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.