S&P, a unit of McGraw-Hill Cos., and Moody's substituted theoretical mathematic assumptions for the experience and judgment of their own analysts. Regulators found that Moody's and S&P also didn't have enough people and didn't adequately monitor the thousands of fixed-income securities they were grading AAA.

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Frank Raiter says Standard & Poor’s placed a “For Sale” sign on its reputation March 20, 2001. That day, a member of an S&P executive committee ordered him, the company’s top mortgage official, to grade a real-estate investment he’d never reviewed.

S&P was competing for fees on a $484 million deal called Pinstripe I CDO, Raiter says.

Pinstripe was one of the new structured-finance products driving Wall Street’s growth. It would buy mortgage securities that only an S&P competitor had analyzed; piggybacking on the rating violated company policy, according to internal e-mails reviewed by Bloomberg News.

“I refused to go along with some of this stuff, and how they got around it, I don’t know,” says Raiter, whose business unit rated 85 percent of all residential mortgage deals at the time.

“They thought they had discovered a machine for making money that would spread the risks so far that nobody would ever get hurt.”

Relying on a competitor’s analysis was one of a series of shortcuts that undermined credit grades issued by S&P and rival Moody’s, according to Raiter. Flawed AAA ratings on mortgage-backed securities that turned to junk now lie at the root of the world financial system’s biggest crisis since the Great Depression.

“I view the ratings agencies as one of the key culprits,” says Joseph Stiglitz, the Nobel laureate economist at Columbia University in New York. “They were the party that performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies.”

Driven by competition for fees and market share, the agencies stamped out top ratings on debt pools that included $3.2 trillion of loans to homebuyers with bad credit and undocumented incomes between 2002 and 2007.

As subprime borrowers defaulted, the companies have downgraded more than three-quarters of the complex, structured investment pools known as collateralized debt obligations (CDOs) issued in the last two years and rated AAA, the gold standard for debt.

Without those AAA ratings, banks, insurance companies and pension funds wouldn’t have bought the products.

Bank write-downs and losses on the investments totaling $523.3 billion fueled the collapse or disappearance of Bear Stearns, Lehman Brothers, Merrill Lynch and Seattle-based Washington Mutual and and led to the government’s plan to buy $700 billion of bad debt from distressed financial institutions.

S&P, a unit of McGraw-Hill, and Moody’s substituted theoretical mathematic assumptions for the experience and judgment of their own analysts.

Regulators found Moody’s and S&P also didn’t have enough people and didn’t adequately monitor the thousands of fixed-income securities they were grading AAA.

The S&P’s Raiter and his counterpart at Moody’s, Mark Adelson, say they waged a losing fight for reviews that focused on a borrower’s ability to pay and the value of the underlying collateral.

That was the custom of community bankers who extended credit only as far as they could see from their front door.

“The part that became the most aggravating — personally irritating — is that CDO guys everywhere didn’t want to know fundamental credit analysis” says Adelson, who quit Moody’s in January 2001 after being reassigned out of the residential mortgage-backed securities business. “There is no substitute for fundamental credit analysis.”

S&P hired Adelson in May as chief credit officer, responsible for setting the company’s ratings criteria as part of a broader management shake-up.

Raiter served on the S&P structured-finance group’s executive-rating committee until 2000, when he says he was demoted for his clashes with his bosses.

The former marine and community banker retired in March 2005, when he became eligible for company-paid medical benefits.

Tougher criteria

Now facing the threat of lawsuits and tighter regulation, Moody’s and S&P say they are adopting tougher criteria to more accurately evaluate and monitor the debt.

In January, S&P reassigned Joanne Rose, its top structured-finance ratings executive since 1999, to a new post as executive managing director for risk and quality policy.

In May, Brian Clarkson resigned as president of Moody’s Investors Service. He was the company’s top structured-finance executive for most of this decade.

“Independence, integrity and quality remain the cornerstones of everything we do and everything we stand for,” S&P’s vice president of communications, Chris Atkins, wrote recently in response to questions from Bloomberg News. “We have an important role to play in helping to restore confidence and increase transparency in the credit markets, and we are determined to play a leadership role.

“We are certainly not going to respond to a disaffected ex-employee’s statements,” Atkins added in an e-mail, without specifying any individual.

Anthony Mirenda, a Moody’s spokesman, declined to respond to questions submitted in writing and by phone.

AAA ratings on subprime mortgage investments can be traced to the rise on Wall Street of quantitative analysts, or quants, with advanced degrees in math, physics and statistics.

They developed computer-driven models that didn’t rely on historical performance data, according to Raiter and others.

If the old rating methods were like Rembrandt’s portraiture, with details painted in, the new ones were Monet impressionism, with only a suggestion of the full picture.

Since the Great Depression, U.S. agencies have relied on S&P and Moody’s to help evaluate the credit quality of investments owned by regulated institutions, gradually bestowing on them quasi-regulatory status.

Yet as the 21st century began, much of that knowledge became obsolete.

Banks were combining thousands of fixed-income assets into custom blends of high-yield bonds, aircraft leases, franchise loans, mutual-fund fees and mortgages.

These structured investment pools didn’t have the performance history that lay behind the corporate bonds.

The spinoff of Moody’s by Dun & Bradstreet in September 2000 changed the service’s focus from informing investors to responding to the demands of banking clients and shareholders, say several former Moody’s analysts.

They requested anonymity because they signed nondisclosure agreements when leaving or because they do business with the company.

Hunt for deals

“Up until that point, there was a significant emphasis on who’s got the right criteria,” says Richard Gugliada, the former S&P global ratings chief for CDOs who retired in 2006.

“Then Moody’s went public. Everybody was looking to pick up every deal that they could,” he said.

Clarkson became Moody’s group managing director for structured finance in August 2000, a month before the spinoff.

He replaced Adelson and other analysts to make the residential mortgage-securities unit more responsive to clients, say several former Moody’s professionals who requested anonymity because of confidentiality agreements.

The executive visited Wall Street banking customers to pledge a closer, more cooperative relationship and asked whether any of his analysts were particularly difficult to work with, former Moody’s managers say.

“Things were becoming a lot less collegial and a lot more bottom-line driven,” says Greg Gupton, senior director of research in Moody’s quant group at the time.

He is now managing director of quantitative research at New York-based Fitch Solutions, a consulting unit of Paris-based Fimalac. Fimalac also owns Fitch Ratings, the third-largest bond-analysis company.

Clarkson didn’t respond to requests for comment.

Successful at first

The efforts initially produced results. Moody’s share of rating mortgage-backed securities jumped to 78 percent in 2001 from 43 percent a year earlier, according to the industry publication Inside Mortgage Finance in Bethesda, Md.

It was in this environment that the Pinstripe deal landed on Raiter’s desk. The underwriters were units of what now are the investment banks Credit Suisse Group based in Zurich, and RBS Greenwich Capital Markets in Greenwich, Conn.

The CDO packaged residential mortgage securities and real-estate investment trusts.

“We must produce a credit estimate,” Gugliada, a member of the structured-finance rating group’s executive committee, wrote to Raiter in a March 2001 e-mail.

“It is your responsibility to provide those credit estimates and your responsibility to devise a method for doing so. Please provide the credit estimates requested!” he wrote, signing off with his nickname “Guido.”

“He was asking me to just guess, put anything down,” says Raiter. “I’m surprised that somebody didn’t say, ‘Richard, don’t ever put this crap in writing.’ “

Over Raiter’s objections, S&P graded 73 percent of the Pinstripe bonds AAA. Managed by New York-based Alliance Capital Management, now AllianceBernstein Holding, the CDO paid off investors in November 2004.

Other deals wouldn’t fare as well.

S&P outlined the alchemy of structured finance in a March 2002 paper for clients, “Global Cash Flow and Synthetic CDO Criteria.”

While arguing that the process wasn’t “turning straw into gold,” the authors said the goal was to create a capital structure with a higher credit rating than the underlying assets would qualify for without financial engineering.

By estimating the percentage of a debt pool that would pay off, the raters could assign AAA grades to the safest portion of the investment and lower marks on the rest.

About 85 percent of structured-finance CDOs qualified for the top grade, according to Moody’s.

Buying protection

The deal sponsors could bolster the structure by buying protection from the two largest bond insurers, Ambac Financial Group and MBIA.

This way, subprime mortgages with elevated default risks could be pooled into CDOs with top ratings.

As lending standards fell, earlier deals performed better than later ones.

The annual volume of mortgage securities sold to private investors tripled to $1.2 trillion between 2002 and 2005, according to Inside Mortgage Finance. The subprime portion of the CDOs rose fourfold, to $456.1 billion.

Low interest rates fueled the home-financing boom while investor demand for yields encouraged banks to structure subprime mortgages into higher-paying securities.

Between 2001 and 2005, the annual value of asset-backed CDOs surged 11-fold to $104.5 billion, then more than doubled to $226.3 billion in 2006, according to the industry newsletter Asset-Backed Alert in Hoboken, N.J.

Through it all, the rating companies had a basic conflict: They were paid by the businesses whose products they rated.

Moody’s told the Paris-based Committee of European Securities Regulators in November 2007 — in the 49th footnote of a 35-page response to its questionnaire on structured finance — that it allowed managers who supervised analysts to “provide expert input” on fees “in a limited range of circumstances.”

SEC critical

The Securities and Exchange Commission in July identified S&P and Moody’s as accessories, finding they violated internal procedures and improperly managed the conflicts of interest inherent in providing credit ratings to the banks that paid them.

Some investors became nervous that the rating companies’ mathematical models and AAA grades were out of touch with reality.

“There was no model — there was nothing — that could work for modeling interest-only, adjustable, nonpayment liar’s loans,” says Stephen Berger, chairman of Odyssey Investment Partners, a New York-based private-equity firm.

In California, fixed-income investor Julian Mann feared the worst as subprime lending fanned out across the country.

“We said this is a train wreck waiting to happen,” says Mann, a vice president of the Los Angeles-based investment-management firm First Pacific Advisors.

The 90-day delinquency rate on subprime mortgages rose from 5.14 percent in 2003 to 6.37 percent in 2004 and 8.63 percent in 2005, according to First American Core Logic, a San Francisco-based data provider.

S&P’s Raiter says he was urging management to develop more-sophisticated financial models and buy more detailed loan data for monitoring securities the company graded.

“We knew the delinquencies were bad,” he says. “The fact was, if we could have hired a supreme being to tell us exactly what the loss was on a loan, they wouldn’t have hired him because the Street wasn’t going to pay us extra money to know that.”

In late 2005, First Pacific’s Mann says, he invited East Coast investors to take a subprime-mortgage tour up Interstate 5, California’s main artery, to see the problem for themselves.

Unfamiliar territory

“Nobody wanted to do it,” he says. “Unfortunately, most of the models were constructed by people who hadn’t seen most of America and certainly weren’t familiar with the areas they were rating.”

That September, Mann’s boss, Thomas Atteberry, acted while others hesitated.

He told investors in a monthly letter that he was liquidating the highest-risk real-estate securities in First Pacific’s New Income fund, which held $1.85 billion in bonds.

Atteberry wrote he was “very concerned about the subprime sector” and “that these trends may be a very early sign of the emergence of credit quality deterioration in general.”

It was 22 months before S&P and Moody’s started downgrading mortgage securities and CDOs that held similar loans.

Atteberry had no idea how right he would be.

Gugliada, like Raiter, now says he views as flawed many of the ratings S&P and Moody’s assigned.

“There was the self-delusion, which hit not just rating agencies but everybody, in the fact that the mortgage market had never, ever, had any problems, and nobody thought it ever would,” Gugliada says.

In the SEC’s July 8 report examining the role of the credit-rating companies in the subprime crisis, the agency raised questions about the accuracy of grades on structured-finance products and “the integrity of the ratings process as a whole.”

“Let’s hope we are all wealthy and retired by the time this house of cards falters,” one unidentified analyst told a colleague in a December 2006 e-mail, according to the SEC report.

The e-mail was signed with a computerized wink and smile: “;o).”

Moody’s stock peaked at $74.84 on Feb. 8, 2007, a day after London-based HSBC Holdings said it would set aside about $10.56 billion for losses on U.S. home loans.

That statement was among the first signs of the subprime meltdown.

The reckoning swept Wall Street five months later.

On July 10, 2007, Moody’s cut its grades on $5.2 billion in subprime-backed CDOs. That same day, S&P said it was considering reductions on $12 billion of residential mortgage-backed securities.

Still, they continued stamping out AAA ratings.

Moody’s announced Aaa grades on at least $12.7 billion of new CDOs in the last week of August 2007. Five of the investments were lowered by one or both companies within three months. The rest were cut within six months.

“Models were bad”

“The greed of Wall Street knows no bounds,” says Stiglitz. “They cheated on their models. But even without the cheating, their models were bad.”

By August, Moody’s had downgraded 90 percent of all asset-backed CDO investments issued in 2006 and 2007, including 85 percent of the debt originally rated Aaa, according to Lucas at UBS Securities.

S&P has reduced 84 percent of the CDO tranches (or sections) it rated, including 76 percent of all AAAs.

“Credit in Latin means ‘to believe,’ ” says former Moody’s analyst Sylvain Raynes, now the head of his own New York bond-analysis firm, R&R Consulting.

“Trust and credit is the same word. If you lose that confidence, you lose everything, because that confidence is the way Wall Street spells God.”