Insider's Game

“I don’t believe so, no,” Clarkson testified.

Apparently, he never knew how structured investment vehicles, aka SIVs, were rated because that was never part of Clarkson’s job description. Not when he sat on the Board of the American Securitization Forum. Not when he was Managing Director of Moody’s Asset-Backed Securities Group from 1994 to 1996. Not when he was Group Managing Director of the Mortgage Finance Group at Moody’s from 1996 through 1997. Not when he was Group Managing Director of Moody’s Global Asset Finance Group from 1997 to 2001. Not when he was Senior Managing Director of Moody’s Asset Backed Finance Group from 2002 through 2003. Not when he was Co-Chief Operating Officer of Moody’s Investor Service, in charge of the Global Structured Finance and US Public Finance franchises, from 2004 to 2007. And not after August 2007, when Raymond McDaniel, the President of the rating agency, chose to step aside and appoint Clarkson in his stead.

As luck would have it, the $400 billion SIV market began to implode right at the point when Clarkson became President of Moody’s Investor Service. The collapse of SIVs triggered the Panic of 2007,  which resulted in a liquidity crisis affecting hundred of billions in commercial paper, which were structurally senior to triple-A-rated SIV notes. Those triple-A SIV notes made history, as the first triple-A-rated debt obligations to default. (That’s right, none of Moody’s triple-A-rated bonds ever defaulted during The Great Depression.)

And though the Panic of 2007 caused a $350 billion reduction in the asset backed commercial paper market, and led to a banking crisis in Germany, and crippled Citibank’s balance sheet, none of that was really Clarkson’s responsibility, at least as it pertained to learning how Moody’s came to assign triple-A ratings for all those SIVs.

SIVs For Dummies

Clarkson’s ignorance is kind of ironic, because, for anyone who ever computed a grade point average, the concept behind SIVs is pretty easy to understand. The general idea behind structured finance is that you can diversify your risk with a diversified portfolio of debt obligations. Moody’s used two different approaches for rating debt portfolios. The first approach–used for portfolios of home mortgages, auto loans, utility bills–evaluated deals according to cash flows. The second approach–used for rating portfolios of rated bonds and corporate loans– evaluated deals according to their grade point averages, or, in Moody’s jargon, their Weighted Average Rating Factors.

SIVs, along with other, very similar bond portfolios–CDOs, CBOs and CLOs–were rated according to their grade point averages. (The diversification of a portfolio, and the reliability of a Weighted Average Rating Factor was determined by certain pre-cooked assumptions about default correlations.) SiVs in particular were considered super-safe, because they were diversified portfolios comprised almost entirely of triple-A and double-A bonds.

SIV bond portfolios were financed in the commercial paper markets, and, if for some reason the SIVs were unable to roll over the commercial paper, the SIVs could rely on the liquidity afforded by: 1.The triple-A-rated capital notes, and/or 2. A prompt sell-off of the highly rated bonds. Since the “market values” of the underlying bond investments were measuredon a daily basis, the bonds were perceived to be highly marketable, and possibility that those bonds were ever sell at a significant discount to par was believed to be very remote.

Some SIVs held large investments in subprime mortgage bonds and CDOs, which, as noted earlier, were not actively traded, so the ability of SIV managers to divine the “market values,” of those bonds remains a mystery.

In late July and early August 2007, to the rating agencies’ great surprise, SIVs were suddenly unable to roll over their commercial paper. And, even more surprisingly, they were unable to sell off their highly-rated mortgage bonds at any price. Investors in triple-A-rated SIVs lost many billions of dollars.

Clarkson’s “Ignorance”

But since Clarkson never attained that advanced level SIV knowledge, he seemed incapable of understanding the documents that addressed the obvious flaws in SIV rating methodology. Check out Clarkson’s answers from this excerpt from the deposition:

Q. Let’s look at the fourth bullet point down:

“Model-driven perspective on the meaning of AAA and P1 deterred a more subjective fundamental approach, which may have been more appropriate given the uncertainty surrounding model parameters and the valuations.”

Do you understand what that sentence means?

A. No, I don’t.

Q: Let’s look at the page ending 950. You see the heading on this page says, “Recommendation: Improve and implement new methodologies for MV transactions”?

A. I do.

Q. You understand “MV” there refers to market value; is that correct?

A. It could, but I don’t know this document.

Q. You’ve seen the abbreviation MV during the course — during your work at Moody’s; correct?

A. I have.

Q. When you saw it, what did it refer to? What did that abbreviation refer to?

A. It usually meant market value.

Q. Let’s look at the first bullet point:

“More conservative parameter assumptions with less reliance on ratings.”

Do you see that?

A. I do.

Q.  Do you understand that sentence?

A. No, I don’t.

Q. Second bullet point is:

“More portfolio transparency and more robust asset pricing information.”

Do you see that?

A.  I do.

Q. Do you understand that sentence?

A. No, I don’t.

Inability To Talk About CDOs

SIVs are very much like CDOs, except CDOs don’t fund themselves with short-term debt.  Clarkson’s knowledge of CDOs seemed somewhat limited, based on his recorded interview with the Financial Crisis Inquiry Commission:

FCIC Lawyer Brad Bondi: You had alluded to models and methodologies for CDOs. During your tenure as co-chief operating officer for Moody’s, what do you recall with respect to updating or managing methodologies or models for rating CDOs where residential mortgage backed securities were the underlying collateral?

Clarkson: I’m really not the person to talk to about models.

Clarkson’s opportunity to have his memory refreshed was upended by unfortunate last-minute circumstances. He was scheduled to testify, shortly after the taped interview, alongside other former Moody’s executives, in open FCIC hearings on June 2, 2010. But, Clarkson, who was not feeling well that day, sent doctor’s note excusing his failure to appear.

One final note: In the Q&A deposition excerpts used above, I edited out the chronic interruptions by Moody’s counsel, Jim Coster of Satterlee Stephens Burke & Burke, who never heard a question he couldn’t object to.