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16%: The share of triple-A rated subprime-mortgage bonds issued in mid-2007 that should never have received that rating, given the information available at the time.
As Congress prepares to rework the business of providing credit ratings, the firms that put their triple-A imprimatur on hundreds of billions of dollars in disastrous investments are raising a familiar refrain: We did the best job we could, given the information we had at the time.
A new paper analyzing the ratings firms' performance at the peak of the credit boom, though, adds to the evidence that their defense is shaky. It also offers a glimpse of the scale of their contribution to the financial crisis.
The paper focuses on investments backed by subprime mortgage loans. Typically, bankers create these investments by stuffing thousands of mortgages into a little company that issues about a dozen separate bonds. Ratings firms decide what portion of those bonds deserve the coveted triple-A rating.
To test how well the ratings firms performed, the paper's authors — Adam Ashcraft and James Vickery of the Federal Reserve Bank of New York, and Paul Goldsmith-Pinkham of Harvard University — tried to figure out how a reasonable person, armed with the most basic information, would have rated the same bonds in the period leading up to the financial crisis. To do so, and to avoid accusations of hindsight, they put together the simplest and most backward-looking ratings model they could. It considered variables such as house prices, credit scores, income, debt levels and the amount of documentation borrowers provided — all factors that the ratings agencies claimed to consider.
As of the second quarter of 2005, the model and the ratings agencies appeared to be in agreement: A bit more than 80% of the bonds in the average deal during the quarter deserved the triple-A rating. But as the quality of subprime lending deteriorated over the next two years – more loans with no documentation, no down payments, and borrowers with lower credit scores – the ratings firms actually gave out more triple-A ratings. In the second quarter of 2007, the average subprime deal contained 84% triple-A bonds, at a time when the model suggested the number should have been only 71%.
In other words, the ratings firms put their gold-standard seal of approval on 16% more bonds than even the simplest model would allow, given the information available at the time. And that doesn't include the hundreds of billions of dollars of even-more-complex securities, known as collateralized debt obligations, that gained triple-A ratings even though they contained or were linked to 100% triple-B subprime bonds.
The most charitable explanation for the ratings firms' behavior is that they try to take a long-term view, discounting current trends in, say, house prices — but the paper's authors note that this alone cannot account for the whole discrepancy. Other possible explanations: Either the ratings agencies were very slow to react to deteriorating mortgage performance, or they inflated their ratings to win business from bankers at a time when rating subprime-backed investments made up a huge portion of their profits.
Whatever the explanation, erroneous triple-A ratings have consequences far beyond duped investors. They allowed banks to buy tons of the bonds without setting aside much capital against losses – a practice that ended in losses greater than the banks could bear. They also made it much easier to keep making cheap loans to homeowners with sketchy credit, helping inflate and perpetuate the housing bubble.
Greater regulation of the credit-rating firms, together with greater legal responsibility for their ratings, might have some unintended consequences. But given the evidence, it's hard to say they didn't bring it upon themselves.
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On June 2 new SEC rules go into effect for structured products that require the issuer to make the specifics of the underwriting available to all credit rating agencies. Not just those hired by the issuer.
This will be a new and radical departure from the practice of the industry.
Up until now the issuer has had full control over who can see the deal prior to it being brought to market. This control of information gave complete power to the issuer and underwriter to shop around for the best ratings. And closed out other rating agencies from developing a rating for a new security.
The SEC needs to extend this new rule to cover all rated debt not just structured products.
All rating agencies qualified in an asset class should have the information to rate a deal. That way investor paid agencies can create ratings that their client base can use when evaluating an offering.
One argument for extending the new rule to all debt types is the use of repo 105 by Lehman, Merrill, Deutsche Bank and others. If more aggressive, investor paid rating agencies had access to the information that the big 3 raters had we would see a broader set of opinions on the stability of the balance sheet of the financial institutions. And likely a more critical analysis of the funding process and liquidity of these firms. More accurate ratings would likely lower systemic risk. Investors would have ratings they could rely on in times of market stress.
More background on the new SEC rules from Sidley Austin:
http://www.sidley.com/sidleyupdates/Detail.aspx?news=4337
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