Let The Blame Begin

Everyone played some rolethe Street, lenders, ratings agencies, hedge funds, even homeowners. Where does responsibility lie?

By Roben Farzad

Who's responsible for the subprime mess? Not us, say the lenders that made risky mortgage loans to consumers. Similar denials come from the Wall Street firms that bought, packaged, and sold the loans to investors; the bond-ratings agencies that said those investments were safer than they turned out to be; and the hedge funds that gorged on them. As the allegations fly, various players are busy issuing disclaimers and pointing fingers at everyone else.

At the center of the controversy are the big bond-rating agencies—Moody's Investors Service (MCO ), Fitch Ratings, and Standard & Poor's, which, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP ). These firms are paid by companies to grade their bonds, and investors use those grades when deciding whether or not to invest. The two biggest agencies, S&P and Moody's, have also profited handsomely in recent years by rating collateralized debt obligations (CDOs), or complicated bonds, backed by tens or hundreds of loans and other kinds of debt, that are structured in a way to offer investors higher yields than similarly rated corporate bonds. Sales of CDOs have quintupled since 2001, though neither Moody's nor S&P break out the revenues they receive from rating them. Without the agencies' stamp of approval, many big investors like pension funds and university endowments wouldn't be allowed to buy CDOs. The market, for all practical purposes, wouldn't exist.


But recently certain CDOs backed by shoddy loans plunged in value as defaults in the mortgages they're based on surged. In July, Moody's and S&P placed on negative review $5.2 billion and $7.3 billion, respectively, of subprime-backed securities, and subsequently downgraded the bulk of them. The actions applied to less than 3% of the total issues in the past year and a half. Critics allege the downgrades were too small and came late. And they claim that cozy ties between the ratings agencies and CDO issuers is the reason. Ohio's Attorney General is looking into potential conflicts of interest.

A key issue is one that applies to many of the agencies' dealings: They are paid by bond issuers, not by the investors who use their ratings. Agencies also help the issuers by telling them what they need to do to garner the highest rating, triple-A. What's more, critics note, when agencies decide on their ratings they don't perform what's known as due diligence—looking at the individual loans that make up the CDOs to make sure those loans are up to snuff. Instead, they base their decisions in large part on the due diligence provided by the issuers themselves.

The result of this arrangement is that everyone has a financial incentive to keep deals coming. Christian Stracke, an analyst with CreditSights, an independent bond research firm that isn't paid by the companies it covers, argues that taking CDO issuers at face value is a mistake. "With trillions at stake," he says, "you have to collect enough data to accurately analyze the product, not just make an educated bet." Stracke says the agencies should have held back some triple-A ratings and declined to rate some of the bonds at all.

Both agencies vigorously deny the conflict-of-interest charges. Says Moody's Managing Director Warren Kornfeld: "Our role is to provide the best independent opinion of credit risk. We will not forbear from taking action."

The agencies stress that they can't possibly keep track of every single loan that makes up a CDO. But they make a point of being as open as possible with their methodology. "We engage in conversations with issuers so that they can better understand our criteria," says S&P spokesman Chris Atkins. Says Moody's Kornfeld: "We obviously have dialogue with everybody and our process is transparent." More fundamentally, they argue their CDO ratings are editorial opinions covered by the free speech protections in the U.S. Constitution, and shouldn't be used to govern investment decisions.

As to the charge that the ratings came too late, Atkins says: "It's to be expected that bond prices will diverge from ratings as they reflect more than just credit quality." Indeed, for all the hue and cry in recent months, most of the CDOs in question have continued to pay out interest as promised. Their value has plummeted mostly because of traders' fears of what might happen in the future, not because the issuers are collapsing. "People are surprised there haven't been more [CDO] downgrades," said Claire Robinson, another Moody's managing director, during a June investor conference. "What they don't understand...is that we don't change our ratings on speculation about what's going to happen."

It'll take months or even years to know for sure how accurate the ratings were purely on the basis of credit performance. "Could you imagine their methodology if they had to take into account everyday trading activity?" asks John Neff, an analyst with investment firm William Blair & Co. in Chicago.


Enter the second group under fire: the fast-trading hedge funds that bought up the riskiest mortgage-backed securities during the housing boom. Stracke notes that "very well-paid and intelligent asset managers wanted new things to buy" and were perfectly happy to buy CDOs larded with subprime loans, even with leverage.

Two failed hedge funds run by Bear Stearns & Co. (BSC ) did exactly that before telling investors in July that their portfolios were essentially worthless. "How is it that one day they say something is worth 100% and the next day zero?" asks Jacob Zamansky, the attorney who made a name for himself suing on behalf of shareholders during the dot-com meltdown. Zamansky is now readying legal action against Bear Stearns on behalf of investors. The firm did not return calls seeking comment.

The hedge funds are pointing fingers at Wall Street, which took in at least $27 billion in revenues from selling and trading asset-backed securities last year. Investment banks are hunkering down for a fight with regulators, too. The state of Massachusetts is looking into Wall Street's equity research on the stocks of subprime lenders. And Bankers Life Insurance Co., based in St. Petersburg, Fla., is suing Credit Suisse Group (CS ) after losing $1.3 million on mortgage-backed securities, saying the issuer withheld information that would have invited lower ratings on the securities. "Ultimately," says Zamansky, "Wall Street must be held responsible. It facilitated these loans."

Wall Street, in turn, is mad at the lenders that made the bad loans in the first place. Deutsche Bank (DB ), UBS (UBS ), and Credit Suisse are suing mortgage companies for failing to buy back loans headed for early defaults.

What's more, the NAACP is suing a dozen lenders for steering African Americans into higher-interest subprime loans. "The more loans get issued, the more new loan sales need to happen" to keep the mortgage origination cycle going, notes Joseph Mason, a finance professor at Drexel University. "It becomes like mainlining heroin or a shark having to move to stay alive."

Zamansky, for his part, is also spearheading lawsuits on behalf of homeowners who claim to have been conned by home-loan scammers. His clients include a blind retired fireman, an 80-year-old couple, and an elderly man with lupus. "Because of fraud by mortgage lenders and brokers," he says, "these people will get thrown out of their homes." The regulators, he adds, "were asleep at the wheel. It was like pre-9/11 intelligence."

But don't expect the lenders to castigate homeowners for taking on too much risk. "It's tremendously un-PC to say this, but this entire circle of blame starts with individual borrowers who wanted more for less, wanted it big, and wanted it now," says Mason. "They got greedy."

Farzad is BusinessWeek's Wall Street and markets editor, based in New York

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