Race to the Bottom

Credit rating companies like Moody's Investors Service, Standard & Poor's and Fitch are coming clean about the mess they have helped create.

Soon, perhaps in a year or so, the Consumer Credit Reporting Agencies, such as Experian, Equifax and TransUnion, will admit they, too, have used outdated and unrealistic models for personal credit "scoring" upon which banks, mortgage companies and consumer lenders of all stripes solely have relied for loan approval decisions for decades.

Ah, the finger-pointing continues apace...

But for now, we focus on the credit-ratings companies. From Bloomberg, former debt-ratings company executives testifying before a Congressional committee said "credit raters relied on outdated models in a 'race to the bottom' to maximize profits." Full Story Here.

Jerome Fons, a former managing director of credit policy at New York-based Moody's, told the House Oversight and Government Reform Committee today that originators of structured securities ``typically chose the agency with the lowest standards, engendering a race to the bottom in terms of rating quality.''

Representative Henry Waxman, the committee chairman, said that the recent history of the credit rating companies ``is a story of colossal failure.'' ``The result is that our entire financial system is now at risk,'' Waxman said.

The House panel is reviewing the role played by S&P, Moody's, and Fitch Ratings in the global credit freeze. The Securities and Exchange Commission in a July report found the firms improperly managed conflicts of interest and violated internal procedures in granting top rankings to mortgage bonds.

It gets better, as one would expect.

Stephen W. Joynt, president and chief executive officer of Fitch Inc. in New York, said it ``is clear that many of our structured finance rating opinions have not performed well and have been too volatile.''

``We did not foresee the magnitude or velocity of the decline in the U.S. housing market, nor the dramatic shift in borrower behavior brought on by the changing practices in the market,'' Joynt said in a written statement to the committee. ``Nor did we appreciate the extent of shoddy mortgage origination practices and fraud'' between 2005 and 2007.

And better.

Waxman said (Moody's) company documents and e-mails obtained by the committee show that officials at the ratings companies recognized the system they were involved in could lead to disaster.

Waxman cited a transcript of a September 2007 meeting in which (Moody's Chairman and CEO Raymond) McDaniel described ``a slippery slope'' of events.

``What happened in '04 and '05 with respect to subordinated tranches is that our competition, Fitch and S&P, went nuts. Everything was investment grade,'' McDaniel said in the meeting. ``We tried to alert the market. We said we're not rating it. This stuff isn't investment grade. No one cared because the machine just kept going.''

Documents from S&P paint a similar picture, Waxman said.

In one document, an S&P employee in the structured finance division wrote: ``It could be structured by cows and we would rate it.'' In another, an employee said ratings companies are creating a ``monster.''

``Let's hope we are all wealthy and retired by the time this house of cards falters,'' from another document. (All emphasis ours.)

Oops. Perhaps neither wealthy nor retired, but about to become the focus of much more intense scrutiny. And, typically, each blaming competitors, consumers and debt originators.

These hearings and the revelations from testimony are instructive, and foreshadow, in about a year or so, the testimony we will be hearing from former and current executives of the Consumer Credit Reporting Agencies.

If Moody's, Standard & Poor's and Fitch all were relying on "old models" of credit-rating in a race to the bottom for profits, we will not be surprised when we learn the Consumer Credit Reporting Agencies (Experian, Equifax and TransUnion) were doing the same, and have been for decades.

Credit scoring models were first developed by Messrs. Fair and Isaac in the late 1950s and later, in 1981, the "credit score" itself, also invented by Fair Isaac Corporation, hence "FICO," and sold to lenders as statistically reliable loan decision-making tools.

In our insatiable quest for instant gratification, the ubiquitous credit score became the sole determinant for most lending decisions, from car loans to credit cards, from mortgages to home equity loans, as lenders - yet today, as referenced in DiTech mortgage commericals - approved or denied loans "in a matter of minutes," without all that time-consuming paper to review.

You know, like tax returns, financial statements and wage stubs. Reviewing all that paper would take an actual person too much time, and thus lenders would have required many more employees known as credit analysts to keep up with loan demand in the last 30 years. The convenience, and "statistical reliability," of the credit score made loan decisions quick and easy, and, therefor, profits quick and big.

We may soon see a more critical examination of the credit-scoring models which have led to more than $2.5 trillion of consumer debt, about $1 trillion of which is represented by unsecured credit cards. It will be interesting to hear the Congressional tesimony defending those practices.