Fed loans are guided by raters who touted subprime debt


By Alison Fitzgerald
Bloomberg News
Thursday, December 18, 2008


Federal Reserve Chairman Ben S. Bernanke is basing hundreds of billions in emergency lending on credit ratings from companies that gave AAA grades to toxic securities.

WASHINGTON -- The Fed has purchased $308.5 billion in commercial paper and lent $631.8 billion under eight credit programs, most of which require appraisals of short-term debt and loan collateral by "major nationally recognized statistical ratings organizations." That, in effect, means Moody's Investors Service, Standard & Poor's, and Fitch Ratings.

It is foolhardy to rely on the three New York-based companies, said Keith Allman, chief executive officer of Enstruct Corp., which trains investors in financial modeling and asset valuation. The major raters issued top marks to $3.2 trillion in subprime mortgage-backed securities at the root of the financial crisis.

"They're outsourcing the credit assessment to a group of people whose recent performance has been unbelievably bad," said Allman, the New York-based author of three books on structured finance and a former vice president in Citigroup Inc.'s securitized markets unit. "If their goal is to not take a loss on these assets, they should be hiring independent analysts."

Rating companies are hired by debt issuers to analyze the quality of securities and the likelihood the borrowings will be repaid. Lenders demand higher interest when a rating is low. If the Fed is relying on unrealistic valuations, it may be charging too little and taking on greater risk than it intends, said Donald van Deventer, CEO of Honolulu-based Kamakura Corp., which provides financial software and consulting.

... 'Favored Arbiters'

It's impossible to gauge the analysis of debt in the Fed programs because the bank won't reveal whom it's lending to or the assets accepted as collateral.

Bloomberg News requested details under the U.S. Freedom of Information Act and filed a federal lawsuit Nov. 7 seeking to force disclosure. In its Dec. 8 response to the lawsuit, the central bank said it was allowed to withhold information about trade secrets and commercial information.

Fitch and Moody’s declined to comment specifically on the Fed’s use of their evaluations.

Fed reliance on major rating companies is an important part of "restoring confidence in the financial markets," said Chris Atkins, an S&P spokesman.

S&P and Moody's said in statements e-mailed to Bloomberg that they had taken steps to improve the transparency of their ratings systems. Fitch CEO Stephen Joynt told a Congressional hearing on Oct. 22 that the company has become more conservative in its ratings.

... Retaining Flexibility

Now is the time to end the trio's "official status as the government's favored arbiters of credit quality,' said Michael Aronstein, chief investment strategist for New York-based Oscar Gruss & Son Inc., a closely held broker and dealer.

"From my perspective, their assessments are not worth any more than any other form of advertising," Aronstein said.

The Fed is confident it's limiting the risks, said Andrew Williams, a spokesman for the Federal Reserve Bank of New York.

"Reserve banks are never obligated to lend," Williams said. "We retain flexibility to decline an issuer if we do not feel secured to our satisfaction or otherwise comfortable with the credit."

The Fed’s main goal in the rescue programs is to stabilize the banking system and get credit markets working again, Bernanke said in a December 1 speech to the Greater Austin Chamber of Commerce in Texas.

... 'Last Resort' Lender

The emergency loans are "consistent with the central bank's traditional role as the liquidity provider of last resort," he said.

"It should be emphasized that the loans that we make to banks and primary dealers through our standing facilities are both overcollateralized and made with recourse to the borrowing firm, which serves to minimize the Federal Reserve's exposure to credit risk," Bernanke said.

A senior Fed official told a conference call with reporters on Dec. 16 that the central bank is considering buying lower-rated securities in some of its lending programs to further boost liquidity.

The central bank is discussing with two independent analysis companies, Egan-Jones Ratings of Haverford, Pennsylvania, and Realpoint LLC of Horsham, Pennsylvania, how it might use their services, according to their CEOs. Williams said he couldn’t confirm the talks.

... 'Dominant Ratings Agencies'

Policy makers should take the opportunity to spearhead a change in the system by elevating the independents, said Alex Pollock, a resident fellow at the American Enterprise Institute in Washington.

Unlike the top three, they are paid by investors who subscribe to their services, rather than by businesses whose products they rate. That makes them less likely to grade securities favorably, Pollock said.

"Why would you limit this to the dominant ratings agencies that helped get us into this situation?" he said.

While the Fed can look at appraisals from any of 10 companies certified by the Securities and Exchange Commission, the three biggest rate the vast majority of instruments.

The Fed also requires that the ratings be publicly available through third parties such as Bloomberg LP, owner of Bloomberg News, which provides assessments from seven certified companies, including Moody's, S&P, and Fitch.

... Investment Grade

S&P, a unit of McGraw-Hill Cos. with 8,500 employees, last year rated 93.6 percent of the $707 billion of U.S. non-agency mortgage-backed securities. Moody's, which employs 3,000, graded 80.2 percent and Fitch, with a payroll of about 2,100, judged 47.3 percent.

The fourth-busiest rater, DBRS Ltd. of Toronto, analyzed 6.8 percent, according to the newsletter Inside MBS & ABS based in Bethesda, Maryland.

Egan-Jones's ratings for Bear Stearns Cos., which the Fed propped up with emergency funding in March, and on Lehman Brothers Holdings Inc., which filed for bankruptcy in September, were consistently lower than those from the major companies, according to Sean Egan, president of the service. Egan-Jones has 19 employees.

While Moody's and S&P classified Lehman debt as A1 and A, respectively, Egan-Jones placed the bank several grades lower, at BBB, as early as May.

... A Matrix

Under the emergency programs, the Fed is buying commercial paper that carries at least the equivalent of an A-1 rating, the second-highest for short-term credit. It is lending to banks that can post collateral the major raters deem to be investment grade, or eligible for bank investment. The central bank can reject collateral or commercial paper if it has doubts about creditworthiness or value.

In addition, policy makers reduce the risk of losing money on a declining asset by loaning as little as 75 percent of the market value. They value some securities according to a matrix and use outside firms to appraise the rest, Williams said. The Fed then cuts that figure by as much as 25 percent before lending, according to its Web site.

General Electric Co., Korea Development Bank and Morgan Stanley are among companies that have said they signed up for the commercial paper program.

GMAC LLC, the largest lender to General Motors Corp. car dealers, said in October that it was granted access to the commercial paper facility through its New Center Asset Trust unit. The unit’s paper earned top ratings of P-1 from Moody’s and F1+ from Fitch, though GMAC itself is rated 11 levels below investment grade by Moody’s. S&P on Dec. 5 put the New Center Asset Trust on watch for a possible downgrade.

... 'Imprudent' Lending

Former executives of the three major raters told a House Oversight and Government Reform Committee hearing Oct. 22 that they had relied on outdated models to maximize profits.

Originators of mortgage-backed and asset-backed securities and collateralized debt obligations "typically chose the agency with the lowest standards, engendering a race to the bottom in terms of rating quality," Jerome Fons, a former managing director of credit policy at Moody’s, testified.

The U.S. Department of Housing and Urban Development said Dec. 4 that it would investigate a Nov. 18 complaint by the National Community Reinvestment Coalition, a Washington-based advocate for affordable housing. Moody's and Fitch made "public misrepresentations" about the soundness of subprime securities that led to "imprudent" mortgage lending, the coalition said.

... No Discussions

Sen. Carl Levin, a Michigan Democrat and chairman of the Permanent Subcommittee on Investigations, is conducting a "preliminary inquiry" into the companies. role in the financial crisis, he said Dec. 5.

The SEC voted Dec. 3 to bar ratings services from discussing compensation with bankers seeking assessments and to limit gifts to their employees from the underwriters.

From 2002 to 2007, Moody’s and S&P provided top ratings on debt pools that included $3.2 trillion of loans to homebuyers with low credit scores and undocumented incomes, according to data compiled by Bloomberg.

... $997.1 Billion

As subprime borrowers defaulted, the companies downgraded more than three-quarters of the structured investment securities known as CDOs that had been rated AAA.

Writedowns and losses on that debt incurred by banks, brokers, insurers and Fannie Mae and Freddie Mac totaled $997.1 billion worldwide, Bloomberg data show.

The central bank wants to stabilize financial markets and mitigate the effects of the recession, as well as "support the functioning of credit markets," Bernanke said Dec. 1 in a speech in Austin, Texas. He didn't address the credit rating system.

The Bloomberg lawsuit is Bloomberg LP v. Board of Governors of the Federal Reserve System, 08-CV-9595, U.S. District Court, Southern District of New York (Manhattan).

* * *

Help Keep GATA Going

GATA is a civil rights and educational organization based in the United States and tax-exempt under the U.S. Internal Revenue Code. Its e-mail dispatches are free, and you can subscribe at http://www.gata.org/.