THE FIX WAS IN

CHAPTER THREE

THE FINANCIAL MELTDOWN MOODY’S REIGN OF TERROR APRIL 2012

INTRODUCTION:  MOODY’S CULTURAL WARS

In Chapter Two, I explained why Warren Buffet was so angry with Moody’s.  It had been corrupted (legally), Buffet knew it (too late), and that corruption was of central importance (to the Financial Meltdown).   

Moody’s granted AAA ratings, the same top rating given to the U.S.  Government, to TRILLIONS worth of mortgage-backed bonds called Residential Mortgage Backed Securities (RMBS).  It was beyond rational.  Except for one thing: it made Moody’s a LOT of money. 

But back in the year 2000, when Moody’s went public and Wall Street was gearing up for the RMBS avalanche, the profit for Moody’s was only a potential.  Unlike Wall Street, Moody’s was not equipped to handle the volume.  In fact, its very culture conflicted with the volume such profits required.   

Moody’s senior executives knew it.  They knew the RMBS Department had to change.  It had been a fortress of financial rectitude.  Now they needed to convert it into an engine of go-go financial frenzy.   

That conversion (from rectitude to go-go) accurately can be described as Moody’s “Reign of Terror,” complete with an abused and exploited sub-population.  That population was Moody’s very own prized employees.     To understand, you need to know about Moody’s corporate culture before the conversion. 

MOODY’S CULTURE BEFORE GOING PUBLIC

Before going public in 2000, Moody’s culture was like a small Ivy League school without the students.  Most of its analysts and attorneys were from Ivy League colleges, held advanced degrees (PhDs and JDs were common), and had relevant real-world experience in their respective fields.  At a truly international level, they were considered of the highest caliber and their ratings solid gold.  Remember this.

The mood was collegial, interactive and exacting.  “Getting it right” was the important thing.  The “it” was the rating.   “Right” was the correct rating for the security, no matter what.  The investment world looked to Moody’s for rigor, transparency and total objectivity.  The Moody’s analysts knew it and upper management preached the gospel.  Moody’s was the best.  Period.  No one could push it or its employees around. 

MOODY’S PEOPLE: THE GUARDIANS

For the rating of any security, Moody’s paired a Rating Analyst with an Attorney.  The Analyst tested and verified the numbers; the Attorney scrutinized the legal structure of the security.  Their pay was far less than Wall Street, but that did not matter.  What mattered was their ratings were sacrosanct.  In a sense, they served as the Financial Guardians who determined the worthiness of what was sold to the public---and if a security was dubious, it was their duty to point that out.  They knew it and were proud. 

THE WORLD OF INVESTORS DEPENDED ON MOODY’S

By law or custom, most institutional buyers of stocks or bonds are required to take ratings into consideration.  If a security’s rating is not high enough, they cannot buy the security.  So institution investors “buy” the rating just as surely as they “buy” the securities themselves.  The usual cut-off is a rating of at least “A,” which is called “investment grade.”  AA is better.  AAA is the best.  When a security is rated less than “A”, it is considered non-investment grade and most institutions are forbidden from buying it.  For example, a rating of BBB is not investment-grade and most institutions cannot buy it.    

The analysts at Moody’s obviously knew this.  Back in 2000, they also knew most buyers of large blocks of stocks & bonds were pension funds, insurance companies and mutual funds whose primary goal was preservation of wealth.  At stake were the retirement funds/safety nets for scores of millions of people. 

Conservatism & safety thus were the watchwords and intense scrutiny was required.  This meant Moody’s typically took months to approve the rating for a new security.  If an analyst needed more information, he simply asked.  Because Moody’s was so powerful, answers were provided immediately.    

Moody’s position on this cannot be overstated.  Literally, all over the world, investors looked to Moody’s for accuracy and reliable information.   It was a role Moody’s cherished.  It made Moody’s special.  It made Moody’s people powerful.  They had status.  They were an exclusive club.   No Wall Street firm would dare bully them.

THEN MOODY’S WENT PUBLIC AND IT ALL CHANGED

When Moody’s went public, its senior executives became eligible for stock options and other bonuses available only in public companies.  This single fact was key.  It shifted the primary focus of senior executives from “getting it right,” to maximizing Moody’s stock price. 

To obtain the maximum share price, Moody’s needed to maximize earnings.  To maximize earnings, it needed to expand, dramatically, that part of its business with the potential for fast growth.    

Such fast growth could not be found in the existing supplies of corporate and government security offerings.  They were stable but static.  They would not grow much.  But the RMBS market (mortgage-backed bonds) was new and unexploited.  And boy, was it sexy.  It promised volume in the trillions because its potential market was financing or refinancing every home in America: Trillions worth of new mortgage loans.  No other prospective market could come close.    

This fact also cannot be overstated.  The potential was beyond huge.  It was historic.  By the year 2000, all the players knew it and wanted in.  If a Wall Street participant did NOT jump in, he was a fool.  It was a shark feeding frenzy.  That was Wall Street.   

WALL STREET’S PROBLEM

There was only one big problem.  To create RMBS that could be sold in the trillions, Wall Street needed Moody’s.  It needed the ratings Moody’s provided.  Investors bought the ratings.  Moody’s was the King of Ratings.    Wall Street had to get Moody’s cooperation and given Moody’s historically exacting, even persnickety, culture, they thought it would require a bloody battle.   

Then a funny thing happened.

Moody’s went public in 2000 and all those Executive stock options did the trick for them.  Moody’s did not just cave. It joined the frenzy.

SO BEGAN THE REIGN OF TERROR

When Moody’s senior executives looked around the RMBS department, they looked for someone to amp it up.  They wanted production, not excuses.    

They found their perfect prototype in a man named Brian Clarkson, whose academic credentials were minimal and whose prior experience at Moody’s was one of analytical slough.  He, quite simply, was not up to Moody’s old standards.  That did not matter.  Senior management saw in him an aggressor who could drive the department exactly the way they wanted.  So he was handed the mantle and an order: charge!

BRIAN CLARKSON’S OPPRESSIVE MANAGEMENT STYLE

To state that Clarkson was a bully is like stating the Pope is Catholic.  As one former employee said, “The key enforcer of the cultural change at Moody’s was not a technique, but Brian Clarkson.”   

Clarkson’s primary weapon was simple: he fired people.

An analyst named Richard Michalek stated “I think I can say, with only a little exaggeration, that I have heard Brian conjugate the verb 'to fire' in moods and tenses most grammarians do not even know exist.  In my ten years at Moody's, I do not think I had three consecutive encounters with Brian in which he did not threaten to fire someone, describe someone he had fired or identify someone he should have fired.”

CLARKSON’S SPECIFIC INTIMIDATION TECHNIQUES

Clarkson employed four specific tactics to get his results:

1.   He fired dozens of analysts and attorneys.  He did so often and with brutality.  He was like a Nazi concentration camp commander wandering the grounds and shooting prisoners simply because he could.  He was empowered.  His superiors wanted his brutality.   

2.   To replace the fired analysts, he hired junior analysts he easily could control.  One of his favorite ploys was to hire recent college graduates who were legal aliens.  They needed work visas to remain in the United States.   He knew they faced immediate probable deportation if fired.  Think of that.  Your very legal status in the United States is subject to the whims of a bully.    For Clarkson, it was perfect: he wanted docile employees and he got them.

3.   He starved the RMBS group of resources.  Analysts continually complained about their need for more research, lack of backup, working on weekends and nights.  They were isolated and forced to work on many more transactions than they could handle.  This meant they could not spot tough rating issues, let alone deal with them.  Instead, under threat of being fired, they jammed the securities through the system. 

[Tragic fact: while rating trillions of RMBS, Moody’s never employed an analyst who had direct real estate experience.  NOT EVEN ONCE.  Existing analysts knew they needed experienced real estate talent and kept asking for.  They never got it.]

4.   Clarkson encouraged Wall Street bankers to refer all complaints directly to him.  This part is CRITICAL.  Prior to Clarkson, no Wall Street investment banker would dare pressure anyone at Moody’s.  After Clarkson, they were invited to complain.  They were solicited to complain.  Clarkson called them personally and regularly met with them.  He took them to lunch.   If they found some analyst recalcitrant?  Fine.  He was transferred or fired.    Someone too slow?  An attorney with too many questions?   Fine.  He or she was replaced.    

CLARKSON RELISHED HIS POWER

It should be noted Clarkson enjoyed pulling employees into his office and firing them.  He enjoyed his power.   He bragged about it.

Moody’s Senior Analyst Mark Froeba:

“Brian was notorious within Moody's for a joke he told: that his only regret in firing people from Moody's RMBS Group was that one of them got a job before he could fire him.”

SENIOR MANAGEMENT KNEW IT ALL ALONG

Finally, here is what Froeba had to say in FCIC testimony about cultural change at Moody’s, Brian Clarkson, and the attitude of Senior Management: it is damning:

"Before I leave the topic of threats of termination as a tool to implement the culture change at Moody's, it is important to point out that Brian was not a rogue manager running amok while Moody's Board and CEO/President were deceived about his conduct.  They recognized in Brian the character of someone who could do uncomfortable things with ease and they exploited his character to advance their agenda.  They were the ones who put Brian in charge of the RMBS Group and we can be quite confident he was not put there to improve morale! This is why it is important not to think about Brian separately from the people who were using him to implement the culture change at Moody's, first John Rutherford Jr.  and then Ray McDaniel.”

Rutherford and McDaniel were the successive CEOs of Moody’s.  They knew everything about Clarkson.  They knew he was a bully.  They knew he terrorized the RMBS department and promoted brutal sycophants.  They knew he courted Wall Street and fired or elevated on their command.  Hell, they promoted him because of it.  They wanted him and his trillion-dollar production machine in fine working order.  They did not care how many bodies were stacked up in the meantime.    

CONCLUSION: MOODY’S CULTURE WAS CORRUPTED

Senior Executives successfully mutated Moody’s culture.  They hired and repeatedly promoted a bully who did their dirty work.  Trillions worth of questionable home loans were jammed through the system.  They gave most of those housing bonds AAA ratings, the same rating as the U.S.  Government, even while starving the RMBS department of even ONE person with real estate experience. 

Senior executives did not care.  They wanted Clarkson’s cash-flow machine no matter what the cost.  And what a cost.  We still see it as the Great Housing Depression continues to roil the nation. 

                                     THE END

THE FORMAL PART OF THIS CHAPTER IS OVER NOW

You can stop reading and go watch TV.  Go ahead.  Go.  However, if you are interested in what an RMBS is, read further.  It ain’t complicated. 

A SIMPLE EXPLANATION OF RMBS

A bond is nothing more than a promise to pay debt.  Usually, corporations and governments sell them for $1,000 each.  With mortgage-backed bonds (aka RMBS), there is no corporation or government making a promise to repay the debt.  It is merely homeowners, bundled together, making payments on their home loans.  It is that simple.

BALANCE SHEET OF A TYPICAL RMBS

As you can see, an RMBS is simply bundled together home loans.  The assets (shown on the left) are home mortgages bought from companies that created them, like mortgage bankers, S&Ls and banks.  To buy them, bonds are sold to raise the cash.  Their source of repayment is homeowners paying their home-mortgage debt.  When an investor buys an RMBS bond, he buys the cash flow from homeowners as they make their monthly mortgage payments.  Like I said, it is that simple.

When Moody’s rated these bonds, it broke them into subgroups.  The top subgroup (the bonds that get paid first) is rated AAA.  This subgroup of bonds gets paid EVERYTHING prior to the next subgroup getting paid anything.  That is why the AAA subgroup is called “senior debt.”  It is senior to all the other claims.

During the boom, some 90% of all RMBS subgroups were rated AAA.    This was the keystone for Wall Street.  It meant a group of bundled together home loans was deemed as safe an investment as the U.S.  Government.  It made those bonds easy as pie to sell.  It made Wall Street a fortune.  It made senior executives at Moody’s salivate with greed. 

After the AAA bonds get paid, the next subgroup (the AA group) gets paid.   Then the next subgroup and the next after that, each with successively lower ratings.   

So that is the story about how Moody’s corrupted itself.  Except one thing: you need to understand it within America’s historical financial context.

THE HISTORIC CONTEXT

The ENTIRE DEBT of the United States of America, accumulated since its inception more than two centuries years ago, is about $16 TRILLION.

By comparison, between the year it went public, 2000, and 2008, the amount of RMBS Moody’s rated was almost $24 TRILLION.   

You do the analysis. 

It was a psychedelic nightmare.   

THE FIX WAS IN

 

THE FINANCIAL MELTDOWN CHAPTER TWO  WARREN BUFFET'S ANGER AT MOODY'S  DECEMBER 2011

INTRO: WARREN BUFFET’S RELUCTANT APPREARANCE AT THE FCIC HEARING

It was early June 2010 and Warren Buffet was on the FCIC hot seat next to the CEO of Moody’s, Ray McDaniel.  Buffet was visibly pissed. He had to be subpoenaed to show up.  But he was the biggest investor in Moody’s and everyone wanted to know why. He had not prepared any written testimony.  And something strange was going on: Buffet was so openly hostile to McDaniel, he made a point of half-turning his back on him.  When asked a question about Moody’s operations, Buffet stated he had talked to McDaniel only twice and had met him in person only today. And in open contempt, he said, “I don’t even know where their [Moody’s] headquarters is located.” 

I think if he could have reached around and strangled McDaniel, he would have.

It was at the afternoon session of the Financial Crisis Inquiry Commission (FCIC) hearing in NYC in June.  The morning session had featured a series of analysts from Moody’s who had been fired for daring to oppose Moody’s rampaging---out of control---real estate group.  The afternoon session was devoted to only Buffet & McDaniel and was about Moody’s’ Big Picture.  It was not pretty.

INTRODUCTION:  HOW WE GOT HERE

In Chapter One of this Blog, I outlined the sheer volume of mortgage-backed bonds groups---called Residential Mortgage Backed Securities (RMBS)---rated by Moody’s, the credit rating agency.  It was an avalanche: between 2000-07, Moody’s rated some 78,000 individual groups (called tranches) of mortgage-backed bonds that were then sold to the public, equal to about $2.3 billion per day. 

The volume was beyond rational.  Indeed, to state that Moody’s actually rated anything probably is a myth.  It processed ratings like from the episode of “I Love Lucy” where the cakes keep coming out on a conveyor belt faster and faster until Lucy goes crazy.  THAT was Moody’s.  As one Wall Street executive said, Moody’s was “handing out AAA ratings [on RMBS] like candy bars.”

WHY WARREN BUFFET BOUGHT MOODY’S STOCK

Warren Buffet, the Sage of Omaha, is one of the most famous businessmen in the world.   His net worth exceeds $30 billion. He started his company, Berkshire Hathaway, in the 1960s.  His business strategy is simple: invest in well-known, conservatively run companies with high brand-name recognition and which generate strong positive cash flows.  Then use the cash flow to invest in yet more companies that offer the same advantages.

Moody’s was exactly that: a brand name that could charge more for that brand.  And Buffet liked Moody’s for another reason: it had, he said, “duopoly” pricing power.

“DUOPOLY” PRICING POWER: WHAT IS IT?

For the sake of conservatism, most institutional buyers of stocks & bonds are required by either custom or law to have two credit ratings on whatever they buy.  Since there are only three major rating agencies, the only choice of the issuers---the sellers of stock & bonds---is which two to employ.   That fact gives rating agencies, as Buffet said, “duopoly” pricing power: two of the three rating agencies are always employed.   For Buffet, it was a no-brainer: if Moody’s only did average, it wins the business two out of three times.  And Moody’s was not average.  When Buffet bought the stock in 2000, Moody’s was the Rolls Royce of the industry.  Its methodologies were the most thorough.  It was the best. 

BEFORE GOING PUBLIC:  WORKERS LOVED MOODY’S TOUGH-MINDED ETHIC

Richard Michalek, a former Vice President at Moody’s, stated when “I started at Moody’s in 1999, the firm was ‘conservative’ and the derivatives group was ‘intellectual.’ New hires were experienced and then heavily mentored on the job.  To ensure sufficient analysis, every deal was assigned a lawyer and a ‘quant’.  The lawyer ensured the deal documentation was sufficient and correct, and the quant did the math.”

                                                     
Mark Froeba, a Senior Vice President at Moody’s who started there in 1997, said “Moody's had an extremely conservative analytical culture. Moody's analysts were proud to work for what they believed was by far the best of the rating agencies. They viewed Moody's competitors as a very distant second in quality and ratings integrity. Moody's was a place that outsiders loved to hate (as the title of one article at the time put it). Everyone understood that for any new product that was unusual or complex, the Moody's rating was the one to get and that without it, it would be difficult or even impossible to market the new product.”

I was at the FCIC hearing where Froeba said this.  He paused then,  and rather wistfully continuned:  “In short, the Moody’s of that time had the stature, and maybe even the power, to stop something like the subprime bubble had it arisen then.”

A LITTLE BACKGROUND ON CREDIT RATING AGENCIES

Credit rating agencies are in the business of, well, rating the credit of companies and governments.  The highest rating is AAA.  The lowest is D.  There are three major credit-rating companies: Standard & Poor’s (S&P), Fitch and Moody’s.  [By the way, Rating “Agencies” are not “agencies” at all; they just call themselves that because it sounds more official---as though they were impartial, Government-type “agencies.”]

Both Fitch and S&P are owned by big holding companies involved in many activities. Moody’s itself was owned by Dun & Bradstreet until 2000, when Moody’s was spun off in a public offering to unlock “unrealized value.”  Buffet immediately bought a 20% position in the company because he loved that “duopoly” pricing power.   It was his standard fare: the company could not lose.   Further, it was the only rating agency that, by itself, was public.

A LITTLE BACKGROUND ON “AAA” RATINGS

The highest rating a company or government can have is AAA, and it is very tough to obtain.  Only four U.S. Corporations have it:  Microsoft, Johnson & Johnson, Automatic Data Processing and Exxon Mobil.   One rating agency recently even downgraded the AAA rating of the United States of America.  Yet AAA ratings were granted to trillions worth of mortgage-backed bond groups.  Why?  How could bundled-up mortgage loans be rated the same as Microsoft?  And many were not even normal home loans; they were  no-down-payment, no-proof-of-income, no-doc home loans.   How could they obtain the coveted AAA ratings? There had to be a Fatal Flaw---and there was.

THE FATAL FLAW: HOW RATING AGENCIES ARE PAID

Rating agencies used to be paid by the people who wanted their information, meaning investors and potential investors who bought the information to help them make decisions.  This is called the “subscriber pays” model.  You paid for a subscription and you literally got a magazine showing ratings of companies.

That changed in the 1970s when the system evolved into an ‘issuer pays’ model, by which the issuer (either the company itself or more likely, the investment bank underwriting the company’s stock or bond)---that issuer chooses and pays the rating agency.

According to Moody’s annual statement, “The rationale for this change was, and is, that issuers should pay for the substantial value [that] objective ratings provide in terms of market access.  In addition, it was recognized that the increasing scope and complexity of the capital markets demanded staffing at higher levels of compensation than could be received from publication subscriptions alone.”

I have quoted this passage with italics because it is so deliberately dense and logical sounding.  It is that way because it attempts to mask an inherent conflict of interest: the guy you rate is also the guy who pays you.

At first, the issuer-pays model was not a problem.  Companies do not come to market that often.  A big stock or bond offering might be $3 billion; a huge one might be $20 billion.  Moody’s did not need the good graces of---or revenue from---any one company.    Or any group of companies.

This changed with the RMBS market.   Remember, Moody’s was rating $2.3 billion worth of RMBS bonds PER DAY.   Furthermore, there were only a few issuers---usually the big Wall Street houses---not thousands of public companies.   Wall Street created the RMBS market; Wall Street controlled it.   The real players were limited: Lehman, Merrill, Goldman, Citi, BoA, Bear,  Morgan and a couple more.  They DID have the power to influence the ratings, and boy, did they.

AFTER GOING PUBLIC:  WORKERS AT MOODY’S BECAME PAWNS TO SENIOR EXECUTIVE BONUSES

When Moody’s went public in 2000, its senior executives became eligible for stock options and everything changed.  The senior executives wanted giant paydays through their stock options, which meant a quest for a high & higher stock price, which required higher & higher earnings.   Within a few years, the quality of its ratings soon became subservient to the quest.

The former Moody employees from the morning Hearing talked about it a lot.   Their bosses told them to go with the flow.  They should keep their heads down and churn out the AAA ratings.  They did: tranche after tranche after tranche rolled off the line.   As I said, it amounted to $2.3 BILLION PER DAY at Moody’s alone. 

If any employees slowed the process, say in an attempt for a patina of rigor, they were chastised.  If they even asked for more information, they were threatened.

Richard Michalek, a lawyer at Moody’s, refused to back down.  He repeatedly questioned the structuring of mortgage-backed bonds Goldman Sachs was selling.   What happened?   A senior guy at Goldman called a senior guy at Moody’s and Michalek was removed.

This happened continually.  The employees at Moody’s were treated like servants, chastised like children, dismissed with aplomb.  The investment banks regularly intervened.   They cajoled, swore, and threatened the bosses at Moody’s:  either give us the ratings we want, and do it quickly, or we will take our business elsewhere.

If an analyst at Moody’s protested too much, he/she was fired.  Most of the original real estate group DID protest, and most WERE fired or transferred into oblivion.   So over time, the remaining employees were crushed, trodden, subdued into perfect little get-along, go-along automatons.   The senior executives won.  They got their bonuses.

As a conflict of interest, it was a Perfect Storm.   Let me be specific: because it gave the issuers, investment banks, so much power, the ratings were corrupted.  The corruption was legal but it was real and as the RMBS fiasco played out, it was instrumental in bringing the world’s financial system to its knees.

By the time of the FCIC hearing, Buffet knew it, but it was way, way too late.  That is why he was so pissed.

THE NEXT CHAPTER:  HOW MOODY’S WAS BRIBED

ONE NAGGING DETAIL:  BARNEY FRANK

Several friends have swallowed the notion that Congressman Barney Frank from Boston had a central and pivotal role in the Financial Meltdown.  They keep asking me about him and when I get to the Chapter(s) about Fannie Mae and Freddie Mac, the two Government-Sponsored-Entities involved in the national housing market meltdown, I will tell you some details about Barney Frank’s involvement---along with others, like Presidential candidate Newt Gingrich.

But let me make a point at this time about how central Barney Frank (or Gingrich) actually was.   Imagine the movie Gladiator in which Russell Crowe plays the glorious gladiator character; imagine the scene in the Coliseum in Rome when he does battle with the bad guys; imagine all the bit players in the movie; now imagine the crowd (even if computer-generated) cheering on the human slaughter.  

Here is how important Barney Frank was to the Meltdown: he would be the crowd cheering on the fighters, not even a bit player, just another face in a crowd of a hundred thousand.   If you believe otherwise, you simple do not know the facts.   Worse, you have swallowed lies made up by those who really caused the Meltdown to deflect attention from their own behavior, which always was one thing: greed.

THE FIX WAS IN

THE FINANCIAL MELTDOWN  CHAPTER ONE OCTOBER 2011

PREQUEL: HELLO AGAIN

As some lucky readers may remember, I used to write periodic Economic Bulletins explaining various facets of the economy. I stopped some years ago because the economy became wonderful---and boring--- and because I was offered a gig writing a monthly column for a lifestyle magazine called Coast. Now that gig is gone and the economy is ever so much more interesting. So here goes again.

STARTING AT THE END:

JUNE 2010: THE HEARING ROOM IN NEW YORK CITY

The Hearing was in NYC. It was early June and already hot. My hotel was close, so I walked and by the time I arrived, I was sweating. The Hearing Room was small and Spartan. The anxiety of the four men seated directly to my right and in front of the Commissioners was real—even surreal. Their faces were etched. The hands of the closest, Dr. Gary Witt, were shaking. He and the three others, all former executives of Moody’s real estate unit, were the morning witnesses in the day’s session of the Financial Crisis Inquiry Commission.

They yearned to give their testimony, grateful for the opportunity. Moody’s, the credit-rating agency, had been corrupted---legally---and they had resisted it. For their efforts, they were fired or transferred into oblivion. Now it was their chance to tell what happened.

HOW I GOT THERE: THE FINANCIAL CRISIS INQUIRY COMMISSION

In late 2009, Congress created the Financial Crisis Inquiry Commission to investigate why the financial system failed. It had ten Commissioners backed by some sixty staff. It was bi-partisan. Its chairman was Phil Angelides, who used to be Treasurer of the State of California. Phil is scary smart and a friend (and without his direct help as Treasurer, the Orange County High School of Arts would not exist). I asked him if I could attend and he said fine, the Hearings were public, and he would make sure I got good seats.

THE HOUSING BUBBLE: WHO WAS RESPONSIBLE?

Everyone knows the Housing Bubble became a big disaster and that its collapse is the single dominant component of the Financial Crisis.

How the bubble got created is a subject of much finger pointing. Prime villains include shoddy lenders, unscrupulous loan brokers, Fannie Mae, octopus investment banks like Goldman Sachs, out-of-control commercial banks like Wachovia and greedy home speculators. The list goes on. All these accusations are true. But they miss the Main Point..

The Main Point is who provided the money for the loans and how. That is the key. Nothing else much matters. No Money = No Loans. Ample Money = Ample Loans. And the money was not just ample. It was huge, gargantuan, beyond previous scale or conception.

SALIENT POINT:

There is one salient point you need to know at all times: The Fix Was In. The whole system was corrupted so insiders could get rich. The corruption involved everyone in the food chain---EVERYONE.

But the key to it all, the gate-keeper, was the rating agency Moody’s. It was at the root. Moody’s could have stopped it. Or checked it. Or slowed it. Or at least caused some people to think again. But it did not. It did the opposite. It more than enabled the Housing Bubble. It whipped it. It flogged it. Moody’s took out its lash and kept it out, crudely driving its analysts in a frenzy.

Why? To cash in too.

THE NUMBERS

To understand the enormity of the disaster, you need to know some simple numbers. Between 1988 and 1997, the total of all mortgage originations (both from buying homes and refinancing them) was $6.7 trillion. Then over the next ten years, 1998-07, the number rose some 350% to $23.6 trillion. Take a look at the graph below.

As you can see, in the second ten years, it was an avalanche of cash. A torrent. A flood. It was historical. Never before had so much cash been thrown at the housing market and it swept America, and much of the developed world, over the cliff. Without massive government intervention, it would have become another World-Wide Depression. As it is, the Great Recession still roils the world.

WHO PROVIDED THE MONEY FOR THE LOANS?

Institutional investors provided the money. They included pension funds, 401K Administrators, money-market managers, big banks, insurance companies, and multi-national institutions of all kinds.

Institutional investors did not originate the loans. Mortgage brokers, banks and S&Ls originated the loans. In turn, they typically sold these loans as mortgage-backed bonds to institutional investors. Those bonds were a relatively new but simple concept. You bundle together a bunch of home loans and sell them as bonds. These bonds are called Residential Mortgage Backed Securities (RMBS). Their source of repayment is homeowners paying their home-mortgage debt. Simple. A solid concept. Nothing wrong with it.

The market for RMBS started in the early 1990s, but did not take off until about 2000 when the avalanche started.

WHY THE BONDS COULD BE SOLD TO INSTITUTIONAL INVESTORS

Institutional investors, like pension and money market funds, collectively have tens of billions of new money pouring into their coffers every month. The managers are required to invest only in safe instruments, like blue-chip stocks or bonds. In the financial world, this means stocks or bonds with credit-ratings of at least “A.”

Credit ratings range from a low of “D” to a high of “AAA”. In America, there are only four companies with a credit rating of AAA (and the U.S. Government recently was downgraded to AA by one rating agency).

The RMBS bonds could be sold because the Credit Rating Agencies generally gave them AAA ratings.

THE NUMBERS FROM MOODY’S

Residential Mortgage Backed Securities (RMBS) are sold in groups called tranches. An average tranche rated by Moody’s had a total value of about $65 million, from which investors could buy a few bonds---or a lot. Because of their AAA credit rating, the bonds were in high demand and Moody’s had to gear up to process the groups.

The sheer number of individual RMBS tranches rated by Moody’s is hard to believe. Between 2000 and 2007, Moody’s granted ratings on more than 72,400 individual tranches. Even the word “granted” is not accurate. Moody’s spewed the ratings. It heaved them. It disgorged them in a financial orgy never before seen. On an average day, it approved 35 tranches; and this is only an average. During the height of the frenzy, it was out of control. One of the former executives said it was like a famous “I Love Lucy” episode when the cakes kept coming out of the conveyer belt faster and faster and faster until Lucy goes crazy.

MOODY’S NO LONGER RATED BONDS: IT PROCESSED THEM

The pressure was so intense Moody’s functionally ceased to rate RMBS bond tranches. It processed them.

Mr. Eric Kolchinsky, a Team Manager Director at Moody’s said “at the beginning of the decade, it took 2-3 months to rate any particular RMBS. But eventually, the pace increased to 2-3 weeks to 2-3 days and in ’07 it was at times just one day.”

Think of that. The pressure to process the ratings was so intense—so maniacal—the time period allotted to analyze them dropped from 2 months to ONE day. Moreover, said Kolchinsky “the analysts at Moody’s were always over worked. There were no weekends and the week days were very long and exhausting.” Mr. Kolchinsky complained loud and long to his superiors. For his troubles, he was suspended.

Mr. Mark Froeba, a Senior Vice President, stated, “the RMBS Group was notoriously understaffed, underpaid and overworked. By forcing analysts to work on many more transactions than they could comfortably handle, they were effectively prohibited from delving too deeply into any one of the transactions. The quality of their analysis - and the likelihood that analysts would spot tough issues - dropped precipitously.” Mr. Froeba complained and was ‘downsized’ from Moody’s in 2007.

Mr. Richard Michalek was a Senior Credit Officer at Moody’s Investor Service. He had joined Moody’s because of its sterling reputation as an objective rater, but it steadily deteriorated under the pressure for more. To get more, Moody’s resorted to “management by fear and intimidation.” When Mr. Richard Michalek complained about this style of management, his position was eliminated.

TENTATIVE CONCLUSION: MOODY’S WAS OUT OF CONTROL

It would be easy to state the real estate unit of Moody’s---never really all that big in relation to the whole company---simply got out of control and could not function appropriately. That is the premise of Moody’s current posturing.

THE REAL CONCLUSION: MOODY’S KNEW EXACTLY WHAT IT WAS DOING

Moody’s posturing is, in a word, bullshit. It knew exactly what it was doing. It knew exactly how much pressure it was placing on its analysts. One after another complained; one after another was fired. Moody’s wanted their product so badly---specifically the revenue flowing from it---no mere analyst, or the whole group, could get in its way.

Read the next installment to find out why Moody’s did it. I will give you one hint, an answer you already know: greed.