Key credit rating agencies are coming in for more flack, with various media — including Bloomberg, the FT and the Wall Street Journal in the last two days – focusing on the agencies’ role in fuelling, or even triggering, the current market upheavals.
In an article headlined “Moody’s, S&P lose credibility on CPDOs they rated”, Bloomberg on Tuesday says that Moody’s and Standard & Poor’s, “arbiters of creditworthiness”, are losing their credibility in “the fastest growing part of the bond market”:constant proportion debt obligations.
The ratings firms last month gave a new breed of credit derivatives triple-A ratings, “indicating they were as safe as US Treasuries”, reports Bloomberg. “Now, investors are being offered as little as 70 cents on the dollar for the CPDOs”, which use credit-default swaps to speculate that companies with investment-grade ratings will be able to repay their debt.
The FT, meanwhile, examined growing doubts among investors and analysts about the reliability of agencies’ ratings in July, and on Wednesday, reports on growing problems for the firms in the field of structured investment vehicles. SIVs, SIV-lites and conduits all make money through one basic principle – funding higher yielding, long-term investments or lending with very cheap, very short-term ABCP issued mainly off-balance sheet, it explains.
Moody’s, in a note in late July, described SIVs as “an oasis of calm in the subprime maelstrom”. “But, since then, there has been a large-scale rush for the exits in the asset-backed commercial paper (ABCP) markets that fund these and similar vehicles,” notes the FT.
This placed huge strain on the banks that pledge back-up liquidity to SIVs and bank-run asset-backed conduits.
That strain emerged as the main driver behind the recent panic in the global overnight money markets that forced central banks to intervene and provide liquidity.
“For many of these vehicles, all of their funding must be rolled over, or renewed, on average every one and a half to two months.
“The differences between these programmes lie in the kind of triggers that can force them to sell assets and how much support they have from sponsoring banks.
It remains unclear exactly which kinds of vehicles are facing the greatest difficulties. “What is clear,” says the FT, “is that all these operators are being forced to pay more for what funding they can get”.
It is also clear that SIVs are hardly the “oasis” described by Moody’s.
The Journal, meanwhile, examines the role of the agencies in triggering the subprime lending crisis, starting with S&P’s decision in 2000 on “an arcane corner of the mortgage market”. S&P said that “a type of mortgage that involves a ‘piggyback’, where borrowers simultaneously take out a second loan for the down payment, was no more likely to default than a standard mortgage,” reports the Journal.
While its pronouncement went unnoticed outside the mortgage world, piggybacks soon were part of a movement that transformed America’s home-loan industry: a boom in “subprime” mortgages taken out by buyers with weak credit.
Six years later, S&P reversed its view of loans with piggybacks. It said they actually were far more likely to default. By then, however, they and other newfangled loans were key parts of a massive $1,100bn subprime-mortgage market.
“Today that market is a mess,” says the Journal. “As defaults have increased, investors who bought bonds and other securities based on the mortgages have found their securities losing value, or in some cases difficult to value at all. Some hedge funds that feasted on the securities imploded, and investors as far away as Germany and Australia have suffered. Central banks have felt obliged to jump in to calm turmoil in the credit markets.”
“It was lenders that made the lenient loans, it was home buyers who sought out easy mortgages, and it was Wall Street underwriters that turned them into securities.
“But credit-rating firms also played a role in the subprime-mortgage boom that is now troubling financial markets. S&P, Moody’s and Fitch Ratings gave top ratings to many securities built on the questionable loans, making the securities seem as safe as a Treasury bond.”
Further spurring the boom was a less-recognised role of the rating companies: their collaboration, behind the scenes, with the underwriters that were putting those securities together.
“Underwriters don’t just assemble a security out of home loans and ship it off to the credit raters to see what grade it gets. Instead, they work with rating companies while designing a mortgage bond or other security, making sure it gets high-enough ratings to be marketable,” reports the Journal. The result of the agencies’ collaboration and generally benign ratings of securities based on subprime mortgages, it adds, “was that more got marketed”.
The Journal, like the FT and others, says the credit-rating firms “are used to being whipping boys when things go badly in the markets”. “They were criticised for being late to alert investors to problems at Enron and other companies where major accounting misdeeds took place. Yet they also sometimes get chastised when they downgrade a company’s credit.”
This summer, the firms downgraded hundreds of mortgage bonds built on subprime mortgages. But they say those bonds represent only a small part of the subprime-mortgage market, says the Journal.
The subprime market has been lucrative for the credit-rating firms. Compared with their traditional business of rating corporate bonds, the agencies get double those fees when they rate a security backed by a pool of home loans. The task is more complicated. Moreover, through their collaboration with underwriters, the rating companies can actually influence how many such securities get created, explains the Journal.
Moody’s took in around $3bn from 2002 through 2006 for rating securities built from loans and other debt pools. This “structured finance” – which can involve student loans, credit-card debt and other types of loans in addition to mortgages – provided 44 per cent of revenue last year for parent Moody’s Corp, up from 37 per cent in 2002, notes the Journal.
Perhaps that is why the agencies have been so slow to adjust their standards. The Journal says that S&P, back in April 2006, said it would raise the amount of collateral that underwriters must include in many new mortgage portfolios – in recognition that a larger number would go bad.Still, S&P didn’t lower its ratings on existing securities then, reports the Journal, saying it had to further monitor the performance of loans backing them – and thus helping the market for these loans hold up through the rest of the year.
In March 2007, S&P said it expected home prices to stagnate this year but grow 3-4 per cent in 2008. By early July, S&P had lowered this forecast, saying its chief economist projected that home prices would fall 8 per cent from the 2006 peak to a trough in the first quarter of 2008.
Defaults and delinquencies rose. Hard-pressed borrowers found it harder to get a new loan to bail them out or to sell their homes to pay off the loans. By July, almost a third of the loans in Washington Mutual’s subprime pool were delinquent or in foreclosure. This performance, much worse than what credit-rating firms had expected, forced Moody’s and S&P to slash their ratings on several securities backed by those loans. On some, S&P cut an initial A-minus investment-grade rating by five notches, to a below-investment-grade BB.
The downgrading, starting late last year, became an avalanche this summer. On July 10, Moody’s cut ratings on more than 400 securities that were based on subprime loans. S&P put 612 on review, and downgraded most two days later. The moves jolted financial markets and prompted some investors to criticise the ratings firms for misjudging the market.
The firms said that the soaring market of 2005-06 had reduced the relevance of their statistical models and historical data.
S&P, Moody’s and Fitch Ratings have since repeatedly toughened their ratings methodology for new subprime bonds, requiring significantly bigger cushions. They now assume more and quicker defaults among pools of loans, especially those with piggybacks, notes the Journal.The changes have had an effect. About 27 per cent of loans made in the first quarter of this year had piggybacks attached, down from 35 per cent a year earlier, according to S&P research. Overall, issuance of subprime-mortgage bonds is down 32.5 per cent this year through June, according to Inside Mortgage Finance. That is resulting in lower Wall Street profits and tighter lending standards for consumers.
Now, US congressional committees are broadly examining the mortgage market, as are various state and federal agencies. It’s not clear whether ratings firms will become a focus of the inquiries but at this point, it may be fair to conclude that they should be.