Credit Crisis 101: Blame the credit-rating agencies
As the great credit crisis of 2007-2008 finally begins to lose steam, most people still don’t understand what the heck happened. For good reason. It’s confusing stuff. The terminology is complicated. The people aren’t well known. The pieces move around quickly.
To the rescue comes Roger Lowenstein, author of When Genius Failed and, significantly, a fine article in this past weekend’s New York Times Magazine. In a nutshell, Lowenstein explains methodically, and in some of the simplest declarative sentences you’ll find written in business journalism, how conflicts of interest at the credit-rating agencies — Moody’s (MCO), S&P (MHP) and Fitch — misled investors in mortgage-backed securities.
The conflict is straightforward, and I’ve written about it here before: The agencies make most of their money from fees paid by bond issuers and their banks rather than from the investors who rely on the ratings. Lowenstein neatly dismisses the credit agencies’ explanation that they did the best they could with the information they had at their disposal. In a pivotal passage, Moody’s walks readers through an actual portfolio of subprime mortgages that was packaged by an investment bank and rated by Moody’s. The actual names are obscured as “Subprime XYZ,” which is how Moody’s was willing to share the illustrative example with Lowenstein. Consider this passage:
The loans in Subprime XYZ were issued in early spring 2006 — what would turn out to be the peak of the boom. They were originated by a West Coast company that Moody’s identified as a “nonbank lender.” Traditionally, people have gotten their mortgages from banks, but in recent years, new types of lenders peddling sexier products grabbed an increasing share of the market. This particular lender took the loans it made to a New York investment bank; the bank designed an investment vehicle and brought the package to Moody’s.
Moody’s assigned an analyst to evaluate the package, subject to review by a committee. The investment bank provided an enormous spreadsheet chock with data on the borrowers’ credit histories and much else that might, at very least, have given Moody’s pause. Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs — “teaser” loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble — lending on the belief, or the hope, that new money will bail out the old.
Moody’s learned that almost half of these borrowers — 43 percent — did not provide written verification of their incomes. The data also showed that 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside. That suggested a risky degree of concentration.
On the plus side, Moody’s noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. “That was a comfort feeling,” Robinson said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, “You’ll give up your ski chalet first.”
This shows Moody’s understood full well that the mortgages were all subprime. This means
that, by definition, the mortgage holders had inferior credit, and that a giant percentage didn’t supply documentation to back up their income claims on their mortgage applications. Moody’s and others say they were victims of fraud. Yet they’ve admitted to Lowenstein that they were willing victims of fraud. A final note to Claire Robinson, the veteran Moody’s executive quoted at the end of that passage: People who can’t afford prime mortgages typically don’t have ski chalets.
It’s worth taking a step back here and asking what can be done about the conflict. I met Monday with Bill Hambrecht, the founder of the old Hambrecht & Quist [now part of JPMorgan Chase (JPM)] as well as his current firm, the dutch-auction promoter WR Hambrecht + Co. He told me it’s not simply that the ratings agencies curry favor with the banks. It’s also that the analysts at the agencies, who might make in the neighborhood of $100,000 a year, cozy up to the bankers they meet with because they’re interested in going to work for the banks, where they can earn a lot more money. Hambrecht’s solution: Empower the government to rate bonds, especially if the government requires certain kinds of fund managers to own only officially-rated bonds. Lowenstein, by the way, comes to essentially the same conclusion, though he doesn’t directly advocate a government-run ratings regime.
These companies are facing regulatory wipeout. Were the acting with criminal intent or were they just incompetent? Either way they are damaged goods.
My two cents: nothing is free. Who is going to pay for this new proposed Government agency’s employees to perform research and analysis to issue quality ratings if this same agency is going to issue ratings for free? Tax hike anyone?
Ok, let’s not raise tax that much to anger the voters, let’s keep the cost of running this Govt rating agency low by not paying the analyst as much — more incentives for these same analyst to cozy up to the bankers…
IMHO, this problem cannot be solved by simply finding another agency to issue ratings, government ran or not. Now, I’ll go back to reading all the other great ideas of solving this problem.
So, would you say that the Rating Agencies and the banks were in this scam together to package these loans and sell them as AAA? There were definitely monetary reasons for this to happen so, motive can be established. It seems so obviuos that this actually took place. Somehow, if anyone knows exactly how please respond, how they are able to pull the wool over the Fed’s eyes? Maybe buyers of these “bundled” assets should have let the bread rise, in other words give the asset some time to prove itself(positive/negative) regardless of the rating. Contrary, how can you hold the Rating agency accountable and not the bank/mortgage company for approving these loans in the first place? The banks response: the customer approved, signed on the dotted line and they are responsible not us.(New reg. needed)That seems to get them off the hook, somehow? So, the question should not be who was responsible for this mishap but who made all the profit on this “easy money”. The Rating agency definitely should have more oversight when rating financials and more regulations are definitely needed for the disbursement of this “fiat” money in general. In closing the mortgage company/bank that sold the “AAA” rated asset at 6% guaranteed 12% or more return at maturity to the buyer that “trusted” the AAA rating. Can the buyer file suit against the rating agency for negligence now that they are blaming the bank for fraud? Isn’t it the rating agencies responsibility to make sure the securities are indeed AAA+? Some many questions but no one wants to take responsibility, pretty sad. Maybe it really was a pre-conceived idea….to be continued.
Here is another alternative for rating agency agency regulation:
We propose the adoption of “equivalent disclosure” rules for issuer communications with Nationally Recognized Statistical Rating Organizations (NRSROs).
Equivalent disclosure would require an issuer, or person acting on its behalf, to disclose material nonpublic information to all NRSROs if it discloses that information to one NRSRO.
The institution of equivalent disclosure would strengthen financial markets by ensuring that all NRSROs have adequate and equivalent information from issuers upon which to base their credit analysis.
We are not proposing that issuers be required to share material non-public information with all market participants as is embodied in Reg FD. We are proposing a more narrow application to the credit markets.
Issuer disclosure would be required to all NRSROs that rate securities in the specific asset category (as outlined in the Credit Rating Agency Reform Act of 2006 and the SEC Final Rule) for which the issuer has securities outstanding.
This broadened disclosure will increase the volume of information available to NRSROs and help unbind a market that has relied on the opinions of creditworthiness from a very small group of credit rating agencies.
This proposal does not alter the ability of NRSROs to have any form of business model that they choose. Issuers can continue to pay NRSROs to rate their securities.
Issuers may likely continue this practice because of the bundle of services offered by the NRSROs to market participants.
Fitch, Moody’s and Standard & Poor’s have satisfactory track records in predicting defaults but current events in the credit markets suggest that a broader array of opinions from more NRSROs would be useful for the integrity of the markets.
We are currently expecting too much from a small handful of firms to provide timely, aggressive, and consistent credit analysis for the entire universe of fixed income securities.
The Credit Rating Agency Reform Act of 2006 creates a new framework for rating agencies to become NRSROs but the important problem of information asymmetry from issuers to the NRSROs persists. The adoption of equivalent disclosure will go a long way to improve the current shortcomings in the credit markets.
It would beneficial for investors to have a wide variety of NRSROs providing credit analysis. We believe a wealth of credit rating firms will only come about when there is a wealth of information from issuers.
I don’t think analysts will stop “cozy up to the bankers” just because the rating is done by the government.
Make the government rate securities (for free I guess) would eliminate the conflict of interest, but like with most solutions eliminating one problem just creates new ones.
Since the government would be doing the ratings for free; there is no incentive of the government to rate non standard bonds (less inovation). Also, ratings would be have less quality; since, the government does very little well. I can’t think of anything that has worked better after the government took control.
The last time I checked the Post Office,Amtrack, Schools(Not all of them),Social Security(Not Broken Yet) are mostly fine. However, the decisions of the rating agencies have led to recessions,layoffs and inflation.
Yes, We want the Govt. to step in and decide the ratings from the private agencies.
He wants the same entity that manages the post office, Amtrack, our schools, and social security to oversee bond ratings? Crrrrrrraaaaazzzzy.
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Wall Street watchers think of capital markets and financial players out west as being on the "other" coast. That's not how it's viewed in the Pacific time zone. From the venture capitalists of Sand Hill Road to the bond kingpins of Orange County to the corporate finance department at a certain software company in Redmond, Wash., there's plenty going on "out there." Adam Lashinsky should know. A native of Chicago, he has covered West Coast finance for a decade, with an emphasis on money matters in Silicon Valley. If it involves money and it's happening west of the Mississippi, look for it in Go West. 
First of all Harry,
The post office is no longer under Federal ownership, has not been for many years. The main reason stamps have gone up so much.
Schools, have you lost your mind!! We are last in the industrialized world in education. Geez, probably the stupidest post i have read in years. The liberals have controlled public education since 1962 and the results are a disaster. Our kids our lazy bums because the public schools insist on implanting socialized crap in their brains instead of math and science.
Amtrac that is a joke too. Currently two routs are profitable, west coast Seattle to SF and the Ne corridor, DC to Boston. The system has generated exactly one profitable year in almost 40.
Sure, the government should stick to what it does best, building B1 bombers, only one crashed in the 20 years of its existence. Also make plenty of weapons, that is what the US is good at.