountains of this crap
into Cheyne's SIV, where it was destined to be sold off to other
suckers down the line. The only thing that could possibly get in the way
of the scam was some pesky ratings agency.
Fortunately for the bank and the hedge fund, these subprime SIVs were
a relatively new kind of investment product, so the ratings agencies
had little to go on in the area of historical data to measure these
products. One might think this would make the ratings agencies more
conservative. In fact, caution in the face of the unknown was supposed
to be a core value for these companies. As Moody's put it, "Triple-A
structures should not be highly dependent on untestable assumptions."
But when it came to the Cheyne SIV, Moody's punted on caution. In an
e-mail sent to executives from both Morgan Stanley and Cheyne in May
2005, David Rosa, a Moody's senior analyst, admitted that when it came
to this SIV, he had nothing to go on.
"Please note that in relation to assumed spread [volatility] for the
Aa and A there is no actual data backing up the current model
assumptions," he wrote. In lieu of such data, he went on, "We will for
now accept the proposal to use the same levels as [residential
mortgage-backed securities] given that this assumption is supported by
the analysis of the Aaa data . . . and Cheyne's comments on their views
of this asset class."
Translation: We have no historical data, so we'll just accept your
reasoning for the time being, even though you have every incentive in
the world to lie about the quality of your product.
At one point, a Morgan Stanley analyst even claimed that the bank had
written, in Moody's name, an entire 12-page "New Issue Report" for the
Cheyne SIV – a kind of ratings summary in which Morgan Stanley appears
to have given itself AAA ratings for large chunks of the deal. "I attach
the Moody's NIR (that we ended up writing)," yawns Morgan Stanley
fixed-income employee Rany Moubarak in a March 2006 e-mail. The attached
document came proudly affixed with the "Moody's Investors Service"
logo. (Both Moody's and Morgan Stanley deny that anyone other than
Moody's wrote that report.)
Morgan Stanley ended up getting both Moody's and S&P to rate the
deal, and that was not only common, it was basically industry practice.
There were many reasons for this, but a big one was a concept called
"notching," in which the agencies gave ratings penalties to any
instrument that had not been rated by their own company. If a SIV
contained a basket of mortgage-backed securities rated AA by Standard
& Poor's, Moody's might "notch" those underlying securities down to
A, or even lower. This incentivized the banks to hire as many ratings
agencies as possible to rate every investment vehicle they created.
Again, despite the fact that the ratings agencies enjoyed broad
quasi-official subsidies, and despite the powerful market leverage that
techniques like "notching" gave them, they still routinely chose to roll
over for banks. And the biggest companies were equally guilty. In the
case of the Cheyne deal, Standard & Poor's was every bit as craven
September 2004, an S&P analyst named Lapo Guadagnuolo sent an
e-mail to Stephen McCabe, the agency's lead "quant" on the Cheyne deal,
who apparently was on vacation. The e-mail chain was mostly a bunch of
office gossip, where the two men e-whispered about an employee who was
about to quit. But sandwiched in the office banter was an offhand line
about the Cheyne deal and how full of shit it was. "Hi Steve!"
Guadagnuolo wrote cheerily, adding, "How is Australia and how was
Thailand????Back to [Cheyne] . . . As you know, I had difficulties
explaining 'HOW' we got to those numbers since there is no science
behind it . . .
"Thanks and regards . . . have you heard that [redacted] has resigned . . . and somebody else will follow suit today!!"
McCabe, blowing off the "no science behind it" comment, answered
eagerly, "Who, Who, Who????" The quadruple question mark must be an
A month later, McCabe seemed more concerned about the lack of science
in the Cheyne deal. He complained in an e-mail to his boss, Kai Gilkes,
who was the agency's senior quantitative analyst in Europe.
"From looking at the numbers it is quite obvious that we have just stuck our preverbal [sic] finger in the air!!" he fumed.
Gilkes was experiencing his own crisis of conscience by mid-2005,
complaining in an oddly wistful e-mail to another S&P employee that
the good old days of just giving things the ratings they deserved were
disappearing. "Remember the dream of being able to defend the model with
sound empirical research?" he wrote on June 17th, 2005. "If we are just
going to make it up in order to rate deals, then quants are of precious
Frank Parisi, Standard & Poor's chief credit officer for
structured finance, was even more downtrodden, saying that the model
that his company used to rate residential mortgage-backed securities in
2005 and 2006 was only marginally more accurate than "if you just simply
flipped a coin."
Given all of this, why would top analysts from both Moody's and
Standard & Poor's rate such a massive deal like Cheyne without any
science to back it up? The answer was simple: money. In the old days,
ratings agencies lived on subscriptions sold to investors, meaning they
were compensated – indirectly, incidentally – by the people buying the
But over time, that model morphed into the current "issuer pays"
model, in which a company like Moody's or Standard & Poor's is paid
directly by the "issuer" – i.e., the company that is actually making the
For Cheyne, for instance, the agencies were paid in the area of $1
million to $1.5 million to rate the deal by Morgan Stanley, the very
company with an interest in getting a high rating. It's the ultimate in
negative incentives, and was and continues to be a major impediment to
honest analysis on Wall Street. Michigan Sen. Carl Levin, one of the few
lawmakers to focus on reforming the ratings agencies after the crash,
put it this way: "It's like one of the parties in court paying the
to this model, ratings-agency business soared during the bubble era. A
Senate report found that fees for the "Big Three" doubled between 2002
and 2007, from $3 billion to $6 billion. Fees for rating mortgage-backed
securities at both Moody's and S&P nearly quadrupled.
So there were powerful incentives to whitewash deals like Cheyne. The
eventual president of Moody's, Brian Clarkson, actually copped to this
awful truth in writing, in a 2004 internal e-mail. "To put it bluntly,"
he wrote, "the issuer could take its business elsewhere unless the
rating agency provides a higher rating."
Both Moody's and Standard & Poor's employees described
complex/exotic new financial products like CDOs and SIVs as "cash cows,"
and behind closed doors, executives talked openly about the financial
pressure to give scientifically unfounded analysis to products the banks
wanted to sell.
The minutes from a 2007 conference of Standard & Poor's
executives show that the raters knew they were in way over their heads.
Admitting that it was virtually impossible to accurately rate, say, a
synthetic derivative loan deal with underlying assets in China and
Russia, one executive candidly admits, "We do not have the capacity nor
the skills in house to rate something like this." Another counters,
"Market pressures have significantly risen due to 'hot money.'" The
first retorts that bankers are pushing boundaries, asking the raters to
help them play the highly cynical hot-potato game, in which bad loans
are originated en masse and then instantly passed off to suckers who
will take on all the risk. "Bankers say why not originate bad loans,
there is no penalty," the executive muses.
Hilariously – or tragically, depending on your point of view – an
S&P executive at the conference even tossed off a quick visual
sketch of their company's moral quandary. The picture is atrociously
drawn (it looks like a junior high school student's rendering of a
ganglion cell) and comes across like the Wall Street version of Hamlet
showing the industry traveling down a road and reaching a "Choice
Point" crossroads, where the two options are "To Rate" and "Not Rate."
The former – basically taking the money and just rating whatever crap
the banks toss their way – is crudely depicted as a wide, "well marked
super highway." Meanwhile the honorable thing, not rating shitty
investments, is shown to be a skinny little roadlet, marked "Dark and
narrow path less traveled."
Obviously, the ratings agencies like S&P ultimately decided to
take the road more traveled, choosing profits over scruples. Not that
there wasn't some token resistance at first. For instance, some at
S&P hesitated to allow the use of a questionable technique called
"grandfathering," in which old and outdated rating models were used to
rate newly issued investments.
In one damning e-mail chain in November 2005, a Morgan Stanley banker
complains to an S&P executive named Elwyn Wong that S&P was
preventing him from putting S&P ratings on Morgan Stanley deals that
used this grandfathering technique. "My business is on 'pause' right
now," the banker complains.
Wong took the news that S&P was holding up deals over the
grandfathering issue badly. "Lord help our fucking scam," he said. "This
has to be the stupidest place I have worked at." Wong, incidentally,
was later hired by the U.S. Office of the Comptroller Currency, our top
federal banking regulator.
The purists, however, couldn't hold out for long. In the Cheyne case,
when one of the "quants" tried to hold the line, Morgan Stanley went
over their heads to someone on the business side at the company to get
the rating it wanted.
In July 2004, for instance, analyst Lapo Guadagnuolo sent an e-mail
to Morgan Stanley's point man on the Cheyne deal, Gregg Drennan, and
told him that the best he could do for the "mezzanine capital notes" or
"MCN" piece of the SIV – a piece that Drennan wanted at least an A
rating for – was BBB-plus. Drennan responded in an e-mail that CC'd
Guadagnuolo's boss, Perry Inglis, telling him that Morgan Stanley
"believe[s] the position the committee is taking is very inappropriate."
Ultimately, the analyst committee agreed to give the dubious
Mezzanine Notes an A rating, marking the first time these middle-tier
investments in a SIV ever received a public A rating. For Wall Street,
this was occasion to par-tay. In the summer of 2005, one of the Cheyne
hedge-funders sent out a celebratory e-mail to Morgan Stanley execs,
bragging about getting the ratings companies to cave. "It is an amazing
set of feats to move the rating agencies so far," the hedgie wrote. "We
all do all this for one thing and I hope promotions are a given. Let's
hope big bonuses are to follow."
Later on, S&P caved even further, agreeing to allow Morgan
Stanley to lower the "capital buffer" in the deal protecting investors
without suffering a ratings penalty. As late as February 1st, 2006,
Guadagnuolo was defiantly telling Morgan Stanley that the one-percent
buffer was a "pillar of our analysis." But by the next day, Morgan
Stanley executive Moubarak had chopped Guadagnuolo's knees out. He
cheerfully announced in a group e-mail that the bank had managed to
remove this "pillar" and get the buffer knocked down to .75 percent.
Tina Sprinz, who worked for the Cheyne hedge fund, sent an e-mail
that very day to Moubarak, thanking him for straightening out the pesky
analysts. "Thanks for negotiating that," she says. The ratings process
shouldn't be a "negotiation," yet this word appears throughout these
In the Cheyne deal, just the plaintiffs in the lawsuit invested a
total of $980 million in "rated notes," and those who invested in these
"MCNs" were completely wiped out. Analysts from both agencies would
express regret and/or trepidation about their roles in unleashing the
monster deals and their failure to stop the business-side suits running
the companies from selling them out. Gilkes, the S&P analyst who
worried about shunning real science in favor of just making things up,
later testified that the subprime assets in such SIVs were "not
"They should not have been rated," he said.
the significance of Cheyne is that it showed how the ratings agencies
sold out in an effort to get business, the significance of the next
deal, Rhinebridge, is that it showed how low they were willing to stoop
to keep that business.
Rhinebridge was a subprime-packed SIV structured very much like
Cheyne, only both the quality of the underlying crap in the SIV and the
timing of the SIV's launch were significantly more horrible than even
Not only did Morgan Stanley insist that the ratings agencies allow
the bank to pack Rhinebridge full of a much higher quantity of subprime
than in the Cheyne deal, they were also pushing this massive blob of
toxic mortgages at a time when the subprime market was already
approaching full collapse.
In fact, the Rhinebridge deal would launch with high ratings from
both agencies on June 27th, 2007, less than two weeks before both
Moody's and S&P would downgrade hundreds of subprime mortgage-backed
securities. In other words, both Moody's and S&P were almost
certainly in the process of downgrading the underlying assets in the
Rhinebridge SIV even as they were preparing to launch Rhinebridge with
"It was the briefest AAA rating in history," says the plaintiffs'
lawyer Dan Drosman. "Rhinebridge went from AAA to junk in a matter of
There is an enormous documentary record in both agencies showing that
analysts and executives knew a bust was coming long before they sent
Rhinebridge out into the world with a AAA label. As early as 2005,
S&P was talking in internal memorandums about a "bubble" in the
real-estate markets, and in 2006 it knew that there had been "rampant
appraisal and underwriting fraud for quite some time," causing "rising
delinquencies" and "nightmare mortgages."
In June 2007, the same month Rhinebridge was launched, S&P's
Board of Directors Report talked about a total collapse of the market.
"The meltdown of the subprime-mortgage market will increase both
foreclosures and the overhang of homes for sale."
It was no better at Moody's, where in June 2007, executives were
internally discussing "increased amounts of lying on income" and
"increased amounts of occupancy misstatements" in mortgage applications.
Clarkson, who would become president two months later, was told the
week before Rhinebridge launched that "most players in the market"
believed subprime would "perform extremely poorly," and that the
problems were "quite serious."
Yet the two ratings agencies not only kept those concerns private, they both took outlandish steps to declare just the opposite.
In a pair of matching public papers, both Moody's and S&P
proclaimed that summer that while subprime might be going to hell,
subprime-packed investments like SIVs might be just fine. The Moody's
report on July 18th read "SIVs: An Oasis of Calm in the Sub-prime
Maelstrom," while an S&P report on August 14th, 2007, was titled
"Report Says SIV Ratings Are Weathering Current Market Disruptions."
The S&P report was so brazen that it even shocked a Morgan
Stanley banker involved in the SIV deals. "I cannot believe these morons
would reaffirm in this market," chortled the banker in an e-mail the
day after the paper was released.
cheyne and a hell of a lot of other subprime investments ultimately
blew to smithereens, taking with them vast amounts of cash – 40 percent
of the world's wealth was wiped out in the aftermath of the mortgage
bubble, according to some estimates. 2008 was to the American economy
what 9/11 was to national security. Yet while 9/11 prompted the U.S.
government to tear up half the Constitution in the name of public
safety, after 2008, authorities went in the other direction. If you can
imagine a post-9/11 scenario where there were no metal detectors at
airports and people could walk on carrying chain saws and meat cleavers,
you get a rough idea of what was done to reform the ratings process.
Specifically, very little was done to change the way AAA ratings are
created – the "issuer pays" model still exists, and the "Big Three"
retain roughly the same market share. An effort by Minnesota Sen. Al
Franken to change the compensation model through a new approach under
which agencies would be assigned to rate new issues through a government
agency passed overwhelmingly in the Senate, but in the House it was
relegated to a study by the SEC – which released its findings last year,
calling for . . . more study. "The conflict of interest still exists in
the exact same way," says a frustrated Franken.
The companies by now are all the way back in black. In 2012, for
instance, Moody's profits soared 22 percent, to $1.18 billion.
McGraw-Hill, the parent company of Standard & Poor's, scored $437
million in profits last year, with the rating business accounting for 70
percent of the company's profits.
In February, the Obama Justice Department, in an action that seems
belated, filed a $5 billion civil suit against Standard & Poor's,
drawing upon some of the same data and documents that were part of the
Cheyne and Rhinebridge suits. As part of that action, high-ranking
officials at S&P were interviewed by government investigators and
admitted that they had shaded their ratings methodologies to protect
market share. In this deposition of Richard Gugliada, head of S&P's
CDO operations, the government asks why the company was slow to
implement updates to its model for evaluating CDOs:
Q: Is it fair to say that Standard & Poor's goal of
preserving an increasing market share and profits from ratings fees
influence the development of the updates to the CDO evaluator?
A: In part, correct.
Q: The main reason to avoid a reduction in the noninvestment
grade ratings business was to preserve S&P's market share in that
Years after the crash, it's a little insulting to see industry
analysts blithely copping under oath to having traded science for market
share, especially since the companies continue to protest to the
contrary in public. Contacted for this story, Moody's and S&P
insisted many of the documents in this case were simply taken out of
context, and that their analysis throughout has been rigorous, objective
It's a thin defense, but it's holding – for now. McGraw-Hill stock
plunged nearly 14 percent when news of the Justice Department suit
leaked, and dropped nearly 19 percent for February, but has since
regained much of its value – its stock rose nearly 16 percent in March
and April, as markets reacted favorably to, among other things, its
recent settlement of the Cheyne and Rhinebridge suits. The markets
clearly think the ratings agencies will survive.
What's amazing about this is that even without a mass of ugly
documentary evidence proving their incompetence and corruption, these
firms ought to be out of business. Even if they just accidentally sucked
this badly, that should be enough to persuade the markets to look to a
different model, different companies, different ratings methodologies.
But we know now that it was no accident. What happened to the ratings
agencies during the financial crisis, and what is likely still
happening within their walls, is a phenomenon as old as business itself.
Given a choice between money and integrity, they took the money. Which
wouldn't be quite so bad if they weren't in the integrity business.
This story is from the July 4 - July 18, 2013 issue of Rolling Stone