Tuesday, July 3, 2007

The Ratings Game

The bond rating agencies are taking a lot of heat lately because of their unwillingness to downgrade various mortgage-backed bonds whose collateral is clearly in distress as delinquencies and foreclosures climb to 10-year highs. Various money managers, bond traders, et. al. are blaming them for not taking more decisive action. Sadly, however, this is yet another instance of lack of understanding of how the system really works: rating agencies are not in the prediction business. They analyse the here and now and thus their ratings actually reflect the past since financial statements, defaults, etc. are historical data. At the top of the economic cycle everything is firm: defaults are low, collateral prices are rising and thus a high percentage of loans go into the AAA tranches. That and the explosion in derivatives trading created the massive structured finance sector.

So what are rating agencies doing now as things are softening? They are sitting on their hands and waiting. The whole mortgage default process, from late payment to foreclosure and final sale at auction takes many months - almost a year. There is no way for the rating agencies to predict what the bond holders will recoup in the form of sale proceeds, i.e. how adequate the collateral is and therefore what the new ratings of the various CDO tranches should be, particularly within the "cascade" structure all of them use. Over the next 6+ months there will be a full set of historical data and the rating agencies will act.

Knowledgeable finance professionals have long been aware of the lagging nature of bond ratings, particularly when it involves securitizations of various loan obligations. We can all argue that rating agencies "should know better", but in truth that's not their role in the game. It is the various money managers who buy the stuff that are supposed to be able to interpret a particular rating as being ex post facto, rather than containing firm evidence of financial strength.

But in this era of waning pension fund contributions, higher life expectancies and zooming medical costs, what is a money manager to do to get an extra 10 basis points and still maintain the minimum required average rating for his/her portfolio? Holding his nose firmly closed (some even shut their eyes...) he buys the stuff and prays.

Bottom line: yes, rating agencies are complicit in this developing MBS mess - but only to the extent that they did not alter their usual practice, developed over decades of professional experience. Their "crime" is more one of omission rather than commission. For real "perps" we should be looking elsewhere - but this is a subject for another post.


  1. There is a great paper here: http://hudson.org/files/publications/Hudson_Mortgage_Paper5_3_07.pdf explaining how ratings were misapplied to MBS.

    Happy to have you back, sir.

  2. Thank you Jason. I can't get the link to the article to work, however.


  3. SPECTRE of DeflationJuly 3, 2007 at 9:00 AM

    You forgot to mention that they [Credit Agencies] changed their standards in Feb. of this year in order to make the deals. They are as much at fault as anyone with this debacle. Like everyone else associated with this mess, greed once again got the best of them.

  4. Dear SoD,

    The rating agencies are certainly facilitators, stretching the boundaries of their credibility by basing their ratings on assumptions that only work under bull market conditions. But they didn't create the CDO's, nor did they create the demand for such products - this is why I believe that the majority of the blame should be placed elsewhere.

    I will write a post on this subject soon.


  5. try this link for Huston Inst.


  6. It's possible that you may be asking the wrong question -- you're asking who SHOULD be blamed, when the more relevant question is, who WILL be blamed?

    As for who SHOULD be blamed, it's very hard to pin down anyone. Everyone has an excuse. Bear Stearns, for example, was just managing a fund where everyone knew the risks. It's not THEIR fault, is it?

    And yet, the SEC has opened several investigations.

    You say that rating agencies shouldn't be blamed. Well of course they shouldn't be blamed. They were just doing their job, evaluating risk according to long-established formulas and reporting on them.

    But they WILL be blamed. They ARE being blamed. Maybe they think their job was to follow a formula, but a lot of bankrupt, angry investors think that their job is give them early warnings of risks. The ABX index fell sharply in February and the ratings agencies just said, "Huh? That doesn't affect our formula." Well, a lot of angry people won't agree with that, and a lot of people are going to think that they colluded with their buddies at Bear Stearns and JP Morgan and so forth, so that everyone will look good. The SEC may well investigate and find illegal collusion, and infer fraud.

    And the worst hasn't even happened yet. We're still on the road to a full-scale stock market crash and global financial crisis. It might happen next week, next month or next year, but it's coming sooner rather than later. And when it happens, no one will be safe.



    John J. Xenakis
    E-mail: john@GenerationalDynamics.com
    Web site: http://www.GenerationalDynamics.com

  7. SPECTRE of DeflationJuly 4, 2007 at 6:06 PM

    Hellasious said...
    Dear SoD,

    The rating agencies are certainly facilitators, stretching the boundaries of their credibility by basing their ratings on assumptions that only work under bull market conditions. But they didn't create the CDO's, nor did they create the demand for such products - this is why I believe that the majority of the blame should be placed elsewhere.

    I will write a post on this subject soon.


    Thanks much for the reply. It's hard to pin the blame on any one group because it became a mania where ethics, character, a thought for your fellow man were thrown out the window by everyone involved.

    That being said, I think the Ratings Agencies get a big ole' slice of the blame pie. When investors depend on their Educated Judgement concerning ratings on various instruments, it's unethical and possibly criminal to change your standards in Feb. of this year in order to "do the deal".

    The lawyers are about to make a killing, and if you are a Forensic Accountant/Auditor even better.

    PS: Got popcorn? :>)!

  8. SPECTRE of DeflationJuly 6, 2007 at 8:27 AM

    Subprime contagion?

    Ohio's attorney general is investigating the role that credit-rating agencies like Moody's played in rubberstamping dicey bonds, report Fortune's Katie Benner and Adam Lashinsky.
    By Katie Benner and Adam Lashinsky, Fortune
    July 5 2007: 11:16 AM EDT

    (Fortune Magazine) -- While Bear Stearns is the most recent financial institution to find itself caught up in the subprime-mortgage quagmire, the three credit-rating agencies - Standard & Poor's, Moody's (Charts), and Fitch - may be the next ones to see their good names dragged through the mud.

    The reason? Ohio attorney general Marc Dann is building a case against them based on the role he believes their ratings played in the marketing of risky mortgage-related securities.

    "The ratings agencies cashed a check every time one of these subprime pools was created and an offering was made," Dann told Fortune, referring to the way the bond issuers paid to get their asset-backed securities (ABSs) and collateralized debt obligations (CDOs) rated by the agencies. These ratings run from AAA for debt with the lowest risk of default all the way down to noninvestment- grade bonds, which many pension funds are prohibited from purchasing in their charters. "[The agencies] continued to rate these things AAA . [So they are] among the people who aided and abetted this continuing fraud," adds Dann.

    Ohio has the third-largest group of public pensions in the United States, and they've got exposure: The Ohio Police & Fire Pension Fund has nearly 7 percent of its portfolio in mortgage- and asset-backed obligations.

    As I mentioned days ago, the Rating Agencies are about to be beat to a pulp just like a very dirty rug. The lawyers are licking their chops!