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First, let's kill all the rating agencies, a reader recently wrote in an e-mail.
That's perhaps a bit Draconian, but there is no doubt that the rating companies -- Moody's (MCO, news, msgs), Standard & Poor's and Fitch dominate the market -- played a critical enabling role in creating this crisis.
And there is no doubt in my mind that unless we "fix" the companies that rate debt and debt-based derivatives, we're just asking for a replay of the current financial catastrophe five years down the road.
In this column, you'll find three ideas for fixing the rating companies. It's the second in a three-part series on the reforms we need to prevent a replay of this crisis. The first part of this series, "Fake inflation numbers masked crisis," ran Dec. 5. The third part is scheduled Dec. 19.
Just how much blame do the big three rating companies -- together they control about 80% of the market for rating debt and the complex derivatives built on debt -- deserve for their role in creating this crisis? Plenty, in my book.
The rating companies were wrong when they gave bundles of mortgages and derivatives based on those mortgages, worth billions of dollars, their highest ratings for safety. These "safe" investments later blew up, sometimes just months after the ratings were issued. And the companies persisted in being wrong for months as the crisis unfolded.
Moody's under the magnifying glass
You can get a sense of the problem by following the track of the downgrades issued by any one of the big three. Here's a partial list I've put together from headlines about Moody's:- April 30, 2007: Moody's downgraded the ratings on 27 pools of mortgage loans created in the previous two years by Lehman Bros. (LEHMQ, news, msgs) because the subprime mortgages in the pools were showing more losses than forecast. The pools were made up of loans initially valued at $14.1 billion.
- July 10, 2007: Moody's cut its ratings on 399 mortgage-backed securities because of higher-than-expected delinquencies in the mortgages underlying the securities. Moody's also put an additional 32 securities under review for possible downgrade. Total value of the debt: $5.2 billion.
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- Aug. 16, 2007: Moody's downgraded 691 mortgage-backed securities because of what the company called "dramatically poor overall performance." The securities were backed by piggyback mortgages. A piggyback mortgage is a second mortgage signed on the same day as the first mortgage to allow a homebuyer to finance 100% or more of the purchase price of a home. The $19.4 billion downgrade represented 76% of all securities rated by Moody's in 2006 that were backed by piggyback mortgages. "These loans are defaulting at a rate materially higher than original expectations," the company said in a news release.
- Oct. 11, 2007: Moody's downgraded an additional $33.4 billion in securities backed by residential mortgages because of higher-than-projected losses in the underlying subprime mortgages. These subprime mortgages were originated in 2006 and represented almost 8% of the dollar value of all securities rated by Moody's in 2006. The company also put $23.8 billion more of securities on review, including 48 rated Aaa, the company's highest rating, and 529 rated Aa. Moody's affirmed the Aaa and Aa ratings on an additional $280 billion in securities.
- April 21-22, 2008: Over two days, Moody's downgraded 1,923 tranches (pieces of securities with, theoretically, different risk and safety characteristics) of subprime securities backed by residential mortgages. The 1,923 tranches were pieces of 232 separate residential mortgage-backed securities rated in 2005-07.
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How strong is the fear?On Dec. 9, investors snapped up Treasury bills paying 0%. Not since 1940 have T-bills paid so little, yet demand was 4 times greater than the supply. The real problem, Jim Jubak says, is that the alternatives aren't any better.
A litany of problems
Anything leap out at you from that partial list?First, how quickly the securities went bad after they were rated. Most of these deals were rated in 2006 -- some in 2005 -- and by 2007 they'd already gone bad.
Second, how many of the securities that went bad received what were supposed to be extremely safe Aaa or Aa ratings. We're not talking about really risky paper turning out to be really risky, as predicted, but supposedly safe paper turning out to be really risky.
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Third, how much really horrible junk Moody's actually rated. There was all that Aaa- and Aa-rated debt that turned out not to be Aaa-safe. But there was also $25.5 billion in securities backed by piggyback mortgages. Moody's later downgraded this junk, but that means the company gave it a high enough rating initially so a downgrade was possible.
Fourth, how frequently the phrase "performed worse than projected" crops up. OK, if you get blindsided by a general market collapse and it takes down your safest Aaa tranches, I can understand that language. But applied to a security based on a piggyback mortgage? How could Moody's have any expectation that this set of securities wasn't a bomb waiting to explode?
And finally, the rating companies were wrong not just because they made a ton of mistakes, failed to understand the deals they were rating and agreed with the prevailing Wall Street belief that any downturn would be limited. No, they were wrong because in recent years they've increasingly built their businesses on selling their ratings to the companies that issue these securities and the Wall Street banks that structure them.
Continued: Where they got their paychecks
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