Credit Slips highlighted a recent Hudson Institute paper by Joseph Mason and Joshua Rosner, “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions.”
It’s an excellent piece of work, and I recommend it to anyone who wants to understand more about the risks of mortgage backed securities and CDOs. It also paints a particularly damning picture of the role of ratings agencies, worse than anything I have seen so far (and the Financial Times has had some articles that were pretty jaundiced). Not only are the rating agencies playing a hopelessly compromised role (they are involved in the structuring of various asset backed securities, and have become increasingly dependent on fees from investment banks whose very products they are rating), but quite a few of their practices are difficult to defend. For example:
1. When rating agencies change the models they use for rating various types of MBS and CDOs, they apply them only on a going-forward basis. They do not re-rate older vintage deals in light of their supposedly better understanding
2. The models have omitted inputs that one would consider basic. The paper notes:
Even in the existing data fields that the agency has used since 2002 as “primary” inputs into their models they do not include important loan information such as a borrower’s debt-to-income (DTI), appraisal type and which lender originated the loan.
3. The agencies appear to deliberately delay in updating their assumptions if they would lead to downgrades. One illustration:
Fitch staff were asked about the home price assumptions they are assuming. After several participants pressed them on the issue a Fitch respondent stated that they assumed a mid-single digit HPA. This is in stark contrast to fourth-quarter median home price data for 2005 and 2006 which “confirms a national home price correction has been under way, with the U.S. median home prices down 2.7%.
While this information isn’t pretty, it’s in line with what many of us knew or suspected. I take it as a sign of the authors’ disgust that, in a digression from the thrust of the article, they dispute the rating agencies’ contention that they are merely journalists (and therefore exempt from liability for what they produce) and argue that the rating agencies may be underwriters and therefore subject to securities liability.
But the writers find more fundamental, and troubling problems with the agencies’ role. In a section of the paper that gets a bit mathy, they demonstrate that the ratings methodologies used by the agencies, which were developed for corporate issuers, have imbedded assumptions about the distribution of outcomes that are inappropriate for mortgage securities. As a result, the system is hard wired to produce late downgrades.
It gets worse. Although CDOs have grown quickly in a very few years, even in that short span the market has been volatile. It dropped substantially in 2001-2002 period. In addition, CDOs buy whatever debt securities are fashionable (for instance, they were active in manufactured home paper until that turned a cropper, and they have never gone back to it).
Why does CDO appetite matter? Because they have become fundamental to the mortgage issuance process:
Because the 90 percent of higher-tier (senior) securities in an MBS cannot be sold without selling the 10 percent of lower-tier (junior) securities first, even a small decline in CDO funding of mezzanine MBS investments relative to the total MBS market can have a large effect on MBS funding, and therefore consumer mortgage funding.
Mind you, I am only skimming the surface of this thorough and well researched work. It also discusses how mortgage pools are not diversified, how CDO managers are replacing mortgages that are pre-paid with crappier paper, how the rating agencies have built statistical models for ABS paper that rest on ratings models that are also statistical, and have not considered the correlations between them, plus other juicy stuff.
The policy recommendations are astute:
The potential for prolonged economic difficulties that also interfere with home ownership in the United States raises significant public policy concerns. Already we are witnessing restructurings and layoffs at top financial institutions. More importantly, however, is the need to provide stable funding sources for economic growth. The biggest obstacle that we have identified is lack of transparency. The structural changes noted in our previous draft largely went unnoticed by MBS investors until only recently. We argue that those changes went unnoticed largely because of the existing complexity and valuation difficulties underlying today’s MBS markets.
But policymakers and ratings agencies are still reluctant to examine some of the key frictions that have caused the present mortgage mess.
Congress is calling for increased loan mitigation without thought to the vast heterogeneity in mitigation standards existing in today’s market nor a sound analysis of best practices in the field.
While the mortgage industry is pulling back from high LTV products, which makes perfect sense in an economic climate with little home price appreciation, many are pushing to expand the high-LTV sector, even with little hope of owners building equity to incentivize repayment, much less any limit to limit cash-out refinancing that arbitrage the mortgage interest tax deduction and erode the buildup of equity on government-insured mortgage products.
Some are even proposing bailouts for overextended borrowers, ignoring the approximately half of U.S. homeowners who own their homes outright through their own sweat, perspicacity, and prudence.
And there is still no focus on monitoring bank funding markets. The feared outcome is nothing more than a 21st century bank run, this time from CDO investors rather than depositors. High yields in MBS in the past several years led to a massive infusion of CDO “hot money” into the MBS sector in an environment similar to that of the thrift crisis of the late 1980s. Like the thrift crisis and its aftermath, therefore, recent events not only threaten these institutions, but also threaten the U.S. consumer and taxpayer as well.
Perhaps of greater concern is the reputational risk posed to the U.S. capital markets—markets that have historically been viewed as among the most transparent, efficient, and well regulated in the world. The economic value of mortgage securitization and the risk transfer value of CDO issuance support their further use. However, there should be significant resources allocated to building the regulatory framework surrounding their structuring, issuance, ratings, sales, and valuation. We believe that efforts to provide transparency to these new product areas can foster stability while maintaining liquidity to the underlying collateral sectors and supporting further meaningful financial innovation and capital deepening.
At present, even financial regulators are hampered by the opacity of over-the-counter CDO and MBS markets, where only “qualified investors” may peruse the deal documents and performance reports. Currently none of the bank regulatory agencies (OCC, Federal Reserve, or FDIC) are deemed “qualified investors.” Even after that designation, however, those regulators must receive permission from each issuer to view their deal performance data and prospectus in order to monitor the sector.
Significant increases in public access to performance reports, CDO and MBS product standardization, and CDO and MBS securities ownership registration can help decrease the existing over-reliance on ratings agency inputs to rate and ultimately value the securities and reducing the valuation errors inherent in “marked-to-model” (rather than marked-to-market) portfolios. SEC Regulation AB was a (late) start for ABS and MBS. Overall, however, the U.S. economy needs an efficient public CDO market that allows transparent open-market pricing of market risk and outside research into new securities and funding arrangements. U.S. homeowners and consumers deserve stable and efficient funding to support their pursuit of the American dream.
The paper’s conclusion:
In summary, the structural changes in mortgage origination and servicing have interacted with complex RMBS and highly volatile CDO funding structures to place the U.S. housing market at risk. Equally as important, however, is that housing market weaknesses feed back through financial markets to further weaken financial instruments backing today’s CDOs. Decreased housing starts that will result from lower liquidity in the MBS sector will further weaken credit spreads and depress CDO and MBS issuance. This feedback mechanism can create imbalances in the U.S. economy that, if left unchecked, could lead to prolonged domestic economic implications for U.S. standing in the world economic order.
Unfortunately, the ratings agencies know that the mood of the SEC and the federal courts is strongly against interpreting liability under the securities laws to include so-called secondary players like ratings agencies, lawyers, accountants, etc. Even the underwriters got off lightly recently in the anti-trust lawsuit that was heard by the Supreme Court. Today’s hearings in the House about the SEC might touch on the issue.