Sleeping With the Enemy -- Rating Agency Conflicts Surface

In one email from August 2004, an S&P executive asks a colleague whether the firm might discuss adjusting criteria for rating certain issuances "because of the ongoing threat of losing deals."

In another email, from April 2006, a Moody's executive laments to another he is "getting serious push back from Goldman on a deal they want to go to market with today."

"For a hundred years, Main Street investors trusted U.S. credit-rating agencies to guide them toward safe investments," Levin said in explaining why the ratings agencies were being singled out. "But now that trust has been broken."

Representatives from the rating agencies apologized to the panel for their mistakes but blamed the errors not on ill-conceived incentives but instead on an unexpected downturn in housing prices and a sudden tightening of credit.

"Let me assure you that Moody's is certainly not satisfied and I am not satisfied with the performance of our ratings during the unprecedented market downturn," said Moody's CEO Raymond McDaniel.

In one of the more interesting and timely pieces of testimony to take place at the Senate hearing last week, a former Moody's employee spoke about the now infamous synthetic CDO at the heart of the SEC's case against Goldman.

Moody's Misled?

Eric Kolchinsky, the former team managing director of Moody's Structured Derivatives Products Group, was running the division within Moody's that rated ABACUS 2007-1.

Kolchinsky insisted that during the process of creating the now infamous ABACUS vehicle, the rating agency was never clued in to hedge fund manager John Paulson's intention to short the deal.

The SEC claims that Goldman committed fraud by keeping Paulson's agenda hidden from investors even as he helped design a seemingly doomed portfolio.

Goldman has said it had no responsibility to tell investors of Paulson's role and furthermore that the parties involved would have been aware that some entity, for all intents and purposes Goldman, would have been short the deal, and that as a market maker Goldman was purely matching up an aggressive yield seeker with a party seeking to take the other side of the bet.

Kolchinsky told the Senate Permanent Subcommittee on Investigations that neither he nor his staff knew about Paulson's intentions to sell ABACUS short.

"It's something that I would have wanted to know," Kolchinsky said. "It just changes the whole dynamic of the structure."

"Our investigation has found that investment banks such as Goldman Sachs were not market-makers helping clients," Levin said. "They were self-interested promoters of risky and complicated financial schemes that were a major part of the 2008 crisis."

Levin added: "They bundled toxic and dubious mortgages into complex financial instruments, got the credit-rating agencies to label them as AAA safe securities, sold them to investors, magnifying and spreading risk throughout the financial system, and all too often betting against the financial instruments that they sold and profiting at the expense of their clients."

One of the more standard but no less unseemly aspects of derivatives deal creation during the bubble involved banks shopping deals around to ratings agencies in a bid to secure the highest rating. Each deal paid the agencies as much as $50,000. The SEC has already moved to eliminate references to ratings from certain rules so as to deter investors from treating them as so-called seals of approval.

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