In the wake of the crisis of 2007-08 and the
ensuing Great Recession, there was a torrent of criticism of the credit rating
agencies, such as Standard & Poor’s and Moody’s, which had given their
highest ratings—AAA—to mortgage-backed securities (MBS) and collateralized debt
obligations (CDOs) that defaulted in massive numbers. One popular explanation
for the faulty ratings has been that the agencies gave inflated
rating to securities because they were paid by the issuers; if an agency
declined to give a AAA rating, it wouldn’t be used and wouldn’t be paid. This
explanation has been questioned by economists. I personally think (along with
some economists) a better explanation is that the rating agencies were working
from the same faulty assumption as everyone else: that a substantial decline in
home prices was highly unlikely. Put slightly differently, the rating agencies
(and almost everyone else) did not believe that there was a housing bubble.
I’m not equipped to sort out those issues.
Rather, I want to recount my personal experience with the role of the rating
agencies in the MBS world immediately before the
tsunami hit. I didn’t negotiate with any rating agencies and all my experience
related to prime and alt-A residential mortgage securitizations (RMBS), so my
observations may not hold for CDOs and subprime MBS.
There are only four rating agencies:
Standard & Poor’s (S&P), Moody’s, Fitch, and Duff & Phelps. S&P
and Moody’s are the big fish, Fitch a smaller fish, Duff a minnow. An RMBS
issuance needs ratings from two agencies, and no one would proceed with a RMBS
rated only by Fitch and Duff. Which means that every securitization had to have
a rating from either S&P or Moody’s. What’s more, investors occasionally
insist on ratings from both the big guys, so that issuances rated by both S&P and Moody's were a bit more saleable. Under these circumstances, an
issuer’s power to negotiate for higher ratings was limited.
A RMBS issuance consists of a number of
classes with different ratings from AAA to junk. As homeowners default on their
mortgages, the lowest-rated class takes the losses until it is wiped out, then the next
lowest-rated class, and so on up the ladder. In rating RMBS, the rating agencies
principal decision is the level of protection that will justify rating a class
AAA (or AA, or A, and so forth). That comes down to a decision as to how much
padding there should be under each class. Should 5% of the issuance be rated
below AAA, or should it be 5.5%?
In my experience, issuers shopped for ratings,
but that shopping was limited to how much of the issuance would be rated AAA.
The decision was important to issuers because AAA classes fetched higher prices
than lower-rated classes. But as a percentage of the offering, the differences
between rating agencies was small, on the order of tenths of a percent. So in a
$500 million offering, one rating agency might be satisfied with a $24 million
cushion of below-AAA classes while another might want $26 million. A financial
crisis is not made of such differences.
As I said, my experience was with prime and
alt-A RMBS. The ratings of CDOs, which were more central to the crisis, may
have had a different dynamic.
—Stan
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