RMBS/CDO Ratings: Kolchinsky Protests and is Transferred

The events which led up to Kolchinsky’s transfer had been building for some time. Since 2004 Wall Street’s banks had been “securitizing” portfolios of the riskiest mortgage loans—those the market labeled “subprime.” This designation initially meant that the loans were not good enough to be purchased by Fannie Mae or Freddie Mac, two big government-supported entities (GSEs).

Wall Street banks had become well practiced in a kind of financial alchemy. Starting with subprime mortgages, they created cash flow pools to service different securities. These securities were issued as “Residential Mortgage-Backed Securities” (RMBS), each bearing a different bond equivalent maturity, e.g., 5 years, 10 years. Having pulled off this feat once, the banks repeated the process in an even more audacious way. Collateralized Debt Obligations were developed in the 1990s. These were bonds secured by payments made on other debt instruments, e.g., credit card or car loans. Now with the mortgage market booming, the banks performed this pooling exercise with RMBS bonds. Cash flows from subprime RMBS were divided into tranches, generating layers of CDOs with ascending credit ratings. Those first impacted by defaults are considered an equity-like residual, and are sold to return-seeking investors. The next tranche attracts the lowest debt rating—usually the rating agencies would assign a Ba. This tranche would bear the second wave of loan defaults. Higher ranking tranches would get very high ratings, often a AAA.

For the Wall Street banks this was quite an accomplishment. A Moody’s or S&P AAA rating had long been considered almost risk free. Yet, starting with mortgage obligations which the GSEs deemed too risky to touch, the banks had fashioned securities, many of which were rated “investment grade” and some garnering the highest rating available.

Rating subprime RMBSs and CDOs was a big “step out” for the rating agencies. These securities enjoyed no GSE backing; thus, new rating methodologies were needed to evaluate higher risks in a rapidly growing market. There was increasing pressure within Moody’s to accommodate mortgage-backed CDO issuance. Rapidly growing new issue volumes meant rapid growth in Moody’s revenues. For a while U.S. housing prices also kept rising. This put a floor under RMBS and CDO performance. Still, Kolchinsky knew that real estate markets don’t just go up. He wondered whether the assumptions embedded in Moody’s risk assessment models were too optimistic.

During 2007 the news from the national mortgage market reinforced Kolchinsky’s fears. For more than a year, mortgage default rates had been rising. Default rates were especially high in the subprime sector. Even worse, housing prices were now stagnant or declining in almost all markets. This was shutting down the resale/refinancing remedies for defaults.

Another flashing yellow light was the ABX price. Launched in January 2006, the ABX index price reflected the balance of “long” and “short” interest in the subprime market; index price trends gave an accurate reflection of investor sentiment. Over the course of 2007 the ABX index registered increasingly negative prices.

For Moody’s these developments were ominous; they meant that many RMBS tranches, including some it had rated AAA, were increasingly likely to default. For Kolchinsky, it meant that the CDO tranches he had rated were likely to follow their underlying mortgage bonds into default.

The entire situation was fraught with tension. Increasingly the mortgage market was “seizing up.” In July 2007, two Bear Stearns hedge funds that were heavily invested in subprime RMBSs and CDOs went bankrupt. Investors did not miss the fact that Bear Stearns let the funds go bust. Having Moody’s downgrade large numbers of outstanding RMBSs was not going to lighten the market’s mood. Yet, it was increasingly obvious that many RMBSs deserved to be downgraded. Moody’s took an initial step in July, putting a limited number of RMBS on “credit watch” for possible downgrade.

In early September Kolchinsky learned that the Moody’s group rating mortgage bonds was moving to downgrade a number of RMBS securities. He immediately became concerned about CDO deals in the pipeline for new ratings. With Moody’s ready to downgrade the securities that would collateralize these new issues, Kolchinsky concluded that CDO ratings should be suspended. In Kolchinsky’s view, continuing to issue ratings would cause Moody’s to violate SEC Rule 10b-5. This rule prohibits misleading statements or omissions of material information pertinent to the purchase/sale of publicly traded securities. To arrive at its RMBS downgrade decision, Moody’s must have relied upon information that also was pertinent to the new CDO deals. Issuing ratings which ignored this information would amount to a material omission—and that could be construed as securities fraud.

Kolchinsky took his case to his boss, Yuri Yoshizawa. He expected a reasonable reception—the facts were clear and powerful. To his surprise, Yoshizawa refused to listen. She directed him to take no action on outstanding CDOs, and to move forward on the deals in the ratings pipeline. Unable to accept this outcome, Kolchinsky took a risk. Andrew Kimball, then Moody’s chief credit officer, had a reputation for listening to differing opinions and acting on facts. The market for subprime securities was obviously cratering. Moody’s had already recognized as much in its RMBS downgrades. Kolchinsky decided to go over his boss’ head to Andy Kimball.

Their conversation appeared to go well. Kimball mostly listened. Near the end he indicated a broad sympathy with Kolchinsky’s case and promised corrective action. Confirmation that Kimball had heard Kolchinsky followed shortly thereafter. On September 21, Moody’s issued a press release (Attachment 1) advising that it intended to modify “expected loss inputs” for its subprime CDO models.¹ This signaled the markets to expect downgrades. To emphasize the point, Moody’s then listed specific subprime-CDO vintages whose loss assumptions would be modified. Shortly thereafter, Moody’s ceased rating new subprime CDO deals.

Kolchinsky felt Moody’s would eventually downgrade thousands of RMBS tranches it had initially rated Ba, including over 80% of those it rated in 2006. Moreover, Moody’s corrected other conditions which had worried Kolchinsky. Brian Clarkson, the key executive who had aggressively pushed Asset-Backed Security (ABS) ratings, left the firm in May 2008. Moody’s also beefed up the responsibilities of its Credit Policy Group (CPG); this committee would now review ratings methodologies for all types of ABS. These developments made it easier for Kolchinsky to accept what might otherwise have seemed a punishing demotion.

In his new position Kolchinsky continued to be consulted about ABS CDO ratings. This kept him in contact with developments within his former group and with the new Credit Committee. It was through these contacts that he learned the news—his former group was tweaking its risk models as a prelude to resuming CDO ratings.

Kolchinsky found this development astounding. If anything, the mortgage securities market was now in worse shape than it had been the year before.² For Moody’s to resume rating new deals seemed to fly in the face of every signal the markets were conveying.

Kolchinsky reluctantly concluded that his former group’s plans could not be justified by any assessment of market fundamentals. Something else must be at work. Kolchinsky found himself thinking about how Moody’s had changed as an institution and how the mortgage-backed securities market had been a powerful agent of those changes.

Moody’s Becomes a NRSRO

Moody’s Investors Service traced its origins to the founder John Moody, who in 1900 published a manual of statistical information about stocks. Moody was a journalist, and he held the view that the public was systematically disadvantaged in terms of information about traded securities. His manual was an effort to level the playing field.³

Over time Moody’s expanded its coverage to include bonds. There was even less information available about bonds than stocks. Perceiving an information vacuum, Moody’s began to issue bond ratings grading the quality of new issues. Institutional investors liked the service. It saved them from having to hire extensive teams of credit analysts to perform their own due diligence. These investors, insurance companies and pension funds, usually had long-term, predictable liabilities; bonds provided a secure way to cover those liabilities so long as the bond issuer paid its debts. Moody’s ratings, along with those provided by Standard & Poor’s, provided investors with an economical way to assess credit risks among many diverse issuers.⁴

Two developments occurred during the 1970s. Both would prove to be contributing factors to the mortgage market crisis. First, Moody’s and the other rating agencies switched from a subscriber-based fee system to one where the issuer of securities paid for its ratings.⁵ This created a conflict of interest for the rating agencies. Their primary role was to act as guardians of investor interests. Yet, it was now the issuers who paid the agencies’ fees. By threatening to withhold fees, issuers could bring pressure on the agencies to issue ratings more positive than the facts warranted.

The second development reinforced the agencies’ importance to the capital markets. The SEC determined that banks would have to allocate capital against owned securities based upon each security’s rating.⁶ This gave the rating agencies a quasi-regulatory function. Since many banks both owned securities and acted as advisers to issuers, the banks now had two reasons to extract the highest possible rating from the agencies.

Moody’s and S&P managed these pressures effectively for the next two decades. Moody’s in particular cultivated a culture that discouraged issuers from trying to influence ratings. Social contact was held to a minimum. Moody’s culture emphasized ratings quality, and took a certain pride in disappointing issuers. Ratings methodologies also grew more sophisticated. A visitor to the agencies during the early 1990s would encounter credit analysts who were technically knowledgeable and well versed regarding their clients’ financial performance.

Several factors changed this situation. For one thing, Moody’s and S&P faced more competition. In previous decades, institutional investors were only interested in deals which carried Moody’s/S&P ratings. Competing agencies, Fitch and Duff & Phelps, were generally regarded as substandard. Over time, however, bank advisers began to chip away at this paradigm. If Moody’s or S&P proved too tough, advisers would take clients to market on the basis of the easier of the big two and one of the lesser agencies. On other occasions, they would go with only one rating—from whichever of the big two conceded the higher assessment. Gradually investor insistence on ratings from the big two softened. Management at the two agencies didn’t miss the point. They were now in a competitive world. Revenues and jobs could be impacted if they annoyed clients or their advisers too much.

A second factor was the rise of “structured finance.” Between the mid-1980s and 1990s new classes of securities were created. The common feature was that their credit support was provided by a designated group of assets as opposed to the general credit of a firm. This began with the creation of Collateralized Mortgage Obligations and soon expanded to include bonds backed by credit card receivables, student loans, equipment leases—pretty much anything that promised a predictable cash flow stream.

The advent of structured finance presented the rating agencies with challenges and opportunities. The challenges lay in: 1) the need to develop new ratings methodologies and 2) managing increasing competition among the agencies. The degree of difficulty inherent in these was not immediately apparent. The opportunities were more obvious. The volume of structured finance offerings grew steadily, until new issuance began to dwarf that of corporate and public sector offerings. Rating agency structured finance revenues grew prodigiously. These contrasting revenue trajectories would profoundly alter Moody’s culture and ultimately its ownership.

Moody’s Culture Changes, and the Firm Goes Public

At the beginning of the 1990s Moody’s was owned by Dun & Bradstreet (D&B). D&B was a venerable company known for credit analysis of private companies. As of 2009, D&B maintained an information data base on more than 179 million companies worldwide. Relying primarily on subscription income, D&B reported 2009 revenues of $1.7 billion.⁷

Moody’s fit comfortably within D&B’s low key, analytical culture. Pressures to generate revenue at the expense of service or reputation were minimal. Indeed, Moody’s was widely considered to be the toughest of the rating agencies. A 1994 article in Treasury & Risk Management magazine was entitled “Why Everyone Hates Moody’s.” Its concluding comment was to the effect that Moody’s corporate culture embodied “a conviction that too close a relationship with issuers is damaging to the integrity of the ratings process.”⁸

This began to change in 1991 with the arrival of Brian Clarkson. A lawyer by training, Clarkson had no credit background. What he did have was an aggressive personality and an instinct to generate results by whatever means necessary. Moody’s management increasingly took a tolerant view of Clarkson’s approach. In 1995, they made Clarkson co-head of the asset-backed finance group. Clarkson quickly realized that structured finance had the potential to outstrip Moody’s traditional units as a revenue producer. For this to happen Clarkson would have to make Moody’s less risk averse and more malleable as regards to the issuer.⁹

This he accomplished by introducing a series of measures at odds with the historic Moody’s culture. First, he made market share the key performance metric. This was combined with a second measure—structured finance analysts were routinely asked to explain why they had failed to secure a ratings opportunity. If Moody’s lost a deal to S&P or Fitch, the analyst would get an e-mail asking for an explanation of any “ratings discrepancy” between Moody’s and its competitors.¹⁰ These two measures delivered a clear message—winning the business was really important, and if that meant being less conservative or less careful analytically, so be it. Just in case these signals were not clear enough, Clarkson added a third—he began to listen to requests by issuers and advisers that specific analysts not be assigned to their deals.

Clarkson’s methods got results. Moody’s share of the mortgage-backed securities market rose from 35% in 2000 to 59% in 2001. Competing agencies complained that Moody’s had lowered its standards. Clarkson opined that it had been timely to take a second look and where appropriate reshuffle the analysts. Reshuffle often meant the analyst exited the firm.¹¹

Senior Moody’s executives became increasingly sympathetic to Clarkson’s approach. Competition among the rating agencies had become more intense. This was particularly the case in structured finance, where each deal involved different asset collateral. This differed from rating corporate debt, where Moody’s and S&P’s long experience with major corporate names still lent their ratings more weight. The big two agencies had no such historic advantage in asset-backed deals, a fact which Fitch moved aggressively to exploit. Moody’s thus found its traditional conservative approach to be a handicap for new asset-backed deals. This dilemma was best summed up by Moody’s CEO, Raymond McDaniel, who told his board in 2007:

“It turns out ratings quality has surprisingly few friends … Ideally competition would be primarily on the basis of ratings quality, with a second component of price and a third component of service. Unfortunately, of all three factors ratings quality is proving the least powerful … In some sectors, it actually penalizes rating quality by awarding ratings mandates based upon the lowest credit enhancement needed for the highest credit rating.”¹²

By this time, McDaniel had additional reasons to focus on market share competition. During the 1990s sentiment built within D&B to separate itself from Moody’s. D&B was looking for growth and it saw Moody’s as a steady-as-she-goes business. Moody’s aggregate revenues were growing at a single-digit pace. So, D&B spun off Moody’s to its shareholders in September 2000. Now running a public company, McDaniel & Co. faced the challenge of producing a rising stock price. This also involved the opportunity to cash in lucrative stock options if they succeeded in doing so.

The early years of the new millennium were not kind to Moody’s reputation. It was widely criticized for missing the frauds at Enron, WorldCom and other corrupt corporations. In 2002–03, it had to downgrade hundreds of CDOs backed by corporate debt.¹³ Moody’s and the other agencies were called to testify about these failures before congressional committees. Ideas began to circulate in Washington about reforming the agencies’ quasi-regulatory role. Yet, nothing fundamental changed. Moody’s adopted a new code of conduct which said all the right things about ratings integrity and distance from issuers. Meanwhile, analysts continued to get reshuffled or removed if their stance cost Moody’s a piece of business.¹⁴

By 2005 Moody’s was a much changed organization. Enough of the old staff remained that some culture of ratings integrity had survived. This was especially the case on the corporate debt side. However, structured finance was increasingly seen as the firm’s engine and cash cow. Moody’s annual revenues were up to $1.6 billion. Operating margins averaged 50%. Structured finance now accounted for almost 50% of revenue, up from 28% in 1998. As such it had produced almost all of Moody’s revenue growth. As for Moody’s stock price, it had increased 340% since the spin-off.¹⁵

The run continued into 2007. CEO Raymond McDaniel would call 1H 2007 “the strongest we’ve had in five years,” as first half revenues hit $1.2 billion. In recognition of these results, Brian Clarkson was named Moody’s president in August, 2007, with annual compensation totaling $3.2 million.¹⁶ Attachment 2 presents a partial Moody’s organization chart, showing Eric Kolchinsky’s reporting chain at the time of Clarkson’s becoming president.

Subprime Mortgage Debt: The Ratings Methodology Challenge

Moody’s growth in structured finance was achieved in the face of a major obstacle—the challenge of rating the new securities Wall Street was minting. The challenge was significant—these securities presented new risks which the agencies heretofore had not analyzed.

Moody’s initially lacked experience and tools to rate subprime mortgage bonds and CDOs. The first generation of RMBSs had been backed by mortgages that qualified for purchase by Fannie Mae and Freddie Mac. As such they enjoyed an implicit Federal government guarantee and were easy to rate. Subprime mortgage-backed instruments enjoyed no such support. Where would Moody’s get the methodological tools to rate these instruments?

One answer was from the banking world. Banks had longstanding methodologies for rating non-investment grade asset-backed and project finance loans. The Wall Street firms bringing deals to the agencies were more than willing to share their risk models. The rating agencies could and did borrow and improve upon these methods. However, bank credit and corporate bonds work one loan at a time. What Wall Street ultimately presented to the agencies was something different—the pooling and tranching of many non-guaranteed loans from multiple markets into new securities. For the agencies, this was a different credit ballgame.¹⁷

This new “securitization” process presented three evaluation challenges:

1. Was the “diversification benefit” claimed by the issuer correctly valued? Did the new security deserve a higher rating than the quality of the underlying assets and if so, how much higher?
2. How close of a connection existed between the new security and the underlying loan collateral? Should a bond go into default, would far flung institutional investors be able to pursue their remedy to seize the underlying assets, thereby minimizing their losses?
3. What would happen to “origination underwriting standards” once the connection between the originator and the loans was severed? Would originators remain prudent once securitization relieved them of the risk of suffering loan losses?

To tackle these challenges, Moody’s analysts needed to do several things. First they needed to make a correct statistical assessment of the diversification benefit across different housing markets. Here the history was supportive. Data going back over a decade supported the conclusion that markets in California, New York, Nevada or Florida were not closely correlated. Historically it seemed that when housing prices rose or fell sharply, they did so on a local, and not a national basis. House price assumptions were critical for assessing probable losses; rising prices tended to suppress subprime losses because insolvent owners could easily refinance a house that had risen in value.

Of course the validity of statistical evidence depends in part on what time period is examined. Going back further than 1990, housing prices showed periods of decline and stagnation. The real question for Moody’s was whether the more recent results represented a new fundamental trend or was instead an asset bubble fueled by low-cost money and public policy.

A second key determination was whether the “overcollateralization” inherent in tranching mortgage assets was adequate to compensate for the higher default risk posed by subprime borrowers. The whole idea of tranching was to protect the more senior investors by subordinating substantial collateral below them. Moody’s had experience with tranching techniques from its earlier work on prime CMOs. Subprime mortgage collateral was another ballgame, however, and the agencies looked to Wall Street for help. This opening gave the investment banks a chance to game the system.

As Wall Street firms developed their models they assumed low default losses due to diversification and rising home prices. Their results showed the senior RMBS/CDO layers to be heavily overcollateralized. The firms complemented this by taking advantage of certain shortcuts built into the models used by the rating agencies. For example, they determined that the agencies’ models used average FICO scores (these measure the creditworthiness of individual borrowers). The Wall Street firms then selected mortgage pools that included borrowers who had dubious credit, but had high FICO scores because their credit history was so limited that no defaults had occurred. On this kind of basis the investment banks pressed for the CDO senior layers to get AAA ratings.¹⁸

Of course, the validity of their approach depended not only on the diversification benefit just discussed, but on an assumption that mortgage underwriting standards had not deteriorated. A general decline in the quality of mortgages originated would undermine any assumption that past history was a good predictor of future losses. Unfortunately, as the banks well knew, standards had decayed—evidence of deteriorating underwriting abounded.

As 2006 turned into 2007, doubts should have intensified about Moody’s ratings models and their key input assumptions. Data from the mortgage market indicated that subprime mortgage defaults were rapidly increasing. Sensing the market turning, some Wall Street firms redoubled their creation of subprime CDOs. The pressure on the rating agencies was about to get a lot worse.

The Subprime Market Begins to Unravel

The mortgage security desks at Wall Street’s leading firms were not oblivious to the mortgage market’s gathering clouds. E-mails and memos began circulating carrying verdicts like “the poor little subprime borrower will not last that long.” On March 7, 2007, Goldman Sachs Firmwide Risk Committee heard a presentation whose first topic was entitled “Game Over – accelerating meltdown for subprime lenders such as Fremont and New Century.” The second topic: “The Street is highly vulnerable, potentially large exposures at Merrill and Lehman.”²⁰

Yet, the Street’s reaction was not a straightforward pullback. For a variety of reasons, some firms instead decided to rush new deals into the market. For those who saw the storm coming, this amounted to trying to clear risky mortgage assets off their books. For others still caught up in the game, it was a case of doubling down on bets that had previously made huge money. For Kolchinsky on the subprime CDO desk, it meant a flood of new deals.

One of those deals especially captured the parlous state of the market. It was called ABACUS 2007-AC1, a collaboration among Goldman Sachs and John Paulson, a private equity investor. Paulson was convinced that the subprime market was about to tank. As one of his employees wrote in January:

“The market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institutional framework.”²¹

Acting on this insight, Paulson designed a huge CDO built to fail. Paulson helped Goldman pick the specific subprime securities to underpin a single, large CDO. Next, he built a massive “short” position, taking out credit default swaps (CDS) that would rise in value if the subprime security prices fell.²² In effect, Paulson and Goldman built a mortgage-backed bomb designed to explode and then bet it would.

Kolchinsky’s group got ABACUS 2007-AC1 to rate. It came in as one of the torrent of deals washing through the agencies in 1Q 2007. Kolchinsky didn’t know about Paulson’s involvement or his short bet. Moody’s awarded the senior tranches AAA ratings.

Kolchinsky soon had reason to regret his decision. In March 2007, two Bear Stearns hedge funds invested primarily in subprime securities reported losses. By May both funds showed large losses after receiving price indications from Goldman valuing their subprime securities at 50 cents/$.²³ In July, Bear Stearns let the two funds go bust.

With storm signals all around, the rating agencies began to respond. On July 10, S&P placed 612 tranches of subprime securities “under review” for a possible downgrade. Moody’s followed shortly thereafter, placing 399 tranches under similar review.²⁴ The action touched only a sliver of the outstanding issues—but it clearly signaled a turning point.

A few weeks later, Kolchinsky came across some UBS research. It showed that within a sample of 111 subprime CDOs, losses of 65% could be expected in the Baa tranches and that these losses would extend into the AAA tranches. The author’s conclusion was chilling: “This is horrible from a ratings and risk management point of view, perhaps the biggest credit risk management failure ever.”²⁵ For Kolchinsky all doubts were now ended. He circulated the research within Moody’s.

When in September Moody’s management finally moved toward actually downgrading subprime securities, Kolchinsky was ready to insist on parallel treatment for CDOs.

Summer 2008 – Moody’s Prepares to Resume Ratings

Sitting now in Moody’s Analytics, Kolchinsky reviewed the events that had transpired since his transfer. In terms of the mortgage market, worst case expectations had been exceeded. Mortgage defaults had accelerated to the point where housing markets across the country were looking at rapidly falling housing prices. The whole economy had been affected. A major recession had begun.

On Wall Street a quiet, desperate struggle for survival was underway. Markets were shocked when in March 2008 Bear Stearns tottered on the brink of bankruptcy. A last minute rescue by the New York Federal Reserve Bank pushed Bear into the arms of J.P. Morgan. In June, Lehman Brothers reported a $2.8 billion 2Q loss. Within days, Citibank, its clearing bank, demanded a $3–5 billion security deposit.²⁶ Huge losses mounted at Fannie Mae and Freddie Mac. This forced the Bush administration to make emergency plans for the entities. When this was reported in July, Fannie Mae’s stock price dropped 50% in two days.²⁷

In such market conditions, Kolchinsky could see no case for Moody’s to resume rating subprime mortgage securities. This made the news from his phone call especially troublesome. The fact that his former group was even considering resuming rating activity was almost beyond belief. Kolchinsky found himself struggling with a strong emotion that something dramatic must be done to stop this.

Kolchinsky began to consider his options. One option was to intensify the internal effort he had waged against rating any subprime CDOs. Kolchinsky felt there were powerful arguments to be made for this position. Some of these he had laid out in e-mails responding to questions from his former group (summarized in Attachment 3).²⁸

Moody’s situation was now highly fluid. The agency had been severely criticized for its performance. Its reputation was in shreds. Lawsuits had been filed and Congress was reconsidering the agencies’ semi-official regulatory role. Another false step could jeopardize much of Moody’s business going forward. Kolchinsky wondered how he might take advantage of Moody’s plight. To be effective, Kolchinsky felt he would need to target a politically powerful audience. He would also need allies around the organization to support his message. Attachment 4 provides a revised Moody’s organization chart post-Kolchinsky’s transfer and Clarkson’s departure.

Here it was discouraging that the recently formed Credit Policy Group was turning out to be a paper tiger. Could this committee somehow be rejuvenated? Were there other players who could lend a hand? Kolchinsky had received valuable advice the prior year from Gus Harris, head of Hedge Fund ratings and Gary Witt in New Products. Both shared his dismay over Moody’s resuming the rating of subprime CDOs. However, the ratings business units still appeared to be driven by revenue and market share targets. The people heading Kolchinsky’s former group were very apprehensive that their business had dried up and no revenue was coming in. Possibly, their jobs were on the line.

This led Kolchinsky to consider a second option. He could make a planned exit from Moody’s. That could free him to participate in the broader reconsideration of the agencies’ role that was now taking shape. Kolchinsky could arm himself with evidence of Moody’s numerous ratings mistakes and failed structural safeguards. Once outside, he could speak to topics “beyond his pay grade” and speak more candidly about where Moody’s sacrificed ratings integrity for its own financial interests.

Of course there were risks with this option too. Suitable employment might not be available. He would also have to consider the possibility of Moody’s taking legal action against him. They might try to impose confidentiality constraints as he was leaving or sue him later, alleging he had disclosed proprietary information. At a minimum Kolchinsky would need legal advice for planning an exit and beyond. Finding the right counsel would take time and it would not be cheap.

Suddenly a third alternative occurred to Kolchinsky. He remembered that he had considered and then rejected the idea of pursuing a “grievance claim” over his previous year’s transfer. At the time Kolchinsky had decided a claim was not worth the trouble.²⁹

Now the situation was changed. Moody’s did not appear on the right track from a ratings point of view. Kolchinsky was starting to conclude his sacrifice had been in vain. He also felt it would take strong action to make a difference going forward.

Filing a grievance claim could provide a framework within which he could press his case about CDO ratings. Kolchinsky would file his claim with the Head of Compliance. Moody’s would have to investigate the facts to discover if the claim had a basis and if it might want to offer restitution. During the investigation Kolchinsky could revisit the ratings issue, show why he had been right to take the actions he did in fall 2007, and that his grievance in part lay with Moody’s failure to address his substantive concerns. When considering the complaint, Moody’s would also have to weigh the risk that being unresponsive could cause Kolchinsky to sue the firm.

Still, this was an unorthodox path to take. Firms have standard protocols for dealing with grievance complaints. Moody’s would be no exception here. Would any airing of Kochinsky’s issues make it to Moody’s higher management? Or would they be pigeonholed inside a human resource/legal framework where substantive matters counted only in the calculus of whether to settle with the employee?

The grievance complaint faced one other complication—Michael Kanef was now Moody’s Chief Regulatory and Compliance Officer. Prior to taking that position, Kanef had been head of the group rating all residential mortgage-backed securities, including subprime. That fact didn’t immediately cause Kolchinsky to rule out the grievance complaint. After all, Kanef had been involved in the decision to downgrade many securities. Still, Kanef’s presence could complicate matters. With the mortgage market imploding, Kanef might well feel conflicted about his prior ratings decisions. How would he react to Kolchinsky’s increasingly clear-eyed criticisms? Would he be sympathetic or defensive?

No path forward looked like a surefire plan. Still, Eric Kolchinsky was determined to do something. He picked up a legal pad and began to outline his options with their pros/cons and personal risks. Perhaps that exercise would bring more clarity to identifying the best course of action.

Attachment 2

Attachment 4

Author’s Note

This case has elements of a whistleblower story. The essential challenge for students is to determine if a viable internal resistance strategy is available. Moody’s is about to resume rating subprime CDO securities. Eric Kolchinsky feels that resumption is more than unjustified, it’s unconscionable. Having helped persuade Moody’s to suspend rating activities once, Kolchinsky must decide if and how it is possible to do this again.

In a larger sense, however, this case is about what happened to Moody’s. This author had direct dealings with Moody’s in the late 1980s. He found them to be an organization of high integrity. They didn’t let clients get close to them in any way. All the Devils Are Here, which devotes a chapter to the firm, quoted the title of a 1994 magazine article: “Why Everyone Hates Moody’s.” The reason was simple—clients didn’t always get the answers they were seeking. Technically they were also better than S&P or Fitch. By the time of Kolchinsky’s case, 2007–08, it seems Moody’s structured finance ratings have been for sale. What happened? This case offers history that begins to provide answers. Students will have to diagnose the causes of Moody’s culture change and reflect on how this influences Kolchinsky’s options for stopping the resumption of ratings.

In considering these issues, close attention should also be paid to Attachment 3. This document sums up Kolchinsky’s reasons for opposing the ratings resumption. Students will want to judge both the validity of his arguments and the manner in which they are framed. Consider also the timing of the case. What was happening in the capital markets in summer 2008 as Moody’s moved toward again rating CDOs? Finally, students will want to analyze Moody’s changing organization charts. As key players move around, do new channels for opposing this decision open up, or is Kolchinsky facing a brick wall?

This case is based upon All the Devils Are Here’s excellent chapter on Moody’s. As the crisis unfolded, this author kept wondering how the toxic securities had garnered AAA ratings. We are indebted to McLean and Nocera for ferreting out the background to this enormous gatekeeper failure. Eric Kolchinsky obviously was instrumental to this case. He provided hours of interviews plus access to personal notes that were vital to delineating the issues.

In retrospect, Moody’s and the other rating agencies bear enormous responsibility for the financial crisis. If they had brought to mortgage securities the rigor typically applied to corporate and municipal debts, red flags would have gone up much sooner. Some of their mistakes were howlers. By not even sampling the underlying mortgage collateral, they completely missed the deterioration of underwriting standards and the out-and-out fraud that later turned CDOs to dust. As semi-official public agencies, they operate in the public’s interest. This now conflicts with their instinctive drives as publicly traded companies. As with the GSEs, these conflicts remain to be sorted out. Revisiting the agencies’ bulletproof immunity to liability may be the place to start.