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Week of 12.26.08

Transcript: Credit and Credibility

BRANCACCIO: The headlines have been full of the biggest scheme in history, 50 billion dollars in alleged fraud. We've been investigating just how trillions of dollars were lost in the wider financial meltdown. Our investigation includes two top Wall Street insiders who explain how greed led a lot of very smart people toward a disaster that has engulfed the globe. Senior Correspondent Maria Hinojosa and producer Brenda Breslauer have our report.

HINOJOSA: The story of what went on inside the collapse of the American financial system begins on the ground with risky mortgages and leads all the way to Wall Street offices where the lucrative financial deals being created out of these mortgages boggle the mind.

STIGLITZ: My reaction to these complicated products—was that it was hocus pocus. That in fact, it was trying to create something out of nothing.

HINOJOSA: Those products were created by a complex chain is made up of many players: from local bankers and brokers to wall street analysts and dealmakers ... but there was one group that could have put on the brakes: the credit rating agencies, like Standard and Poor's, Moody's Corporation and Fitch Ratings. And without their blessing, none of these complicated deals could have gone forward.

RAITER: if they had stood up and said we're not gonna do it, then the other players would have been forced to cut back. But, everyone was having too good a time.

HINOJOSA: Frank Raiter was a managing director at Standard and Poor's for a decade. He is speaking out on television for the first time and he wants to tell the story of how a once highly respected credit rating agency was transformed by the quest for money.

RAITER: During this period, profit was primary. Analytics were secondary.

HINOJOSA: Richard Gugliada, another high level insider who worked at Standard and Poor's, is also speaking out. He wants to explain how all the financial experts could have gotten it so wrong.

GUGLIADA: I don't think the public is really understanding all the intricacies. It's a very complicated story.

HINOJOSA: And it's a story whose unraveling has led to an investigation by the Securities and Exchange Commission ... and Congress.

WAXMAN: The story of the credit rating agencies is the story of a colossal failure.

CUMMINGS: You are the gatekeepers. You're the guys. That's why you're there. And so we are - now we face a situation where we've got a house of cards that has fallen.

HINOJOSA: Once upon a time, credit rating agencies had a solid reputation for

providing an independent analysis about the safety of investments through a scale of letter grades. Triple AAA is the safest, like a U.S. Treasury Bond. The lower the grade, the riskier it is. General motors this month, for example, is way down here in the double CC's.

PARTNOY: It used to be that AAA was gold, and you could generally count on the AAA rating to mean that this company is not going to default. That you will not lose all of your money.

HINOJOSA: Frank Partnoy, a former Wall Street trader turned law professor at the University of San Diego, is considered an expert in financial markets. He blames faulty credit ratings for a big part of the financial meltdown.

PARTNOY: The credit rating agencies and credit ratings were really at the center of the crisis.

HINOJOSA: To understand why, you need understand how Wall Street has transformed the mortgage industry over the past twenty five years. Wall Street figured out that mortgages could be a big moneymaker... and that idea morphed into a new class of complex financial investments. Partnoy agreed to try to break it down for us.

PARTNOY: A bank, a financial institution, a countrywide, for example, makes a bunch of loans....

HINOJOSA: What's going on is that thousands of mortgages are collected into a single pool called a Mortgage Backed Security which is divided up into bonds and sold.

But then it gets even more complicated. Riskier sections of the Mortgage Backed Securities, bonds that are rated Triple B, are pooled together in a totally new financial instrument, called a CDO, a collaterilized debt obligation. Then, through dazzling financial engineering, the majority of the CDO gets a Triple AAA rating.

PARTNOY: And the magic of the process of taking these Triple B's, and so we'll put a bunch of Triple B's in here, is that even though the underlying investments in the CDO are Triple B, the overall rating for the Triple B will be magically Triple A.

STIGLITZ: Effectively they were practicing what I call financial alchemy. Alchemy in the middle ages believed that you could convert base metals like lead into gold. They were doing the same thing.

HINOJOSA: Joseph Stiglitz won the Nobel Prize for economics. A professor at Columbia University who is known around the world for his work, he says that the logic behind these transactions doesn't make sense.

STIGLITZ: This was an attempt to increase the lack of transparency in the markets. It was hocus pocus

HINOJOSA: Hocus pocus or not, the financial wizards who put these deals together, made hefty fees at every link in the chain, including the credit rating agencies. There was such an appetite for these new fangled bonds that by 2003, when the market for traditional mortgages was saturated, lenders turned to more risky loans, subprime mortgages, the ones that people couldn't actually afford.

From the year 2000 to 2007, more than five trillion dollars was spent buying up mortgage backed securities and CDO's around the globe. That brings us to a headline: the drive to issue more and more subprime mortgages - worth hundreds of billions of dollars - came less from would-be homeowners than from wall street firms hungry for more fees and more products to sell.

And who was buying these products? Everyone...from pension funds and 401k' hedge fund guys...even countries like iceland.

So how is it that conservative investors were willing to buy bonds created from risky subprime mortgages?

PARTNOY: The answer is credit ratings. The reason they were willing to take these hot potatoes was that the credit rating agencies had said that they're rated Triple A. They're rated Double A. These are highly rated instruments. They weren't hot potatoes. Or at least they didn't look like they were hot potatoes.

STIGLITZ: The rating agency said, "No, don't worry. These are perfectly safe. We used our fancy, complicated models, and we can certify that these are safe enough to be put in your portfolios."

HINOJOSA: Turns out they weren't. Those triple A rated CDO's are now considered central to the global financial crisis.

We turn to our insiders to understand how this happened.

GUGLIADA: CDOs were growing at phenomenal rates. Fifty to a 100 percent a year

HINOJOSA: Richard Gugliada is a CDO pioneer. At Standard and Poor's, he headed a department that exploded from three people in 1997 to 150 globally by 2005.

GUGLIADA: The group was growing at a very rapid rate. And we were creating the criteria for a whole new class of securities that hadn't really existed two years prior.

HINOJOSA: Gugliada says S&P's credit ratings were based on the most complex statistical models written by top PhDs and math geniuses. The problem, Gugliada asserts, is that they didn't have long term data on how these new financial instruments would perform over time.

GUGLIADA: We assumed that during bad times, more of them would default. But we didn't have any historical data to tell us how bad that could be.

HINOJOSA: So you just said that you didn't have sufficient data to make this huge assumption?


HINOJOSA: So, to me, honestly it's astounding. If you didn't have the data, and you're a data-based credit rating agency, why not walk away?

GUGLIADA: The revenue potential was too large.

HINOJOSA: And keep in mind. The ratings agencies are paid by the companies whose bonds they are rating. It's a built in conflict of interest.

MANN: The rating agencies get paid per deal. So, it's a conflict of interest. The—the more they rate Triple A, the more business they get.

HINOJOSA: Julian Mann is a vice president in a Los Angeles investment firm that manages more than nine billion dollars in pension and mutual funds.

MANN: I'm getting tired of hearing about no one could see this coming. I would say that anybody should have been able to see this coming.

HINOJOSA: Mann says his company doesn't rely on the credit rating agencies and they never invested in subprime mortgages. He says they were looking at the real world, and didn't trust those math models.

MANN: Innovation's fine. Common sense helps, okay. Lending money to somebody who can't pay you back is not innovation. It's stupidity, okay. And it sure isn't Triple A.

HINOJOSA: Mann says he urged east coast investors to come out and look for themselves at the homes underlying these deals, places like Palmdale, a desert city about an hour from Los Angeles.

MANN: The idea that some of this stuff is gonna be Triple A? We took a look at that and said, "This is a train wreck."

What we see are piled up old newspapers .. empty streets, the appearance of homes that are occupied but they're not. they're empty, it's like a Hollywood set.

HINOJOSA: In the world of asset management, Mann says, his company was the exception rather than the rule.

MANN: We were sometimes ridiculed as—as being unsophisticated because we couldn't grasp the complexity of these models. You know, the—I—I don't know what kind of models—can—can actually—transform the law of economics. But—apparently, neither do they 'cause it's not workin'.

When his company questioned the rating agencies, Mann says, no one wanted to hear it.

MANN: We would get on conference calls—with—with—sometimes with the ratings agencies and—and ask them to—to defend their models. And—and to explain how it would square with the real world. And—there was a fair amount of resistance to these. I mean, this was a huge money machine.

HINOJOSA: Okay, so how profitable were CDO's for Standard & Poor's?

GUGLIADA: Very profitable.

HINOJOSA: Give me an example. Throw out some numbers there.

GUGLIADA: A typically fee would be something like a quarter of a million dollars per deal.

HINOJOSA: So—and you were starting to do now how many deals?

GUGLIADA: During the hey days, in the busiest months, we were doing as many as 20, 25 per month.

HINOJOSA: So if you do the math, the CDO division alone was bringing in at least five million dollars a month in the busy season.

And the CDO's were spreading the wealth to Moody's and Fitch as well. Revenues at the three top rating agencies went from three billion dollars in 2002 to over six billion dollars in 2007.

So, was there pressure keep that money coming in?

GUGLIADA: Yes. All of us, Moody's, S & P, Fitch, we were constantly trying to bring in new business.

RAITER: We were quite amazed at—at what they were doing.

HINOJOSA: Frank Raiter, who has an MBA in finance, an expertise in investment analysis and headed his own department at S&P, didn't understand exactly what was going on in Gugliada's area on the floor above him.

RAITER: They're obviously makin' money. We weren't too sure exactly how they were doing that because the general premise to some of us behind what CDO's were—was a mystery

HINOJOSA: So when Richard Gugliada asked for Raiter's help on a CDO deal in 2001, Raiter had problems with the request.

This email exchange, which surfaced in the congressional investigation, gives a window into the internal battles brewing at S&P between the concern over the erosion of standards and the pressure to close the deal.

In the email, Raiter tells Gugliada he can't help without specific data.

"Nevertheless we MUST produce a credit estimate." Gugliada fires back.

Raiter replies "This is the most amazing memo I have ever received in my business career."

HINOJOSA: So tell me why this e-mail from Richard Gugliada was so out of the ordinary.

RAITER: They—Richard and his team had put—in writing a request that our group basically guess on a piece of information that was then gonna be used in developing a rating that Standard and Poor's was gonna put on their screen. For doing a rating that Standard and Poor's was going to issue and stand behind, that a piece of it was based on a guess.

HINOJOSA: A guess?

RAITER: A guess.

HINOJOSA: But this is a serious business. This is a credit rating agency. And in writing, you're being told, "Guess?"

RAITER: Yes. And we told them that we just couldn't guess, that guessing wasn't part of our analytical process. It was certainly frustrating for him, because if he couldn't figure out a way to do it, he might lose the transaction.

GUGLIADA: He was being asked to provide his best-guess, conservative opinion on the probability that that security would default. Based upon public information.

HINOJOSA: Still a guess?

GUGLIADA: And it was by S&P's management policy, approved by the structured finance leadership team that we would provide those answers.

RAITER: I just personally just didn't see it as being part of—of the superior analytical—pledge that I thought we all took when we joined the analytical staff at a rating agency, or at Standard and Poor's.

HINOJOSA: Gugliada says this was simply a small piece of data, one or two mortgage backed securities in a pool of more than a hundred

GUGLIADA: All groups within S&P, and I would conjecture within Moody's as well, had the same issue, which is we—there's no way of obtaining the information we would normally use, okay? So, we need to come up with a shortcut way of doing it. Otherwise, the CDOs are un-ratable. They can't be done.



HINOJOSA: You don't rate it, then. If it can't be done, and it can't be rated, then it shouldn't be rated.

GUGLIADA: All of us found ways of dealing with those couple of positions through a conservative estimate process. Frank just took a little bit longer to get there.

HINOJOSA: Raiter confirms it was management policy but that he never went along with it. He hung on to the email as a sign of the times.

RAITER: It said to me that—common sense had gone completely out the door. And that we not only wanted to make the money, but we were willing to put these requests in writing. It was—an amazing—an amazing event.

HINOJOSA: So much so that you printed it out and—

RAITER: And I hung it on my bulletin board until the day I walked out the door.

HINOJOSA: A former marine and community banker before coming to wall street, Raiter sometimes paid a price for his blunt manner.

RAITER: Well, I did get demoted from the executive committee and along with several other more outspoken managing directors that didn't just sit there and go along with things.

HINOJOSA: Were you seen as like the curmudgeon? The guy who just didn't wanna play with everybody else while everybody was having such a good time?

RAITER: That'd be a fair assessment. I wasn't—I wasn't a player.

HINOJOSA: And Raiter wasn't alone with his misgivings. A number of other internal communications have surfaced in the federal investigations. Consider this instant message exchange between two S&P analysts from April of 2007:

"By the way, that deal is ridiculous."

"I know, right. Model definitely does not capture half the risk. We should not be rating it."

"We rate every deal. It could be structured by cows and we would rate it."

And there's this internal email sent in 2006 by another Standard and Poor's employee: "rating agencies continue to create [an] even bigger monster - the CDO market. Let's hope we are all wealthy and retired by the time this house of cards falters." It ends with a smiley face.

As for Gugliada's email to Frank Raiter, he acknowledges that it does illustrate the drive for more business.

GUGLIADA: The real thing about this memo, is it points out among other things, the push for market penetration, and the need to bring in the revenue.

HINOJOSA: And that push was also evident in this 2004 email to Gugliada from another managing director talking about the "threat of losing deals" to Moody's unless S&P relaxed its rating requirements.

STIGLITZ: Competition led to a race to the bottom. The firms were competing to get business. And you don't get business by saying what you're selling is garbage. You get business by helping them sell the product so that they could facilitate this bubble that was going on and which has now cost us so much.

HINOJOSA: During this period, Frank Raiter became increasingly vocal, pushing management to adopt a more comprehensive computer model, one that would analyze more data on mortgage loans and more accurately take into account the exploding subprime market.

RAITER: Those requests for additional and more powerful databases and to build databases inside the firm were just—rejected.

HINOJOSA: So why didn't—Standard and Poor's management basically give you what you needed in terms of staffing and—and funding for your new model?

RAITER: Well, off the top, the—the—the most important reason that we can point to is that we were already making so much money that continuing to invest in—in the new models and in the R and D work wasn't necessarily gonna result in a bigger market share.

HINOJOSA: But, why wouldn't the higher-ups at a ratings agency like Standard & Poor's want to have the most efficient, most modern model to judge a changing market outside?

RAITER: Well there was a difference between the analysts that were in the trenches doing the ratings and doing the research and analysis on what was—happening in their markets, and the business people.

HINOJOSA: When we asked Standard and Poor's for a sit down interview, they declined our request but sent us this letter.

"Contrary to Mr. Raiter's assertions, S&P has invested significantly in our models, and this work has never stopped for budgetary reasons." "Our ratings and our criteria...have always resulted from analytical considerations, not revenue considerations."

Raiter left the firm in 2005 after ten years as an executive.

RAITER: I voted—with my feet and just left.

HINOJOSA: In October, he told his story to Congress.

RAITER: Profits were running the show. I mean, in a nutshell that was the simple answer. And the business managers that were in charge just wanted to get as much of the revenue into their coffers.

HINOJOSA: As for Gugliada, he left Standard and Poor's in 2006, before much of the mortgage meltdown hit and is now writing a book about it all.

So where were the regulators in all this?

STIGLITZ: There was a party going on, and no one wanted to be a party pooper. We had regulators that didn't understand their job. The job of a regulator has traditionally been to take away the punch bowl, when the party gets too raucous, because otherwise, the taxpayer is going to wind up cleaning up the mess.

HINOJOSA: Regulators, Stiglitz charges, were so caught up with Wall Street that they lost sight of Main Street.

STIGLITZ: They bought into this mystique of innovation, that somehow we had created something out of nothing. But they hadn't got—at the kinds of innovations that really would have made our economy work better.

What were the innovations that people really care about? Well, people want to buy a home and be able to stay in it. They wanna be able to manage the risk that they face; the risk of interest rates going up—the risk of their income going down.

But Wall Street didn't do that kind of innovation that would've made a lot of difference for a lot of people.

MANN: I think it's time, as a nation and—and as an industry, we—we came to Jesus. We—we looked America in the eye and said, "We screwed up. And it was more about the—the deal rather than the credit quality."

HINOJOSA: Three weeks ago the SEC finally adopted rules to prevent conflicts of interest and require more transparency from the credit rating agencies. And the rating agencies have promised Congress and the public they will reform.

SHARMA: We have announced a number of actions....

JOYNT: We need to both revisit our models, seek to rate less complex instruments...

MCDANIEL: We are working very hard to make sure that we can reinstill a sense of trust in the market.

HINOJOSA: Keep in mind that these three CEO's, executives at the once sleepy credit rating agencies, earned $80 million among them over past six years.

STIGLITZ: The takeaway is that we have developed a peculiar form of capitalism, where the wizards of—Wall Street walk away with the profits and we, the American people walk away with the losses.

BRANCACCIO: President-elect Obama has vowed to put in new financial regulations as part of his economic recovery plan. the idea is to hold accountable key players in the financial world... including the credit rating agencies. Obama says this tough new regulatory structure is "long overdue."

And that's it for now. From New York, I'm David Brancaccio. We'll see you next week.

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