FOR five months, it has been clear that rising delinquencies and foreclosures, coupled with higher interest rates on adjustable mortgages and declining home price appreciation, would undermine the market for mortgage securities. Yet it took Moody’s Investors Service, Fitch Ratings and Standard & Poor’s, the three leading agencies that rate long-term debt, until this month to react to this looming financial crisis, which involves more than $1.2 trillion of subprime mortgages originated in 2005 and 2006 alone. As one investor asked during a recent S.&P. conference call, “What is it that you know today that the markets didn’t know three months ago?”
The two largest credit rating agencies, Moody’s and S.&P., announced two weeks ago that they are reviewing and lowering ratings on many of the $17.2 billion in residential mortgage-backed securities. They are doing the same for the pools of these loans known as collateralized debt obligations. The effort is, to use a well-worn but apt phrase, too little, too late. But it is not too late for regulators and legislators to take steps to restore investor confidence and to ensure the future of these markets.
The subprime crisis has not been averted. In fact, it is still largely ahead of us. The downgrades represent only a small fraction — about 2 percent of the mortgage-backed securities rated for the year between the fourth quarters of 2005 and 2006 — of what the rating agencies suggest could be a mountain of bad debt held by investors, including pension plans, banks and insurance companies. The agencies are primarily downgrading assets with expected losses that are already working their way through the pipeline. They are not projecting future losses.
Nor do the downgrades apply only to lower-rated securities. Some even relate to the performance of debts that are rated AAA, meaning the agencies judged them to be of the best quality — bulletproof.
The credit ratings agencies play a more important role in debt markets than stock analysts do with regard to equities. No one was told they could buy a certain stock only if, for example, an unscrupulous stock analyst said it was a “buy.” But regulators require banks, insurance companies and pension managers to purchase only high-quality debts — and the quality is judged by ratings agencies.
And the ratings agencies are far from passive arbitrators in the markets. In structured finance, the rating agency can be an active part of the construction of a deal. In fact, the original models used to rate collateralized debt obligations were created in close cooperation with the investment banks that designed the securities.
Fitch, Moody’s and S.&P. actively advise issuers of these securities on how to achieve their desired ratings. They appear to be helping investment banks, hedge funds and fund companies, all of which have a fiduciary obligation to investors, to develop the worst possible product that would still achieve a certain rating.
Only slightly more than a handful of American non-financial corporations get the highest AAA rating, but almost 90 percent of collateralized debt obligations that receive a rating are bestowed such a title. The willingness of Fitch, Moody’s and S.&P. to rate as investment grade many assets that are apparently not has made structured securities ratings their fastest-growing line of business. Are we to believe that these securities are as safe as those of our most honored corporations?
Fitch and Moody’s claim they are not obligated to verify information or “to conduct any investigation or review, or take any other action, to obtain any information that the issuer has not otherwise provided,” as Fitch puts it in its code of conduct. This disclaimer flies in the face of reason and seems to violate the obligations of Fitch, Moody’s and S.&P. as “investment advisers” under the 1940 Investment Advisers Act. It also seems to violate the mandate by securities regulators that rating agencies adopt and enforce written procedures to ensure that their opinions are based on a thorough analysis of all known and relevant information.
S.&P. has stated that it now has reason to “call into question the accuracy of some of the initial data provided to us.” This suggests that S.&P. may have chosen either to merely accept the data offered it by issuers without doing its own due diligence. Or worse, S.&P. could have ignored other information because it might have hurt revenues by reducing the number of assets it could have rated.
The Securities and Exchange Commission, working with Congress if necessary, should require the credit rating agencies to regularly review and re-rate debt securities. Rating agencies are typically paid by issuers and only for initial ratings, which leads to much of the shoddy analysis and questionable timing in the re-rating of securities.
Training and qualification standards for ratings analysts should also be required to help create consistent, objective, transparent and replicable methods. Moreover, rating agencies should put in place automated and objective systems, based on the changing value of underlying assets, to continuously re-rate debt structures.
Lastly, many accountants and government officials endure a “cooling off” period before they can work for a client. A similar delay for ratings analysts would greatly enhance the integrity and independence of the rating process. Right now, nothing stops a ratings analyst from taking a lucrative job at a bank whose deal he has just rated.
Each of these actions would serve the interest of investors large and small, public and private. Unless the government acts, the credit ratings agencies will stand on the sidelines of the coming crisis, doing nothing until it’s already happened.