Ratings Firms Defend Assessment of Loan Securities
Tuesday, August 28, 2007
For months, securities backed by risky mortgage loans have been in trouble. Now, the credit-rating agencies that once blessed those securities as safe investments are in trouble, too.
The stock of Moody's Investors Service, one of the major raters, is down about 40 percent from its 52-week high on heavy trading. Members of Congress are calling for hearings and more oversight of the rating firms. And institutional investors and industry observers have blamed the agencies for being months late in downgrading a slew of residential-mortgage-backed securities that soon imploded, prompting hedge funds to collapse, foreign governments to intervene and mortgage firms to lay off tens of thousands.
"This is akin to a slow-moving train wreck," said Sean Egan, managing director and co-founder of Egan-Jones Ratings, a Haverford, Pa., rating firm, who has been a vocal critic of the three rating firms that dominate the field -- Moody's, Standard & Poor's and Fitch Ratings. Egan noted that the major rating agencies faced similar criticism when they maintained solid, investment-grade ratings until just weeks before WorldCom collapsed in 2002.
"We've seen this movie before," he said.
In response to the latest vitriol from investors and Wall Street analysts, the big three raters have moved in recent weeks to restore confidence in their work even as they maintain that they acted appropriately and on time. They have adjusted how they rate bonds and other financial instruments; generated a series of new reports about the market; and staged teleconferences to assuage investors hammered by the deterioration in subprime loans, which are made to borrowers with weak credit histories.
The rating firms are paid to rate bonds and other securities issued by banks and other financial institutions. The ratings are a kind of report card, with a top score of Aaa at Moody's, to give investors an idea of the creditworthiness of an investment, or the likelihood it may default.
What is less understood is how the agencies rate more complex securities, such as those backed by a pool of home loans. An underwriter, like a bank, assembles a pool of mortgages and divides them into "tranches" or levels, with different degrees of risks and returns. Investors buy those securities, banking on the underlying assets in the pool -- the monthly loan payments of the mortgage borrowers. The higher the risk, the better the potential return. The rating agencies grade the various tranches, part of a fast-growing line of business called structured finance.
The housing boom in 2005 created a huge market for subprime loans and for securities backed by such risky mortgages. But those loans began to unravel about a year ago. The first signs: borrowers defaulting on their mortgages. Things worsened by the fall. "The rating agencies themselves for a year were putting out warning signs . . . significant reports highlighting the risks, and yet they weren't downgrading," said Joshua Rosner, managing director of Graham Fisher & Co., a New York financial research firm for institutional investors. He said the raters, in effect, were "wearing blinders."
Rosner said that part of the problem is that the raters were acutely aware of their power in the capital markets and hesitated to downgrade securities backed by subprime loans. "They were afraid their actions themselves could roil already weak markets," he said.
The other problem, he said, is that the big three credit raters are paid by the very firms they rate. Scholars in the field have frequently noted what they consider this inherent conflict of interest in the raters' business model. After decades of inaction, Congress last year passed a credit rater law to foster competition and enhance regulatory oversight.
In the case of securities backed by mortgages, the raters have an even closer relationship with the entities they rate, say those familiar with the business. They say raters advise financial institutions about how to put deals together. "In fact, they go back and forth to get the desired tranched rating," Rosner said.
The raters say they do not play a role in structuring such deals. And they say they have not made a secret of the fact that they are paid by the issuers they rate. (Rival Egan-Jones is paid solely by institutional investors.) In addition, they say that their ratings are not compromised by that relationship and that they would not jeopardize their reputation. Analysts, they also note, are not compensated based on the level of ratings they issue.