Sleeping With the Enemy -- Rating Agency Conflicts Surface

April 27, 2010— -- With the Securities and Exchange Commission bearing down on Goldman Sachs for alleged fraud and the Financial Crisis Inquiry Commission gathering its own head of populist steam, another probe about to wind down in the Senate has now formally fingered a chief culprit in the crash: credit rating agencies.

"Had credit-rating agencies been more careful in issuing ratings … we maybe would have averted the crisis," said Sen. Carl Levin, D-Mich., chairman of the Senate's Permanent Subcommittee on Investigations, at a recent hearing. "But they did not. Without credit ratings, Wall Street would have had a much harder time selling securities because they wouldn't have been considered safe."

The Senate subcommittee was set today to wrap up an 18-month probe into the crash of 2008 by grilling some Goldman executives in what is sure to be a heated and closely watched session.

However, while there's plenty of blame to spread around, from the big investment banks like Goldman to loan originators like Countrywide, Levin has laid blame squarely on the doorstep of the top three rating agencies, Moody's Investors Service, Standard & Poor's and Fitch Ratings.

For the Love of Money

The poisoning of the financial system, according to Levin, happened in large measure because the rating agencies, led astray by greed, got into bed with the Wall Street banks.

"The subcommittee investigation found that ... credit-rating agencies allowed Wall Street to impact their analysis, their independence, and their reputation for reliability," Levin said Friday. "And they did it for the money."

Meanwhile, as if the ratings agencies did not have enough heat coming down on them, the Financial Crisis Inquiry Commission last week issued its first subpoena, to Moody's.

It was not clear what information Moody's is being pushed to turn over; nor is it clear why the firm was reluctant to do so without the FCIC having to use the power of subpoena.

Michael Adler, a Moody's spokesman, said Monday that "Moody's has and continues to devote substantial resources to producing documents and making our people available to the FCIC, our regulators, State Attorneys General, Congress and many others tasked with understanding the financial crisis and the role of the rating agencies. We continue to work to provide useful and appropriate responses to these inquiries."

Lawsuits Filed, Emails Unearthed

Intensifying scrutiny of the ratings agencies comes as lawmakers grapple with an overall package of financial reform legislation, a giant grab bag of proposals, including a measure that would potentially make it easier for investors to sue the ratings agencies.

Already ratings agencies have been slapped with a number of negligence lawsuits, including ones filed by Connecticut Attorney General Richard Blumenthal and the California Public Employees Retirement System.

Levin's probe has uncovered new evidence, including emails, pointing to some questionable practices within the rating agencies during the credit bubble's formation, primarily the issuing of coveted Triple-A ratings to derivative securities, such as collateralized debt obligations, that were laced with toxic subprime mortgages.

A slew of particularly damning emails sent by ratings agency executives reveal a culture in which analysts were often at odds with revenue generation agendas.

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.

'Stockholm Syndrome'

Levin's probe also found evidence that the rating agencies relied too heavily on the banks for information -- one rating agency staffer described the problem as "Stockholm Syndrome."

Additionally, analysts at the rating agencies shared their information and internal models with banks so freely that the banks were ultimately able to game the system. In other cases, banks hired former rating agency staffers to help structure deals specifically to secure triple-A ratings.

In 2005, Goldman hired Shin Yukawa, a ratings expert at Fitch. Yukawa would eventually work on the Abacus deals.

In at least one instance. a ratings executive at S&P pointed out, in an email from June 2006, the danger of getting too closely intertwined with Wall Street.

"... [T]he right thing to do is to educate all the issuers and bankers and make it clear that these are the criteria and that they are not-negotiable," the email said. "If this is clearly communicated to all then there should be no monthly questions. Screwing with criteria to 'get the deal' is putting the entire S&P franchise at risk -- it's a bad idea."

ABC News' Matthew Jaffe contributed to this report