What the Credit Crunch Looks Like On the Inside, Pt III

Ritholtz

Way back in the late 1990s into the early 2000s, a previously well regarded group -- stock analysts -- subtly shifted the objectives of their work. Previously, they plied their skills looking for stocks their clients and trading desks could make money buying and selling.

But things change, commissions shrunk from 10 cents per share to 6 to 3 to mere half pennies today. The old business model no longer applied. What rose in its place was a new model that emphasized not the trading of equities, but the investment banking fees that accompanied IPOs. Many analysts compromised their objectivity on the altar of banking fees. This was especially true in the Internet/Technology/Telecom space.

Thus, they went from being somewhat valued allies of the investor class to the guys helping to dump the dogs into an unknowing public's portfolios. Since then, many of this crowd has been vilified (Jack Grubman, Henry Blodgett, etc.), and the securities industry got Spitzerized to the tune of some $$1,387.5 Million dollars in fines (a deal I suspect they would do all over again if they could).

Fast forward to the early 2000s. Interest rates are at 46 year lows, and this time around, another group of shameless whores analysts are following the same playbook: The ratings agencies that gave their AAA blessings to the now defaulting alphabet soup of RMBS, CDOs, CLOs, ABX structured products that has so recently seized up the credit markets.

It was a simple case of pay-to-play to get rated. Portfolio's Jesse Eisinger goes into the ugly details of a surprisingly familiar story:

"Moody’s and S&P dominated for decades, and their business model was straightforward: Investors bought a subscription to receive the ratings, which they used to make decisions. That changed in the 1970s, when the agencies’ opinions were deemed a “public good.” The Securities and Exchange Commission codified the agencies’ status as self-regulatory entities. The agencies also changed their business model. No longer could information so vital to the markets be available solely by subscription. Instead, companies would pay to be rated. “That was the beginning of the end,” says Rosner.

It might come as a surprise, but rating credit is a heck of a business to be in. In fact, Moody’s has been the third-most-profitable company in the S&P 500-stock index for the past five years, based on pretax margins. That’s higher than Microsoft and Google. Little wonder that Warren Buffett’s Berkshire Hathaway is the No. 1 holder of Moody’s stock.

McGraw-Hill’s most recent financial report shows that S&P has profit margins that would put it in the top 10. Fitch Ratings, owned by the French firm Fimalac, is a distant third in market share but nevertheless has an operating margin above 30 percent, about double the average for companies in the S&P 500.

In 2006, nearly $850 million, more than 40 percent of Moody’s total revenue, came from the rarefied business known as structured finance. In 1995, its revenue from such transactions was a paltry $50 million. . ."

The entire article is well worth your time to read in full.

Yes, Moody's, S&P, and Fitch were complicit in what is slowly coming to be viewed as widespread fraud. However, there is more than enough blame for the failure of the credit markets to spread around. The ratings agencies fraudulent ratings -- I won't even bother with the word alleged -- are merely the tip of the iceberg.

As much as the whores credit agencies have a large share of responsibility in this mess, do not forget to save some blame for an even greater ethically challenged industry: those clever folks who work at Wall Street's biggest iBanks. As related by Reuter's Patrick Rucker, it seems that Wall Street often shelved damaging subprime reports. (Sweet!) Here are the details:

"Investment banks that bundle and sell home mortgages often commissioned reports showing growing risks in sub-prime loans to less credit-worthy borrowers but did not pass on much of the information to credit rating agencies or investors, according to some of those who prepared the reports.

The mortgage consultants, known as due-diligence firms, were hired by investment banks to make sure blocks of mortgages conformed to the mortgage seller's own standards. The studies provided a first glimpse of loan quality for ratings agencies and investors who do not normally see the full reports.

As the U.S. housing boom reached its crescendo in 2006 and investors showed a strong appetite for mortgages, lenders relaxed their underwriting standards, and millions of borrowers with poor credit records were able to obtain subprime mortgages as a result.

Default rates on many of those subprime mortgages are now rising, some borrowers face foreclosure on their homes, and investors in the mortgages face losses." (emphasis added)

At this point, we should expect to see a flurry of investigations into the rating agencies and the same slew of Wall Street firms that were involved in the last analyst scandal.

The saving grace for Wall Street maybe (emphasis maybe) that this was less of a "systemic fraud" than the 1998-2002 scandal. They may perhaps escape by merely jettisoning these bad actors, throwing them under the bus to save their own skins. Perhaps.