Thursday, September 25, 2008

Bringing Down Wall Street as Ratings Let Loose Subprime Scourge

(Bloomberg) -- Frank Raiter says his former employer, Standard & Poor's, placed a ``For Sale'' sign on its reputation on March 20, 2001. That day, a member of an S&P executive committee ordered him, the company's top mortgage official, to grade a real estate investment he'd never reviewed.

S&P was competing for fees on a $484 million deal called Pinstripe I CDO Ltd., Raiter says. Pinstripe was one of the new structured-finance products driving Wall Street's growth. It would buy mortgage securities that only an S&P competitor had analyzed; piggybacking on the rating violated company policy, according to internal e-mails reviewed by Bloomberg.

``I refused to go along with some of this stuff, and how they got around it, I don't know,'' says Raiter, 61, a former S&P managing director whose business unit rated 85 percent of all residential mortgage deals at the time. ``They thought they had discovered a machine for making money that would spread the risks so far that nobody would ever get hurt.''

Relying on a competitor's analysis was one of a series of shortcuts that undermined credit grades issued by S&P and rival Moody's Corp., according to Raiter. Flawed AAA ratings on mortgage-backed securities that turned to junk now lie at the root of the world financial system's biggest crisis since the Great Depression, according to Raiter and more than 50 former ratings professionals, investment bankers, academics and consultants.

``I view the ratings agencies as one of the key culprits,'' says Joseph Stiglitz, 65, the Nobel laureate economist at Columbia University in New York. ``They were the party that performed that alchemy that converted the securities from F- rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.''

Gold Standard

Driven by competition for fees and market share, the New York-based companies stamped out top ratings on debt pools that included $3.2 trillion of loans to homebuyers with bad credit and undocumented incomes between 2002 and 2007. As subprime borrowers defaulted, the companies have downgraded more than three-quarters of the structured investment pools known as collateralized debt obligations issued in the last two years and rated AAA.

Without those AAA ratings, the gold standard for debt, banks, insurance companies and pension funds wouldn't have bought the products. Bank writedowns and losses on the investments totaling $523.3 billion led to the collapse or disappearance of Bear Stearns Cos., Lehman Brothers Holdings Inc. and Merrill Lynch & Co. and compelled the Bush administration to propose buying $700 billion of bad debt from distressed financial institutions.

McCain, Obama

``This is appalling,'' says Douglas Holtz-Eakin, the former director of the Congressional Budget Office from 2003 to 2005 who is now a senior policy adviser to the presidential campaign of Republican Senator John McCain. ``It is exactly the kind of behavior that has so badly hurt the financial markets.''

Senator Barack Obama, the Democratic nominee, said in a Sept. 15 interview, ``There's a lot of work that has to be done in examining the degree to which ratings agencies were involved in making some of this debt -- some of the leverage taken on -- look like it was much safer and less risky than it was.''

S&P, a unit of McGraw-Hill Cos., and Moody's substituted theoretical mathematic assumptions for the experience and judgment of their own analysts. Regulators found that Moody's and S&P also didn't have enough people and didn't adequately monitor the thousands of fixed-income securities they were grading AAA.

Raiter and his counterpart at Moody's, Mark Adelson, say they waged a losing fight for credit reviews that focused on a borrower's ability to pay and the value of the underlying collateral. That was the custom of community bankers who extended credit only as far as they could see from their front porch.

`Didn't Want to Know'

``The part that became the most aggravating -- personally irritating -- is that CDO guys everywhere didn't want to know fundamental credit analysis; they didn't want to know from being in touch with the underlying asset,'' says Adelson, 48, who quit Moody's in January 2001 after being reassigned out of the residential mortgage-backed securities business. ``There is no substitute for fundamental credit analysis.''

S&P hired him in May 2008 as chief credit officer, responsible for setting the company's ratings criteria as part of a broader management shakeup. Raiter served on the S&P structured-finance group's executive rating committee until 2000, when he says he was demoted for his clashes with his bosses. The former Marine and community banker retired in March 2005, when he became eligible for company-paid medical benefits.

Beating Exxon's Margin

The rating companies earned as much as three times more for grading complex structured finance products, such as CDOs, as they did from corporate bonds. Through 2007, they had record revenue, profits and share prices. Moody's operating margins exceeded 50 percent for the past six years, three to four times those of Exxon Mobil Corp., the world's biggest oil company.

By 2000, structured finance was the companies' leading source of revenue, their financial reports show. It accounted for just under half of Moody's total ratings revenue in 2007.

While prospectuses don't disclose fees, Moody's says it charged as much as 11 basis points for structured products, compared with 4.25 basis points for corporate debt. A basis point is a hundredth of a percent. S&P says its fees were comparable. A typical CDO paid 6 to 8 basis points, according to Richard Gugliada, 46, S&P's global ratings chief for CDOs until 2005. That would make rating the Pinstripe deal worth $300,000 or more.

Toughening Criteria

Now facing the threat of lawsuits and tighter regulation, Moody's and S&P say they are adopting tougher criteria to more accurately evaluate and monitor the debt. In January, S&P reassigned Joanne Rose, 51, its top structured-finance ratings executive since 1999, to a new position as executive managing director for risk and quality policy. In May, Brian Clarkson, 52, resigned as president of Moody's Investors Service. He was the company's top structured-finance executive for most of this decade.

``Independence, integrity and quality remain the cornerstones of everything we do and everything we stand for,'' S&P Vice President of Communications Chris Atkins said last week in a written response to Bloomberg questions. ``We have an important role to play in helping to restore confidence and increase transparency in the credit markets, and we are determined to play a leadership role.''

``We are certainly not going to respond to a disaffected ex-employee's statements,'' Atkins added in an e-mail, without specifying any individual.

Anthony Mirenda, a Moody's spokesman, declined to respond to questions submitted in writing and by phone.

Rise of the Quants

AAA ratings on subprime mortgage investments can be traced to the rise on Wall Street of quantitative analysts, or quants, with advanced degrees in math, physics and statistics. They developed computer-driven models that didn't rely on historical performance data, according to Raiter and others. If the old rating methods were like Rembrandt's portraiture, with details painted in, the new ones were Monet impressionism, with only a suggestion of the full picture.

S&P and Moody's built their reputations over generations, starting with Henry Varnum Poor's publication in 1860 of ``History of Railroads and Canals in the United States'' and John Moody's ``Moody's Manual of Industrial and Miscellaneous Securities'' in 1900. Since the Great Depression, U.S. agencies have relied on the companies to help evaluate the credit quality of investments owned by regulated institutions, gradually bestowing on them quasi-regulatory status. Yet as the 21st century began, much of that knowledge became obsolete.

Moody's Spinoff

Banks were combining thousands of fixed-income assets into custom blends of high-yield bonds, aircraft leases, franchise loans, mutual fund fees and mortgages. These structured investment pools didn't have the performance history that lay behind the corporate bonds.

The spinoff of Moody's by Dun & Bradstreet Corp. in September 2000 changed the service's focus from informing investors to responding to the demands of banking clients and shareholders, say several former Moody's analysts. They requested anonymity because they signed non-disclosure agreements when leaving or because they now do business with the company.

``Up until that point, there was a significant emphasis on who's got the right criteria,'' says Gugliada, the former S&P global ratings chief for CDOs. He retired in 2006. ``Then Moody's went public. Everybody was looking to pick up every deal that they could.''

Clarkson became Moody's group managing director for structured finance in August 2000, a month before the spinoff. He replaced Adelson and other analysts to make the residential mortgage securities unit more responsive to clients, say several former Moody's professionals who requested anonymity because of confidentiality agreements.

`Less Collegial'

The executive visited Wall Street banking customers to pledge a closer, more cooperative relationship and asked whether any of his analysts were particularly difficult to work with, former Moody's managers say.

``Things were becoming a lot less collegial and a lot more bottom-line driven,'' says Greg Gupton, senior director of research in Moody's quant group at the time. He is now managing director of quantitative research at New York-based Fitch Solutions, a consulting unit of Fimalac SA, based in Paris. Fimalac also owns Fitch Ratings, the third-largest bond analysis company.

Clarkson didn't respond to requests for comment in messages on his home answering machine and in a note left on his door in Montclair, New Jersey.

The efforts initially produced results. Moody's share of rating mortgage-backed securities jumped to 78 percent in 2001 from 43 percent a year earlier, according to the industry publication Inside Mortgage Finance in Bethesda, Maryland.

Rating Pinstripe Deal

It was in this environment that the Pinstripe deal landed on Raiter's desk. The underwriters were units of what now are the investment banks Credit Suisse Group AG, based in Zurich, and RBS Greenwich Capital Markets Inc., in Greenwich, Connecticut.

The CDO packaged residential mortgage securities and real estate investment trusts, according to Fitch Ratings, which, unlike S&P, had reviewed the underlying loans, according to Raiter.

``We must produce a credit estimate,'' Gugliada, a member of the structured-finance rating group's executive committee, wrote to Raiter in a March 2001 e-mail. ``It is your responsibility to provide those credit estimates, and your responsibility to devise a method for doing so. Please provide the credit estimates requested!'' he wrote, signing off with his nickname ``Guido.''

``He was asking me to just guess, put anything down,'' says Raiter, interviewed at his home in rural Virginia, 69 miles (111 kilometers) west of Washington. ``I'm surprised that somebody didn't say, `Richard, don't ever put this crap in writing.'''

`Self-Delusion'

Gugliada, like Raiter, now says that he views as flawed many of the ratings S&P and Moody's assigned.

``There was the self-delusion, which hit not just rating agencies but everybody, in the fact that the mortgage market had never, ever, had any problems, and nobody thought it ever would,'' Gugliada says.

Drawing on a competitor's analysis, and assigning a slightly lower rating because of the uncertainty of the judgment, is called ``notching.'' Securities and Exchange Commission Chairman Christopher Cox proposed in June 2008 to prohibit a government-recognized rating service from issuing a grade unless it has information on the underlying asset.

``Because credit-rating agencies relied on others to verify the quality of the assets underlying the structured products they rated, it is very likely those ratings were often based on incorrect information,'' Cox said in a statement at the time.

Over Raiter's objections, S&P graded 73 percent of the Pinstripe bonds AAA. Managed by New York-based Alliance Capital Management, now AllianceBernstein Holding LP, the CDO paid off investors in November 2004. Other deals wouldn't fare as well.

Not `Straw to Gold'

S&P outlined the alchemy of structured finance in a March 2002 paper for clients entitled ``Global Cash Flow and Synthetic CDO Criteria.'' While arguing that the process wasn't ``turning straw into gold,'' the authors said ``the goal'' was to create a capital structure with a higher credit rating than the underlying assets would qualify for without financial engineering.

By estimating the percentage of a debt pool that would pay off, the raters could assign AAA grades to the safest portion of the investment and lower marks on the rest. About 85 percent of structured finance CDOs qualified for the top grade, according to Moody's.

The deal sponsors could bolster the structure by buying protection from the two largest bond insurers, New York-based Ambac Financial Group Inc. and MBIA Inc. of Armonk, New York.

Strategos Capital CDOs

This way, subprime mortgages with elevated default risks could be pooled into CDOs with top ratings. As lending standards fell, earlier deals performed better than later ones.

Strategos Capital Management LLC, an affiliate of Philadelphia-based Cohen & Co., which manages more than $30 billion in CDOs and other investments, packaged three Kleros Real Estate CDO Ltd. investments between June and November of 2006.

All three Kleros CDOs defaulted after credit downgrades last year. While Strategos liquidated Kleros III, the most recent of the investment pools, in June, it still manages the two earlier ones for investors.

The annual volume of mortgage securities sold to private investors tripled to $1.2 trillion between 2002 and 2005, according to Inside Mortgage Finance. The subprime portion of the CDOs rose fourfold, to $456.1 billion.

Low interest rates fueled the home-financing boom while investor demand for yields encouraged banks to structure subprime mortgages into higher-paying securities. Between 2001 and 2005, the annual value of asset-backed CDOs surged 11-fold to $104.5 billion, and then more than doubled to $226.3 billion in 2006, according to the industry newsletter Asset-Backed Alert in Hoboken, New Jersey.

Basic Conflict

Through it all, the rating companies had a basic conflict: They were paid by the businesses whose products they rated. Moody's told the Paris-based Committee of European Securities Regulators in November 2007 -- in the 49th footnote of a 35-page response to its questionnaire on structured-finance -- that it allowed managers who supervised analysts to ``provide expert input'' on fees ``in a limited range of circumstances.''

SEC Chief Cox said in June that the rating companies engaged in the ``lucrative business of consulting with issuers on exactly how to go about getting'' top ratings.

In a July report that examined the credit rating companies' practices, the SEC said they ``appeared to struggle'' in hiring adequate staff to handle the growth of their business, particularly for evaluating CDOs.

`Spread Very Thin'

The government agency didn't quantify the problem. Moody's annual financial statements show that the company's global employment more than doubled to 3,600 between 2001 and 2007. Its structured-finance revenue more than tripled during that time, peaking at $885.9 million last year.

``It was very difficult to get people in, train them up sufficiently to really understand this stuff -- from structure to quantitative issues -- and then to keep them, because investment banks were very keen to get good people to help them optimize their trade ideas,'' says Kai Gilkes, 40, a former S&P quantitative analyst in London who left in April 2006.

``Analysts were getting spread very thin,'' Gilkes says. ``I remember analysts who would keep their phones on voice mail 24 hours a day. They would only check messages and decide who to get back to. It was crazy.''

Some investors became nervous that the rating companies' mathematical models and AAA grades were out of touch with reality.

`Train Wreck Waiting'

``There was no model -- there was nothing -- that could work for modeling interest-only, adjustable, non-payment liar's loans,'' says Stephen Berger, 69, chairman of Odyssey Investment Partners LLC, a New York-based private equity firm.

In California, fixed-income investor Julian Mann feared the worst as subprime lending fanned out across the country.

``We said this is a train wreck waiting to happen,'' says Mann, 49, a vice president of the Los Angeles-based investment management firm First Pacific Advisors LLC.

The 90-day delinquency rate on subprime mortgages rose from 5.14 percent in 2003 to 6.37 percent in 2004 and 8.63 percent in 2005, according to First American Core Logic Inc., a San Francisco-based data provider.

S&P's Raiter says he was urging management to develop more sophisticated financial models and buy more detailed loan data for monitoring securities the company graded.

``We knew the delinquencies were bad,'' he says. ``The fact was, if we could have hired a supreme being to tell us exactly what the loss was on a loan, they wouldn't have hired him because the Street wasn't going to pay us extra money to know that.''

Subprime Tour Fails

In late 2005, First Pacific's Mann says, he invited East Coast investors to take a subprime mortgage tour up California's main interstate artery, to see the problem for themselves. The I-5 runs from San Diego to Sacramento, passing through Orange County, Bakersfield and Stockton.

``Nobody wanted to do it,'' he says. ``Unfortunately, most of the models were constructed by people who hadn't seen most of America and certainly weren't familiar with the areas they were rating.''

That September, Mann's boss, Thomas Atteberry, acted while others hesitated. He told investors in a monthly letter that he was liquidating the highest-risk real estate securities in First Pacific's New Income fund, which held $1.85 billion in bonds.

Atteberry, 55, wrote that he was ``very concerned about the subprime sector'' and ``that these trends may be a very early sign of the emergence of credit quality deterioration in general.'' It was 22 months before S&P and Moody's started downgrading mortgage securities and CDOs that held similar loans.

He had no idea how right he would be...


`Race to Bottom' at Moody's, S&P Secured Subprime's Boom, Bust

In August 2004, Moody's Corp. unveiled a new credit-rating model that Wall Street banks used to sow the seeds of their own demise. The formula allowed securities firms to sell more top-rated, subprime mortgage-backed bonds than ever before.

A week later, Standard & Poor's moved to revise its own methods. An S&P executive urged colleagues to adjust rating requirements for securities backed by commercial properties because of the ``threat of losing deals.''

The world's two largest bond-analysis providers repeatedly eased their standards as they pursued profits from structured investment pools sold by their clients, according to company documents, e-mails and interviews with more than 50 Wall Street professionals. It amounted to a ``market-share war where criteria were relaxed,'' says former S&P Managing Director Richard Gugliada.

``I knew it was wrong at the time,'' says Gugliada, 46, who retired from the McGraw-Hill Cos. subsidiary in 2006 and was interviewed in May near his home in Staten Island, New York. ``It was either that or skip the business. That wasn't my mandate. My mandate was to find a way. Find the way.''

Wall Street underwrote $3.2 trillion of loans to homebuyers with bad credit and undocumented incomes from 2002 to 2007. Investment banks packaged much of that debt into investment pools that won AAA ratings, the gold standard, from New York-based Moody's and S&P. Flawed grades on securities that later turned to junk now lie at the root of the worst financial crisis since the Great Depression, says economist Joseph Stiglitz.

`Would Have Stopped Flow'

``Without these AAA ratings, that would have stopped the flow of money,'' says Stiglitz, 65, a professor at Columbia University in New York who won the Nobel Prize in 2001 for his analysis of markets with asymmetric information. S&P and Moody's ``were trying to please clients,'' he said. ``You not only grade a company but tell it how to get the grade it wants.''

Presidential candidates John McCain and Barack Obama lay responsibility for the carnage with Wall Street itself. The Securities and Exchange Commission in July identified S&P and Moody's as accessories, finding they violated internal procedures and improperly managed the conflicts of interest inherent in providing credit ratings to the banks that paid them.

S&P and Moody's earned as much as three times more for grading the most complex of these products, such as the unregulated investment pools known as collateralized debt obligations, as they did from corporate bonds. As homeowners defaulted, the raters have downgraded more than three-quarters of the AAA-rated CDO bonds issued in the last two years.

`Cut Too Many Corners'

Facing the threat of lawsuits and tighter regulation, Moody's and S&P now say they are adopting tougher requirements to more accurately evaluate and monitor debt.

``We have made significant progress in achieving these goals,'' Chris Atkins, S&P's vice president of communications, wrote last week in a statement to Bloomberg. ``Working with policy makers and market participants around the world, we will continue to take steps to meet and exceed the high standards for quality we have put in place.'' He wouldn't respond to specific questions for this story.

Moody's spokesman Anthony Mirenda declined to comment after Bloomberg submitted questions in writing and by phone.

``The rating agencies' models were too flawed and cut too many corners, and the raters got pressured by the bankers,'' says Tonko Gast, the chief investment officer of the $5.1 billion New York hedge fund Dynamic Credit Partners LLC. He reverse-engineers the raters' models as part of his investing strategy.

``That's how the race to the bottom was kind of invisible for a lot of people,'' he says.

Favoring Diversity

Starting in 1996, Moody's used a framework known as the binomial expansion technique for rating CDOs, structured funds consisting of aircraft leases, franchise loans, high-yield bonds, hotel mortgages and mutual-fund fees. On the theory that diversification reduced risk, the BET formula rewarded balanced portfolios and punished concentrations of assets, using a proprietary measurement Moody's called the diversity score.

On Aug. 10, 2004, Moody's Managing Director Gary Witt introduced a new CDO rating method that dispensed with the diversity test and made other adjustments to the evaluation of structured-finance products.

``People were just starting to do deals that were all residential,'' says Witt, 49. He retired from Moody's this year and is now an assistant professor of statistics at Temple University's Fox School of Business in Philadelphia. The BET model ``is not as well suited for the highly correlated portfolios that were becoming common in 2004,'' he says.

The emphasis on diversity turned into an obstacle after the 2001 recession, when some assets plummeted in value. Home mortgages, auto loans and credit-card receivables offered higher returns for CDO managers. As mortgage rates fell and the market boomed, investment firms argued the risks in housing were small.

`Moody's Obliged'

``I know people lobbied Moody's to accommodate more concentrated residential mortgage risk in CDOs, and Moody's obliged,'' says Douglas Lucas, 52, the head of CDO research at UBS Securities LLC in New York. The former Moody's analyst says he invented the diversity score in the late 1980s.

A statistical tabulation appearing in the appendix of Witt's paper represented the new formula as more rigorous in calculating risks than the BET. A side-by-side comparison showed that the new model projected losses that were 24 to 165 percent higher than forecast by the old, on a hypothetical investment pool.

Bankers ``could put together a deal with greater concentrations in one area or another,'' says Jeremy Gluck, 52, a former Moody's managing director, who worked with Witt at the time.

Fewer Defaults Projected

In September 2005, Witt and colleagues published a follow-up analysis. Compared with the BET, the new model now projected that the likelihood of collateral defaults affecting CDO bonds rated at least Aa could be 73 percent lower at the extreme, in a range of possibilities.

The new comparison was based on a hypothetical investment pool in which 75 percent of the assets were residential mortgage- backed securities, including 30 percent that were subprime.

Moody's could produce a lower default rate by incorporating a decade of ratings stability for structured finance into its assumptions. The average five-year loss rate on U.S. structured finance products between 1993 and 2003 was 1.9 percent, compared with 6.3 percent for corporate bonds, the company had said in September 2004. A drawback was that raters didn't have data going back to the 1920s, as they did on corporate bonds.

In a press release on the report, Moody's said ``structured- finance ratings are broadly comparable in quality to the ratings of corporate bonds.''

`More Aaas'

Philippe Jorion, 53, a finance professor at the University of California, Irvine, criticizes the Moody's decision to factor ratings stability into its evaluations.

``This uses the output of their model as input into their models,'' Jorion says. ``This type of model is totally out of touch with the underlying economic reality.''

Witt declined in an e-mail exchange to discuss the September 2005 findings or his earlier projections from August 2004.

``The effect that had on structures was to create more Aaas,'' says Thomas Priore, 39, chief executive officer of Institutional Credit Partners LLC in New York, which oversees $13 billion of fixed-income investments.

The Moody's share of the market for rating CDOs was falling before the change, to 76.8 percent in 2004 from 91.5 percent a year earlier, according to the industry publication Asset-Backed Alert in Hoboken, New Jersey. It climbed afterward, to 85.1 percent in 2005 and 96.8 percent in 2006. S&P had 97.5 percent that year, the publication said. Underwriters made obtaining a top grade from one or both raters a condition for the sale of the investment pools.

E*Trade's CDO

The value of asset-backed CDOs tripled to $30 billion in the fourth quarter of 2004, according to the London-based monthly journal Creditflux. The yearly total increased 87 percent to $104.3 billion in 2005. Subprime mortgages came to account for about half the collateral on all asset-backed CDOs issued that year, according to a Moody's estimate.

In December 2005, New York-based E*Trade Financial Corp. raised $300 million to fund E*Trade ABS CDO IV Ltd. It followed the formula Witt and co-authors outlined in the September paper.

Moody's assigned Aaa grades to three-quarters of the CDO's rated bonds, which invested 73.5 percent of the fund's assets in mortgages backed by loans to homeowners with bad credit and limited income documentation. As the subprime market deteriorated, the company in June 2008 lowered $137.3 million of the bonds initially rated Aaa to Baa2 and the rest to speculative.

Gast's Reverse Engineering

Investors began to recognize that Aaa ratings on asset- backed CDOs weren't equivalent to top grades on corporate debt. Dynamic Credit Partners' Gast, 35, a Dutch-born quantitative analyst, says he began to discern that Aaa ratings weren't consistent even between CDOs. He says this demonstrates erosion in the rating companies' standards.

``In '05 already what was clear, I think, was that there was a deteriorating underwriting trend,'' Gast says. ``Because we had it all in-house, we were able to figure out: `Wow, you can tweak so many different parameters to come to the same result.'''

Two CDOs issued two years apart illustrate the point. Both invested in subprime and other mortgage securities, and received AAA ratings on their senior bonds from Moody's and S&P.

In December 2004, NIB Capital Bank NV of The Hague, the Netherlands, and UBS AG of Zurich jointly issued the $1 billion Belle Haven ABS CDO Ltd. The fund manager, an arm of NIB Capital, borrowed 45 times investors' equity to buy real estate securities and other assets, according to the prospectus. That magnified potential gains, while also increasing possible losses.

Tale of Two CDOs

The least-protected bondholders were backed by collateral equal to 102.26 percent of their stake, according to the prospectus, providing a cushion against declines.

Two years later, in December 2006, a U.S. arm of the Zurich investment bank Credit Suisse Group AG issued the $1.5 billion McKinley Funding III Ltd. CDO. The manager, New York-based Vertical Capital LLC, borrowed 84 times investors' equity, and junior investors were backed by a narrower cushion of assets equal to 100.98 percent of their stake, the prospectus shows.

While Belle Haven could put 20 percent of its assets in other CDOs, further magnifying the risks and returns, McKinley could place twice that percentage.

Both CDOs were downgraded as the subprime market deteriorated, with the earlier CDO holding up better than the later one.

Belle Haven's most senior Aaa tranche today retains a Moody's investment-grade rating of A1- and an S&P grade of BBB-. By contrast, Moody's lowered the top tier of the McKinley CDO to junk status, Ca, on September 23. S&P's rating is CCC-.

Because the funds are registered in the Cayman Islands and don't disclose holdings, it isn't known how much investors may have lost.

S&P's Model Changes

Meanwhile, S&P tinkered with its methodology for grading CDOs that bought commercial mortgage securities backed by apartments, hotels, offices and stores, according to an Aug. 17, 2004, e-mail obtained by Bloomberg. Managing Director Gale Scott warned of the ``threat of losing deals'' to Moody's unless the company relaxed its rating requirements.

``OK with me to revise criteria,'' replied Gugliada, then S&P's top CDO-rating executive, the e-mail exchange shows.

In an interview, Gugliada confirmed the e-mail's contents and said it led to one of S&P's adjustments to accommodate clients. He says Scott did research supporting a relaxation of S&P's assumptions about how closely correlated the default probabilities were for commercial real estate securities.

More Flexibility

The changes gave S&P's clients more flexibility. The switch directly preceded ``aggressive underwriting and lower credit support'' in the market for commercial mortgage-backed securities from 2005 to 2007, according to an S&P report that Scott co-wrote in May 2008. This led to growing delinquencies, defaults and losses, the report said.

Scott left in August as S&P cut staff. The company declined to make her available for comment before her departure, and subsequently she couldn't be reached.

Errors sometimes worked their way into the analysis. Kai Gilkes, 40, a former S&P quantitative analyst in London, says he discovered a flaw in the company's main CDO model, the CDO Evaluator, which he updated in late 2005.

In some cases, the S&P system overstated the quality of synthetic CDO Squared securities, Gilkes says. These complex investment pools are based on credit default swaps, a type of insurance against corporate default.

``On collateral rated AA or higher, the S&P model did not properly stress the default behavior of the underlying CDOs, resulting in assets with a lower default probability than their ratings suggested,'' Gilkes says.

`Line in Sand Shifts'

He says he fixed the glitch during ``a major revision'' that December and doesn't know whether any investment was inappropriately rated as a result of the error.

Still, Gilkes says he believed that competitive considerations, as communicated by management, intruded on S&P's ratings decisions up until he left the London office in 2006.

``The discussion tends to proceed in this sort of way,'' he says. ```Look, I know you're not comfortable with such and such assumption, but apparently Moody's are even lower, and, if that's the only thing that is standing between rating this deal and not rating this deal, are we really hung up on that assumption?' You don't have infinite data. Nothing is perfect. So the line in the sand shifts and shifts, and can shift quite a bit.''

`Golden Goose'

Gugliada says that when the subject came up of tightening S&P's criteria, the co-director of CDO ratings, David Tesher, said: ``Don't kill the golden goose.''

S&P declined to make Tesher available for comment.

In the SEC's July 8 report examining the role of the credit rating companies in the subprime crisis, the agency raised questions about the accuracy of grades on structured-finance products and ``the integrity of the ratings process as a whole.''

``Let's hope we are all wealthy and retired by the time this house of cards falters,'' one unidentified analyst told a colleague in a December 2006 e-mail, according to the SEC report. The e-mail was signed with a computerized wink and smile: ``;o).''

Moody's stock peaked at $74.84 on Feb. 8, 2007, a day after London-based HSBC Holdings Plc said it would set aside about $10.56 billion for losses on U.S. home loans. That statement was among the first signs of the subprime meltdown.

The reckoning swept Wall Street five months later. On July 10, Moody's cut its grades on $5.2 billion in subprime-backed CDOs. That same day, S&P said it was considering reductions on $12 billion of residential mortgage-backed securities.

More Aaas

Still, they continued stamping out AAA ratings.

Moody's announced Aaa grades on at least $12.7 billion of new CDOs in the last week of August 2007. Five of the investments were lowered by one or both companies within three months. The rest were cut within six months.

``The greed of Wall Street knows no bounds,'' says Stiglitz, the Nobel laureate. ``They cheated on their models. But even without the cheating, their models were bad.''

By last month, Moody's had downgraded 90 percent of all asset-backed CDO investments issued in 2006 and 2007, including 85 percent of the debt originally rated Aaa, according to Lucas at UBS Securities. S&P has reduced 84 percent of the CDO tranches it rated, including 76 percent of all AAAs.

``Credit in Latin means `to believe,''' says former Moody's analyst Sylvain Raynes, 50, now the head of his own New York bond-analysis firm, R&R Consulting. ``Trust and credit is the same word. If you lose that confidence, you lose everything, because that confidence is the way Wall Street spells God.''

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