What was the Role of the Rating Agencies; Why did They Miss the Mark?
No analysis of the subprime debacle can be complete without addressing the culpability of the ratings agencies that routinely gave “investment grade” ratings to securities that were backed primarily by rights in pools of subprime mortgages. Some of these securities have since been significantly downgraded by these same ratings agencies while many other such securities are likely facing such downgrades. How can securities that were granted “investment grade” ratings suddenly become rated as below investment grade or even junk? How can groups of below prime, exotic, junk mortgages that were originated in an overvalued housing market be pooled together and carved up into different securities most of which are given “investment grade” ratings? These questions and others like them demand an answer.
There is little doubt that most investors purchasing MBS/ABS/CDO securities placed significant emphasis on the ratings issued by the ratings agencies. In many cases, investors were required by law, by their operative documents or by reasonable prudence to limit most, if not all, of their investments to “investment grade” securities. Even more fundamentally, the prices that investors paid for these securities and the benefits that they were willing to accept from their investments was dictated by the purported quality of the securities they were buying (it is well accepted that highly rated debt instruments pay lower interest rates than speculative securities and sell for higher prices).
Furthermore, it is apparent that the ratings agencies understood the importance of their ratings to investors and encouraged investors to rely on these ratings. This is perhaps, best evidence by DerivativeFitch advertisement in which it purports to be “Quantifying All Sides of Risk.” In its advertisement Fitch states:
At DerivativeFitch we are committed to analyzing risk from all angles. Our mission is to develop and deliver ratings, productive and timely analysis of the distinct characteristics of CDOs and the credit derivatives market globally. Through our deep understanding of the market and our unmatched commitment to service, we provide the focus, analysis and insight to help you identify and measure risk in a multi-dimensional market place.
Other ratings agencies held themselves out in a similar manner.
Again, it must be asked — how and why did the ratings agencies miss the mark so badly? What caused this to happen?
Our analyses suggest that, at best, the ratings agencies were “reckless” in the issuance of their opinions and, at worst, were participants in assigning inflated ratings to many MBS/ABS/CDO securities. Among other things, the facts indicate the following:
- the ratings agencies were actively participating with and advising the Wall Street underwriting firms in the structuring and construction of the MBS/ABS/CDO securities
- the ratings agencies generated a significant portion of their revenues from consulting on and rating these MBS/ABS/CDO securities.
- the ratings agencies routinely charged two to three times more in fees to rate MBS/ABS/CDO securities.
- the ratings agencies failed to reasonably investigate, analyze and consider various well known risks that impacted the mortgage securities market including:
- the low credit quality of the loans.
- the impact of exotic mortgage loans such as option mortgage loans, negative amortization mortgage loans, “piggyback” mortgage loans, and “teaser” adjustable rate mortgage loans.
- the impact of new and untested mortgage origination techniques, including no-doc loans.
- the existence and implication of a housing bubble in the US real estate market.
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