Credit rating agencies (CRAs) - firms that valued debt instruments/securities in accordance with the ability of debtors to pay back creditors - played an important role at various stages in the 2007-2008 US subprime mortgage crisis that caused the Great Recession 2008-2009. The complicated new securities of "structured finance" used to finance subprime mortgages can not be sold without ratings by rating agencies "Big Three" - Moody Investors Service, Standard & amp; Poor's, and Fitch Ratings. Most debt markets - many money markets and pension funds - are restricted in their regulations to hold only the safest securities - the securities of rating agencies designated "triple-A". Pool debt institutions gave their highest ratings to include more than three trillion dollars in loans to home buyers with bad credit and undocumented revenues until 2007. The three billion-dollar, three billion-dollar property was downgraded to "rubbish" status by 2010, and writedowns and losses totaled more than half a trillion dollars. This led to "destruction or disappearance" in 2008-9 of the three major investment banks (Bear Stearns, Lehman Brothers, and Merrill Lynch), and the federal government bought $ 700 billion in bad debt from a depressed financial institution.
Video Credit rating agencies and the subprime crisis
Impact on crisis
Credit rating agencies are under surveillance following the subprime crisis to provide investment grade, "safe money" ratings for protected mortgages (in the form of securities known as mortgage-based securities (MBS) and collateralized debt obligations (CDO)) based on "non-prime "- subprime or Alt-A - mortgage lending.
Demand for securities is stimulated by a large global collection of fixed income investments that have doubled from $ 36 trillion in 2000 to $ 70 trillion in 2006 - more than global annual expenditures - and low interest rates from competitive fixed-income securities, made possible by policy Low interest rates from the US Federal Reserve Bank for most of the period The high rating boosted the flow of global investor funds into these securities funding the housing bubble in the US.
Ranking is very important for "private-label" asset-backed securities - such as subprime mortgage-backed (MBS) securities, and collateralized debt obligations (CDO), "CDOs squared", and "synthetic CDO" - the "financial engineering" "more difficult to understand and set prices than individual loans".
The more traditional and simpler "prime" mortgage effects are issued and guaranteed by Fannie Mae and Freddie Mac - federally sponsored "companies". Their security is not questioned by conservative money managers. Private non-prime mortgage securities do not consist of loans to borrowers with high credit ratings or are insured by government companies, so publishers use innovations in the structure of securities to obtain higher agency ratings. They collect debts and then "cut" the proceeds into "tranches", each with different priorities in the stream of income debt repayments. The most "senior" tranches highest in revenue priorities - which usually make the most of a debt pool - receive triple A ratings. This makes them eligible for purchase by pensions and money market funds restricted to top-rated debt, and for use by banks that want to reduce the need for expensive capital under Basel II.
The complexity of analyzing debt pool mortgage and tranche priorities, and the position of the Big Three credit rating agencies "between issuers and securities investors," is what "transforms" agencies into "key" players in the process, according to the Financial Crisis Investigation Report . "Participants in the securitization industry recognize that they need to get a favorable credit rating to sell structured products to investors, so investment banks pay a high enough cost to the rating agencies to get the desired ratings."
According to the CEO of the minister of the securitization industry, Jim Callahan of PentAlpha,
"Rating agencies are an important tool for doing that because you know the people we sell these bonds never really have a history in the mortgage business... They are looking for independent parties to develop an opinion,"
From 2000 to 2007, Moody's rated nearly 45,000 mortgage-backed securities - more than half of what was valued - as a triple-A. In contrast, only the top six (private) companies in the United States are ranked.
As of December 2008, there were more than $ 11 trillion in structured financial funds circulating in US bonds market bonds.
CDO
Rating agencies are even more important in removing the parts of SBM that can not be rated triple-A. Although this is a minority of the value of MBS stages, unless the buyer is found for them, it will not be profitable to make security in the first place. And since traditional mortgage investors avoid risk (often due to SEC rules or restrictions in their charter), this less secure part is the most difficult to sell.
To sell this "mezzanine" tranche, investment bankers collect them to form another security - known as collateralized debt obligation (CDO). Although the raw material of this "liability" consists of BBB, A-, etc. tranches, CRA is assessed 70% to 80% of new CDO tranches of three A. 20-30% of the remaining mezzanine tranches are usually purchased by other CDOs, to make so-called "CDO-Squared" securities which also produce triple A tranches by rating agencies. This process is underestimated as a way of turning "rubbish into gold" or "value laundering" by at least some business journalists.
Trust in rating agencies is essential for CDOs for other reasons - their content may change, so CDO managers "do not always have to disclose what's in the securities". This lack of transparency does not affect the demand for securities. Investors "do not buy so much security" because they "buy triple-A ratings", according to business journalist Bethany McLean and Joe Nocera.
Still another structured product is "synthetic CDO". Cheaper and easier to make than the original "money" CDO, these securities do not provide funds for housing. In contrast, synthetic CDO-purchase buyers essentially provide insurance (in the form of "credit default swaps") against a default mortgage. Synthetics "refer" cash CDs, and instead of providing investors with interest and principal payments from MBS tranches, they pay premium payments such as insurance from credit default swap "insurance". If the referenced CDO fails, the investor loses their investment, which is paid as insurance. Because synthetically designates another CDO (cash), more than one - in fact many - synthetics can be made for the same original reference. This doubles the effect if the referenced security fails.
Here again the triple-A rating to the synthetic "big pieces" by ratings agencies is critical to the success of securities. Buyers of synthetic tranche (who often lost their investment) are rarely an analyst "who has investigated mortgage backed securities", are aware of underperforming mortgage underwriting standards, or that payments they receive often come from investors. betting against solvency-backed mortgage-backed security. Instead, "it is someone who buys ratings and thinks he can not lose money."
Downgrades and writedowns
By the end of 2009, more than half of the debt obligations were secured by the value incurred at the end of the housing bubble (from 2005-2007) that rating agencies rated them the highest "triple-A", "disadvantaged" - that it was well written for " garbage "or suffer a" major loss "(ie not only do they not pay interest but investors will not get back some of their principal investments). The Financial Crisis Investigation Commission estimates that in April 2010, of all mortgage backed securities, Moody's has rated triple-A in 2006, 73% downgraded to junk.
Standard mortgage underwriting deteriorated to the point that between 2002 and 2007 approximately $ 3.2 trillion of loans were granted to homeowners with bad credit and undocumented revenues (eg, subprime or mortgage Alt-A) and bundled to MBSs and secured debt securities that received ranking high and therefore can be sold to global investors. Higher ratings are believed to be justified by a variety of credit enhancements including over-collateralization (ie, guaranteed collateral over debt issued), bad credit insurance, and equity investors willing to bear the first loss. But in September 2008, bank writedowns and losses on this investment reached $ 523 billion.
The rating agency downgraded the credit rating to $ 1.9 trillion of mortgage-backed securities from the third fiscal quarter (July 1 - September 30) to 2007 to the second quarter (April 1 - June 30) in 2008. One agency, Merrill Lynch, sold more than $ 30 billion of guaranteed debt obligations of 22 cents at the end of July 2008.
The net worth of financial institutions that have recently-derived securities decreased, requiring the institution to acquire additional capital, to maintain a capital ratio, which in turn often lowers the net worth of assets from institutions above and beyond the low value of the derived securities. Adding to the financial chain reaction is regulatory - governmental or internal - requires some institutional investors to carry only classroom investment (eg, "BBB" and better) assets. The downgrade below means the sale of forced assets and further devaluation.
Maps Credit rating agencies and the subprime crisis
Criticism
After the financial crisis of 2007-2010, rating agencies are under criticism from investigators, economists and journalists. The Financial Crisis Investigation Commission (FCIC) formed by Congress and the President of the United States to investigate the causes of the crisis, and the publisher of the Financial Crisis Investigation Report (FCIR), concluded that the "failures" of the top three rating agencies were "crucial wheels in the wheel of financial collapse" and "the key to the financial crisis". He went on to say
The mortgage-related securities in the heart of the crisis can not be marketed and sold without the seal of their approval. Investors depend on them, often blindly. In some cases, they are obliged to use it, or standards of regulatory capital depend on them. This crisis is unlikely to happen without rating agencies. Their ratings helped the market soar and their downgrade to 2007 and 2008 wreaked havoc on markets and companies. "
US Securities and Exchange Commissioner Commissioner Kathleen Casey complained about the ratings of major rating agencies "mislead the catastrophies", but agencies "enjoyed their most profitable years over the past decade" while doing so. The Economist magazine argues that "it is beyond the argument that rating agencies do a terrible job of evaluating mortgage-related securities before the financial crisis struck."
Economist Joseph Stiglitz considers "the rating agency as one of the principal actors... They are the alchemists who change the securities from the F-rank to the A-rated Banks can not do what they do without the involvement of the rating agencies. "In their book on crisis - All Demons Are Here - Bethany McLean and Joe Nocera's journalists criticized the ratings agencies for continuing" to slap their triple-A [rankings] on subprime securities even as underwriting worsened - and when the housing boom turned into a direct bubble "in 2005, 2006, 2007. Legal action
Dozens of lawsuits involving inaccurate rating claims are filed against rating agencies by investors. Plaintiffs have been included by bond secured debtors (Ohio state for losses of $ 457 million, California state employees of $ 1 billion), bankrupt investment bank Bear Stearns (for a loss of $ 1.12 billion from allegedly "fraudulently published rankings increased for securities "), bond insurers. The US government is also a plaintiff (demanding $ 5 billion in S & P for "misrepresenting credit risk from complicated financial products").
SEC action
On June 11, 2008, the US Securities and Exchange Commission proposed broad legislation designed to address perceived conflicts of interest between rating agencies and structured securities issuers. The proposal would, among other things, prohibit credit rating agencies from ranking on structured products unless information about the underlying assets of those products is available, prohibiting credit rating agencies from the same product structuring they value, and requiring public disclosure of information used by credit rating agencies to rank on structured products, including information about the underlying asset. The last proposed requirement is designed to facilitate a "disguised" rating of structured securities by rating agencies not compensated by the issuer.
On 3 December 2008, the SEC approved measures to strengthen the supervision of credit rating agencies, following a ten-month investigation that found "significant weaknesses in ranking practices," including conflicts of interest.
Description for inaccurate rank
The FCIC Commission finds that the credit rating of agents is influenced by "flawed computer models, the pressure from finance companies paying rankings, incessant drive for market share, lack of resources to do the job despite profits, and no meaningful public scrutiny." McLean and Nocera blame the credit downgrades on "standard erosion, intentional skeptical suspension, starvation for large expenses and market share, and the inability to stand for" investment banks issuing securities.
Competitive pressures to lower standards
Structured investment in securities is a "gold goose" rating agency - in the words of an agency manager. Agencies gained three times as much to assess complex products as for corporate bonds, their traditional business. In addition to the revenue generated for issuing credit ratings, agencies often earn $ 300,000-500,000 and as much as $ 1 million to build structured investment vehicles. In 2007, the business contributed only half of the total revenue ratings and all revenue growth to Moody's - one of the largest agencies. But there is always the danger of losing this tantalizing business. Issuers play three major credit agencies to each other, 'shop' to find the best ratings.
Richard Michalek, former vice president and senior credit officer at Moody, testified to the FCIC that even when they were not aware, "The threat of losing business to competitors... really tilted the balance of an independent referee of risk...." When asked whether investment banks often threaten to withdraw their business if they do not get the rank they want, former managing director of Moody's team Gary Witt told FCIC,
"Oh God, are you kidding? All the time I mean, that's routine I mean, they'll threaten you all the time... It's like, 'Next time, we'll go with Fitch and S & P'
In Standard & amp; The poor rating service of an email sent by post sent by bankers issuing angry security letters on the possibility of revising a security rating backed housing mortgage, told an analyst: "Hearing your judgment could be a 5 notch back of moddys [ sic equivalent, Will kill you.Hope we do moddyfitch [S & amp; P Moody's competitor and Fitch Rating] just... "
Another email between co-workers at Standard & amp; Poor's written before the bubble burst shows an awareness of what will happen to the securities that they rank high for: "The rating agencies continue to make and [sic] even bigger monsters - the CDO market Let's hope we're all rich and retired. at the moment the house is discontinuous. "
Conflict of interest
Critics claim there is a conflict of interest for the agency - the conflict between accommodating a client whose higher debt rating means higher income, and accurately assessing the debt for the buyer's interest in the customer's debt/customers, which does not provide income to the agency. Being a publicly traded firm increases the pressure to grow and increase profits. Of the two largest institutions, Moody's became a public company in 2001, while Standard & amp; Poor's is part of the publicly traded McGraw-Hill Company.
One study of "6,500 structured debt ratings" produced by Standard & amp; Poor's, Moody's and Fitch, found the ratings by the agency "biased in favor of publisher clients who provide agents with more business ratings.This result indicates a strong conflict of interest, which goes beyond disputes among employees.
Inability to spend human resources
While Moody and other credit rating agencies are quite profitable - Moody's operating margin is consistently over 50%, higher than Exxon Mobil or Microsoft's well-known success, and its shares rose 340% between the time the company was split into a public company and February 2007 - bonuses for low non-management by Wall Street standards and employees complaining about too much work.
According to reporters McLean and Nocera.
"The analysts in structured finance work 12 to 15 hours a day, they make a fraction of the salary of even junior investment bankers.There's far more deals in the pipeline than they might handle.He's overwhelmed.Moody's brass... will not increase the staff because they do not want to be stuck with employee costs if their income slows down. "
Moody's Team Manager, Gary Witt complains that "penny-pinching" and "stingy" managers are reluctant to pay experienced employees. "The problem of recruiting and retaining good staff is insoluble.The investment banks often rent out our best people, as far as I can remember, we never allocate funds to make a counter offer We have almost no ability to do meaningful research. " When asked about this by the FCIC, President Moody Brian Clarkson admitted that investment banks pay more than his agency so retaining employees is a "challenge".
Ranking manipulation
Journalist Michael Lewis believes that low-paying credit rating agency employees allow security publishers to play their securities ratings. Lewis quoted one of Goldman Sachs' "hedge fund managers" who told him, "people who can not get jobs on Wall Street get a job at Moody's," because Moody's pays much less. This is despite the fact that employment in Moody - or other rating agencies - gives analysts the power to increase or decrease securities, while higher paid analysts' recommendations in Wall Street investment banks do not have such an impact. market. However, the difference in payments means that the "smartest" analysts in credit rating agencies "go to Wall Street companies where they can use their knowledge (the criteria used to assess securities) to manipulate the companies they used to work on." As a result, it is widely known on Wall Street that the "workings" of rating models used by credit rating agencies, while "official, confidential", "are ready to be exploited." At least one other investment firm that bet against the credit ratings of institutions with great success believes "there are a large number of games in progress."
When asked by the FCIC Commission on "high turns" and "turn-offs that often leave valuers dealing with their old colleagues, this time as clients," Moody's officials say their employees are prohibited from conducting ratings transactions by banks or publishers when they interview for a job with a particular agency, but notifying the management of such interviews is the responsibility of the employee. After getting a job at an investment bank, former employees are prohibited from interacting with Moody's on "the same set of transactions they value while working", but not on other deals with Moody's.
How to "play"
What can new ratings analysts do to show their new company? According to hedge fund manager Michael Lewis talking with who is betting on mortgage effects, there are a number of ways to play or "reverse engineer" the model of the appraiser.
Rating agencies assess the creditworthiness of loans in part by looking at the average credit scores of borrowers who make up the security. They use FICO, "the most famous and most widely used credit score model". The average FICO score should be about 615 for the loan pool to meet the minimum standards of rating agencies and allow maximum percentage of triple-A tranches.
While using the average is less work than getting a list of individual borrower scores or finding a standard deviation from a set of scores, it leaves useful information. A collection of loans consisting of borrowers all with FICO 615 scores is likely to be far less than the same average loan amount but more dispersion - for example from borrowers half of whom score FICO 550 and half 680, because someone who has scored FICO as low as 550 "is almost certainly to default". Knowing this blind spot, securities publishers who can no longer find a large family of FICO-scoring who want to take out a mortgage find another way to increase the average score.
One way is to convince immigrants to buy a house. People who have recently been in the country, often "never fail to pay the debt, because they have never been given a loan". Such people have a very high FICO score if you ignore a brief credit history or "thin file". Rating agencies do, and FICO scores are ignored and personal or household income. Thus, low-income immigrants increase the percentage of pool of loans that can be declared triple-A "and explain if it is impossible to hear a press report from a" Mexican strawberry picker with $ 14,000 in income and no English "to" lend every penny he need to buy a house $ 724,000 ".
Other "opportunities" for issuers that manipulate credit appraisers include
- Moody's and S & amp; P supports "floating rate mortgage with low-rate teasers over fixed-rate mortgages";
- Their lack of interest in "loans has been made in the booming real estate market";
- whether the lender has a 'second silent', ie a second, undisclosed mortgage that leaves the homeowner with no equity in his home and thus no financial incentive does not leave him if the real estate price falls; and
- "fraud implicit in loans without documents".
"The model used by rating agencies is confined to such an opportunity," Lewis said. "The trick is to find them" before other security publishers do it.
Aftermath
In 2006, the Credit Rating Reform Act was passed, intending to destroy the dominance of the "big three" agency - Standard & amp; Poor, Moody's, and Fitch - making it easier to qualify as a "nationally recognized" rating agency.
However, in 2013, McClatchy Newspapers found that "little competition has emerged in assessing the types of mortgage effects of complex homes that led to the 2007 financial crisis." In the 12 months ending in June 2011, the SEC reported that the top three issued 97% of all credit ratings, down only 1% from 98% in 2007. Critics have complained that the criteria for appointing rating agencies as "a national organization of statistical ratings recognized "written by" unidentified officials of one of the top three rating agencies ", and so difficult that" it prevents at least one potential competitor to win approval and has deterred others from even applying ". Former Federal Reserve Chairman Paul Volcker complained in a September 2013 article about banking and the lack of post-crisis financial reform, that "no meaningful reforms are made by credit rating agencies".
In the spring of 2013, Moody and Standard & amp; Poor's settled two "old" lawsuits that tried to hold them accountable for misleading investors about the security of the risky vehicle they were rated. "The lawsuit filed in 2008 and has sought more than 700 million damages.The terms of completion are not disclosed in either case , and lawsuits are dismissed "with prejudice", which means they can no longer be brought in. Other lawsuits are still in circulation until September 2013.
In the dozens of lawsuits filed against them by investors involving inaccurate rating claims, ratings agencies have defended themselves using the First Amendment defense (based on New York Times Co. v. Sullivan) precedents. It maintains a credit rating is a protected opinion as freedom of speech and requires the claimant to prove the actual crime by the agency. However, some wonder if the defense will eventually win.
According to columnist Floyd Norris at least one rating agency - S & P; responding to the credit crunch by first tightening standards and sacrificing market share to restore its reputation, after which it loosened the standard again "to get more business", tripling its market share in the first half of 2013. This is because, according to Norris,
franchises of any value, they must be credible to investors. But once they overcome that minimal hurdle, they will get more business if they are less critical than their competitors.
References
External links
- "Morgan Stanley Plans To Change CDO Down To AAA Bonds", Pierre Paulden, Caroline Salas, and Sarah Mulholland, bloomberg.com , July 8, 2009
Source of the article : Wikipedia
0 Comments