Fear and Greed Blog

Saskia Scholtes, of the Financial Times, wrote a very good piece in this weekend's FT that gives the best explanation - that I've seen - of the role, and the processes, of the rating agencies in the creation of sub-prime/structured securities:


Ratings game that turned into a guessing game
By Saskia Scholtes

Published: September 29 2007 03:00 Last updated: September 29 2007 03:00

As the subprime mortgage saga rumbles on, it is rare to hear anyone stick up for the rating agencies these days.

They stand accused of granting high ratings to complex securities backed by risky mortgages that have since suffered sharp drops in value. This week they were called before the US Senate to defend their role in the sorry subprime tale that has rocked financial markets.

When it comes to rating corporate debt, the rating agencies are, for the most part, very good at what they do. And they should be. After all, the two dominant agencies, Moody's Investors Service and Standard & Poor's, have been rating corporate bonds since 1909 and 1916 respectively.

This means that when they rate the debt of companies in the steel industry, for instance, they can back up analysis with empirical data spanning several economic cycles.

Over the years, the rating agencies have grown used to criticism from disgruntled investors who have lost money in economic downturns, but they have always had the data to fall back on.

This time it is different. The rating agencies still say they analysed the historical data - only this time the data did not work.

"We have learned some hard lessons from the recent difficulties in the subprime mortgage arena," said Vickie Tillman, executive vice-president at S&P in testimony before the Senate committee on Banking, Housing and Urban Affairs this week.

"We are fully aware that, for all our reliance on our analysis of historically rooted data that sometimes went as far back as the Great Depression, some of that data has proved no longer to be as useful or reliable as it has historically been."

Ms Tillman said some of the changes in borrower behaviour were not predictable, such as the unprecedented level of defaults on mortgages in the first few months after origination, and the fact that, while borrowers who bought homes had generally made their mortgage payments before paying off their credit cards, that no longer appeared to be true. The rating agencies have pointed to other factors that contributed to unexpected losses, including fraud in the mortgage origination process and deterioration in underwriting standards.

But the real problem, say critics, is that the "historically rooted data" the agencies used was not necessarily relevant in the first place.

These critics argue the rating agencies were too dependent on performance data for more traditional mortgages - such as those issued by the government sponsored mortgage agencies Fannie Mae and Freddie Mac. Such "conforming" mortgages bore little resemblance to the private-label subprime home loans characteristic of the recent lending boom. Many subprime borrowers who in the past had little or no access to mortgage credit, for example, took out so-called "interest-only" mortgages. A mortgage is "interest only" if the monthly payment the borrower is required to make consists of interest on the loan, rather than any portion of the principal. The option to pay interest only lasts for a specified period, usually 5 to 10 years. Such mortgages were previously offered only to borrowers with good credit, making comparison with any historical data unreliable at the outset.

Meanwhile, raters left it up to Wall Street underwriters to perform the necessary "due diligence" on risky mortgages and the borrowers backing a given security. That is because under securities laws, rating agencies are not required to do so. Rating agencies assigned ratings based on the information provided by the underwriters, without always asking for more.

An April report from Moody's, for example, shows the rating agency did not until recently consider debt-to-income ratios as a primary piece of data in mortgage models, although this is considered one of the three key predictors of mortgage default. And then came the structuring. Subprime mortgages were packaged into bonds, which were packaged into innovative complex debt securities, for which the rating agencies provided ratings.

So these were structured securities that had never existed before the current cycle, containing mortgages that had never existed, taken out by borrowers that had never been granted mortgage credit. Rating them was surely as close to a guessing game as you could get.

saskia.scholtes@ft.com

Copyright The Financial Times Limited 2007