Home > CDO, derivatives, ratings > Understanding the Underlying: Where do Credit Ratings Come From?

Understanding the Underlying: Where do Credit Ratings Come From?

May 2, 2008

“We’re structure experts, we’re not underlying-asset experts.”

—Moody’s employee

How exactly did the credit rating agencies assign ratings on collateralized debt obligations backed by mortgages? In “Triple-A Failure” in the April 27 issue of the New York Times Magazine, Roger Lowenstein explains in detail how Moodys rated one such issue, which Lowenstein calls “Subprime XYZ”. Lowenstein’s article is notable for the insight it provides into Moody’s ratings process. The ratings agencies were not the only culprit in this crisis, but they played an important role, and the Lowenstein article helps to elucidate that role.

The bombshell in the article is its depiction of the ratings process, which appears mechanistic and uninformed by serious economic analysis of the assets underlying the rated securities. Two quotes from the article are illustrative: “We’re structure experts. We’re not underlying-asset experts,” one employee said. Along similar lines, again from the article and from a different employee: “We aren’t loan officers. Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance [emphasis added], what percent will pay their loans?”

These are remarkable quotes. If you want to know what percentage of a mortgage pool will repay their loans, don’t you need to know what loan officers are doing? If you’re going to use historical default data, don’t you need to know whether loan officers are behaving the same way as in the past? Is history an appropriate indicator for a rapidly ballooning and relatively new asset class? Shouldn’t one consider external indicators of likely housing price changes? Moody’s knew that 43% of the 2,393 borrowers in the mortgage pool had provided no written verification of their income, but the article quotes one of the employees as saying that Moody’s was reassured by the fact that the mortgages were for primary residences: “When you get into a crunch, You’ll give up your ski chalet first.” (Doesn’t that count as an economic analysis of the underlying asset?)  This is not to suggest that Moodys should have visited each house in the mortgage pool, but that they should have been thinking about mortgages as an industry, in this case, one that was in transition.

To top it all off, Moody’s had one day (yes, 24 hours) to rate Subprime XYZ.

It’s not fair to beat up on Moodys just because their ratings on a particular class of structures turned out to have been wrong. Unexpected bad things happen. And it is worth noting that Moody’s traditional bond ratings haven’t (so far) been as off-base as their CDO ratings. The important question is whether Moody’s did a reasonable job assigning the CDO ratings in the first place. After reading Lowenstein’s article it’s hard to conclude that they did.

A colleague who works for a government regulator pointed out that criticizing Moody’s for their “non-economic” default analysis echoes the criticism of audit firms for their failure earlier in this decade to detect corporate frauds. The auditing firms said that their job was to make sure that the numbers added up, not to determine whether the underlying numbers were false. Critics said that the auditing firms were being too mechanistic. The audit crisis catalyzed the Sarbanes-Oxley legislation, which among other things required CEOs to personally certify financial reports. One wonders what Congress and the regulators have in store for the credit rating firms. (If you wonder why Congress is involved at all, seven ratings agencies, including S&P, Fitch, and Moodys, have special status as “nationally recognized statistical ratings organizations” (NRSROs), and this designation gives their ratings regulatory status. If you’re curious, this report explains more.)

I haven’t said anything about the standard criticism of ratings agencies, which is that they are paid by the entities they rate. This creates an undeniable conflict of interest and criticism of this practice is completely justified. The link below to a Floyd Norris column discusses some forthcoming experiments, such as having investors pay the fees.

To think about what the ratings agencies should consider when assigning a rating, suppose that ratings agencies were at least partly paid in the securities they issue. For example, if a ratings agency gives a Aaa rating to an issue, the fee would be entirely payable in units of the issued security, which the ratings agency must then hold for at least 5 years. If the agency gives a C rating, the fee can be paid entirely in cash. For in-between ratings the fee is a combination of cash and securities. The fee would be paid in installments over time and the ratings agency would be permitted to hedge any risk associated with the security except credit risk.

This proposal has its own problems (the payments would have to be structured so that the agencies continued to rate fairly the securities they held), but the thought experiment is nevertheless suggestive. With payment in kind, the agencies almost certainly would find it worthwhile to give more serious thought to the underlying asset.

Related articles:

* In January the Moody’s chief conceded some errors in ratings but defended Moodys. (1/26/2008)
* NY Times columnist Floyd Norris reports on Congress’s look into ratings (4/25/2008)

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Categories: CDO, derivatives, ratings
  1. Jose Etchegoyen
    June 20, 2008 at 3:11 pm

    I agree that Credit Rating failed in assessing the risk of mortgage backed CDOs. However, are we going to blame them for the Credit/Financial System Crisis? Please.

    Around a month ago, the WSJ published an article about Spain’s Real Estate crisis. Two points were very clear about how it is different and thus less severe than that in the US:

    1. The local banking regulation did not allow, like in the US, 95% LTV. On average they were below 70%.

    2. Bankers did not use “creative instruments” to move their loans off balance sheet.

    The latter may be the result of either self consciousness or regulatory pressure. In any case it worked.

    In summary, the responsibility is shared by many stakeholders and I personally believe that a stricter regulatory environment is the main flaw in this history.

  2. RJ Dragon
    June 4, 2009 at 4:49 pm

    I think the credit agencies deserve far more blame than they have received so far for the credit crisis.They were the key “enablers” in the securitization process that spread bad loans throughout the financial system, and the reason banks themselves could throw their credit standards out the window.

    The appropriate standard for a rating agency is “what do the users of the ratings expect?” I think it is clear that most buyers of AAA rated securities believed the rating reflected the fundamental credit worthiness of the securitized portfolio. A money fund manager usually did not examine the underlying mortgage portfolio for credit worthiness, he simply relied on the AAA rating to justify his purchase. So when the rating agencies did not examine the fundamental credit worthiness of the portfolio, they allowed the banks to load their bad loans into these securities with impunity.

    The banks made these loans knowing they would not have to keep them in their portfolio, so they lowered credit standards and chased origination and securitization fees. If the ratings agencies had looked at the underlying credits, this process would have been stopped in its tracks. Instead the rating agencies laundered these bad credits, which allowed the property bubble to inflate to disastrous levels.

    I think your analogy with the accounting profession is spot on. It matters not if the numbers add up if the economic picture they portray is wrong. The rating agencies are rating credit worthiness…they must do the whole job necessary to provide users of their rating with the economic realty of the credits.

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