29 August 2014

The Role of the Credit Rating Agencies

   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.


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