Former S&P Analyst Has Some Things He'd Like To Get Off His Chest

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Yesterday we talked a bit about this lawsuit bubbling around where some investors are suing Moody's and S&P for doing a not so great job rating some asset-backed SIVs called Cheyne and Rhinebridge. I said then that the rating agencies were probably pretty keen to avoid going to trial for negligence, because, well

Because … look, maybe the ratings agencies weren’t negligent in rating these things, maybe their models made sense at the time and were falsified by unexpected future events that no reasonable person could have predicted, but … I’m gonna guess that if this goes to trial they will look bad. I mean, they look bad already, no?

A reader helpfully pointed to a preview of what a trial would look like for S&P and Moody's, in the form of this interview report,* filed by the plaintiffs in February, of former S&P senior quantitative analyst Kai Gilkes, who among other things says that their models made no sense at the time and he predicted that they'd be falsified by expected future events:

He did not feel comfortable with treating RMBS bonds in similar fashion to corporate bonds for ratings purposes, and acknowledged that he voiced his concerns in meetings and in writing while with S&P. ... [H]e again flatly stated that structured vehicles specifically containing subprime RMBS assets "should not have been rated at all."

However, the choice of not rating these structured products was not a viable one, according to Gilkes, because certainly if S&P dd not, others would. He said that it was hard to tell if the agencies were being played off against each other by the issuers, while he believes this to be the case. He said there was "certainly the perception" that competitors were happy with utilizing these underlying faulty assumptions to rate RMBS backed vehicles, and so, in turn, "why shouldn't S&P be happy with it?" With such a huge source of revenue, S&P and its competitors were all under pressure to utilize these bases for ratings, which because of the lack of historical performance data, was "more of a guess than it should have been." ...

The way this system operated meant that "downgrades are bad for everyone" - bad for investors who lose returns and capital, bad for issuers who will lose business, bad for the ratings agencies who will lose confidence, trust and market share, bad for "everyone." He characterized the behavior of S&P and the other major ratings agencies as: "turn a blind eye, cross your fingers and don't change ratings."

There's more and it's in that vein and it's ... well, I dunno, make up your own mind. My own sense is there's no huge smoking gun and actually not much here that hasn't been said publicly before, sometimes by Gilkes. Gilkes himself has some incentive to bash the big rating agencies, and had no direct connection to the deals at issue here - this is not a case of the actual S&P rater on Cheyne testifying against S&P and saying "yeah we knew it was crap and we rated it AAA anyway because money!" There is I suppose a chance that S&P could paint him as a disgruntled outlier - everyone else thought the model was great, he was one weird guy, there's no reason anyone should have predicted this, you fuck one sheep, etc. That is undercut a little bit by, y'know, the fact that the model turned out to suck really bad, but still: how could they have known that in advance? (Except for the guy who did. Sort of. Now claims he did, anyway.)

But this fourteen-page screed against S&P gives you a good sense of why rating agencies - and, notably, banks - don't want to take cases like this to trial. Never mind the chances of having to pay out huge damages, or the general negative publicity that comes with selling terrible products to clients/counterparties. Think of the negative publicity that comes from having your former employees get up in court and tell everyone about their (perhaps exaggerated in hindsight) doubts about your business model. Think of all the Kai Gilkeseses in the world! Think of all the Greg Smiths! I hope all the laid-off ABS structurers got good severance packages.

Declaration of Jason Rowe in Support of Plaintiffs' Opposition to Defendants' Motion for Summary Judgment [SDNY]

* Our reader was impressed that the report was entirely unredacted, because much else in the case is very very redacted. Here's a page from the plaintiffs' memorandum of law that the Gilkes interview accompanied:

This is typical; there are whole pages that are blacked out. What do we think was more inflammatory than that conclusion?

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