Toomre Capital Markets LLC

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Bond Rating Agencies Get Subpoenas

The Wall Street Journal reported on October 26th 2007 in a story entitled Bond Raters Get Subpoenas that Connecticut's Attorney General Richard Blumenthal issued subpoenas to the three largest debt-rating firms as part of an anti-trust investigation. Apparently Standard & Poor's Ratings Service, Moody's Investors Service and Fitch Ratings Service were served with the subpoenas on October 10th. "Standard & Poor's ("S&P"), a unit of McGraw-Hill Cos., and Moody's, part of Moody's Corp., control about 80% of the debt-rating market, which assesses the ability of corporations, banks, mortgage firms, governments and other borrowers to pay back a loan. Fitch is a unit of Fimalac SA of Paris."

This WSJ article continues with the following key information: "My investigation seeks to determine whether credit-rating agencies may be exploiting their dominant positions to unfairly raise prices or exclude competitors. Assuring debt ratings are honest and untainted is vital to investors, companies and government," Mr. Blumenthal said. The focus of the investigation includes three key areas: so-called unsolicited ratings, so-called notching and the concept of exclusive contracts. "There are allegations that some raters conduct an unsolicited rating and then demand the issuer pay for it or face a possible poor rating," the attorney general said. Notching is when raters allegedly threaten to downgrade an issuer's debt unless they get a contract to rate the issuer's entire debt pool, even if parts already have been assessed by another agency. Exclusive contracts give issuers discounts for having all their debt rated by a single agency. "Such agreements may hinder competition by locking out other debt raters," the attorney general said.

Toomre Capital Markets LLC ("TCM") cannot testify whether unsolicited ratings, notching or exclusive contracts are applicable to recent structured finance transactions in areas such as Asset-Backed Securities ("ABS"), non-agency Collateralized Mortgage Obligations ("CMOs"), Commercial Mortgage-Backed Securities ("CMBS"), adjustable-rate mortgage ("ARM") pass-throughs, Collateralized Debt Obligations ("CDOs"), or Asset-Backed Commercial Paper ("ABCP"). However, Lars Toomre can directly testify to how Moody's used unsolicited ratings and notching to establish some supposed credibility in rating residential mortgage-backed securities ("RMBS") in the first place.

Back in 1988, Standard and Poor's was the dominant rating agency in structured finance. Since the early 1980s, S&P had worked closely with the then small group of mortgage underwriters (which essentially were composed of Salomon Brothers, First Boston and Lehman Brothers) to establish rating criteria for these new instruments backed by pools of mortgages and agency pass-throughs. Fitch Ratings Service was acknowledged as a second-tier rating agency relative to the credibility of Standard and Poor's and Moody's was essentially non-existent in structured finance ratings.

At that time, Lars Toomre was the head of the CMO New Issue and Secondary Trading business at Lehman Brothers. Lehman was the dominant investment bank for CMOs and many institutional accounts viewed that they had almost a fiduciary duty to speak with Lars Toomre, Kevin McDermott (presently the head of mortgage investments for the Bank of New York) or Ted Janulis (the present head of Lehman Brothers Mortgage Capital) about what a particular CMO security was worth. The mortgage trading system efforts were spearheaded by Aldon Hynes with key support from Mark Prieto that produced a daily CMO Secondary Market Report that summarized what the Lehman Brothers CMO Desk considered to be the value of each and every CMO Bond Class in the secondary market. Using a computer modeling system that preceded that now embedded in the ubiquitous Bloomberg terminals, the Lehman CMO team was able to perform customized sensitivity analysis on virtually every existing CMO transaction. The new issue modeling efforts were led by Larry Penn with key support from Erik Nygaard and Bob Caldwell. For those transactions about which incomplete information was released, Lehman Brothers and other secondary market traders tacked on an illiquidity spread factor and hence such bond classes tended to trade at a discount to where similarly structured and collateralized bond classes might trade.

If Lars' recollections are correct, in the spring of 1988, Larry Fink, presently the Chairman and CEO of BlackRock (and rumored future Chairman of Merrill Lynch), ran the entire First Boston mortgage operation, Rob Kapito, now the President of BlackRock, headed up the CMO business for First Boston, Ben Golub (now Chief Risk Officer at Blackrock) headed up First Boston's mortgage analytics area, and John Finegold headed up CMO trading for Salomon Brothers replacing Jeffrey Kronthal who had moved on to other roles within that mortgage department. There was no doubt someone in charge of the Goldman Sachs CMO trading business. However, given how relatively miniscule Goldman Sachs was in the mortgage business at the time, whoever that person was did not make a big impression. Michael Vranos at Kidder Peabody (and now head of hedge fund Ellington Capital) was still trading mortgage agency pass-through securities and had not yet focused his attention on the CMO market.

Led by Mark Burton (presently Head of U.S. Financial Institutions Group at Lehman Brothers), Susan Wagner (now Vice Chairman and Chief Operating Officer of BlackRock) and Ralph Schlosstein (former President of BlackRock), the Lehman investment bankers focused on servicing third-party issuers of Collateralized Mortgage Obligations. As a result, in that period Lehman Brothers underwrote the majority of third-party issues for mortgage originators and financial institutions like Ryan Homes, Amerifirst Financial, Centex Corporation, Pulte Homes and Countrywide Financial. Lehman Brothers also was the dominant dealer in the rotating three-underwriter group for the largest CMO issuer at the time, Ryland Homes. Led by Tom Potts and his CFO, Jerry Arcy, Ryland was a dominant issuer that relied primarily on securitizations for its on-going financing needs and come to the securitization market about once a month.

The Ryland Acceptance Corporation CMO issues all used Standard and Poor's bond ratings and a significant number used those from Fitch. At least initially, few carried ratings from Moody's. At the time, Moody's had an insignificant structured finance ratings effort and their ratings for mortgages and asset-backed securities were almost considered a joke. Partly as a result, Moody's elected to make a splash and to try to demonstrate their market influence. Hence, one day in 1988 out of the blue Moody's started to issue unsolicited ratings on private label CMO issues. Of course, they started with the most prominent issuer, Ryland Homes. And surprise, surprise … Is it truly any surprise that Moody's somehow indentified some fanciful, supposed "weak link" in the trust structures supporting the Ryland CMOs? Of course, then since they "did not have access to all of the trust documentation", Moody's decided that they must assign only AA ratings (and specifically not the AAA ratings) to the existing Ryland issues whereas both S&P and Fitch had already issued AAA ratings.

One can well imagine what happened as a result. Institutional investors who had purchased these securities on the basis that they were of the highest credit ratings were up in arms. The Ryland Homes management team was furious with Moody's "willingness to adjust the unsolicited ratings" if it was both paid to rate the outstanding issues and to assign ratings to all subsequent issues. Of course, the cover for adjusting such ratings was that Moody's would gain access to all of the trust structure documentation and hence would be able to see the error in their assumptions based on "important information that previously was unreported", hence reemphasizing to the institutional investor the importance of a Moody's rating review. Trading in the Ryland CMOs ground a virtual standstill as no investors wanted to purchase split-rated paper that had some degree of taint with it. Lehman Brothers, the other rating agencies and underwriters all explained that Moody's position was full of bullshit, but nonetheless the Ryland CMO securities widened out by at least 25 basis points relative to other similarly structured non-Ryland paper.

As the leading dealer in the CMO market and the leading underwriter of the Ryland CMO securities in particular, Lehman Brothers had both sold very significant positions in Ryland paper and had a considerable amount in secondary market inventory. The existing inventory immediately cheapened and many institutional accounts began to sell their holdings back to Lehman Brothers based on the unsolicited split ratings news initiated by Moody's. As head of that business unit at the time, Lars Toomre can speak directly to the losses that resulted from the existing $150 million or so existing inventory plus the additional billion dollars or so of bonds that were repurchased to facilitate client liquidity needs. It took some weeks before Lehman, Goldman and First Boston were able to convince Moody's of the obvious errors in its ways. In the meantime, there were significant losses recorded and when it was all said and done, there was nary a statement of sorrow or regret from Moody's. Rather the Moody's managing director at the time simply and arrogantly stated "It is just business!"

Toomre Capital Markets LLC ("TCM") has not publicly told this Ryland ratings story before. Many institutional investors have always noticed Lars' bias toward S&P ratings at the expense of those from Moody's and wondered why. However, Lars Toomre is doing so now with a reminder to Moody's that indeed "It is just business!" How Moody's could have gotten their sub-prime ratings so wrong is beyond comprehension. What were they thinking about in rating so many securities with high investment grades where with the first signs of a credit contraction, the Moody's ratings fall off the cliff? Perhaps they were just concerned about the rating fees??? Certainly they did not seem to be considering the importance of a Moody's rating review! Talk about effective reputation risk management!!

Good luck Moody's in attempting to defend your actions regarding "unsolicited ratings", "notching" and "exclusive contracts". Even though Moody's very explicitly (and expensively) bullied its way into the residential mortgage-backed securities ratings business, of course we believe you Moody's when you say that you never did that with CDOs, ABCP or any of the other more recent structured product areas. Of course Moody's, you should be presumed to be innocent! We really do believe you and respect your rating expertise… NOT!!!!! After all Moody's, "It is just business!" Reader's comments and thoughts are most welcome.