Rating Agencies: Head in the Sand

I am at a loss as to which allusion better characterizes rating agency behavior: ostriches, as per the headline, or monkeys, as in “See no evil, hear no evil, speak no evil.” But in each case, I think I am being unfair to the animals.

I happened to miss skip past an article in Friday’s Financial Times, “Rating Agencies Under Scrutiny,” on the incorrect assumption that it covered familiar ground. While much of it did indeed recap old news, it had an eyeopener:

One revelation that analysts have described as “extraordinary” this week is that S&P has no specific estimate of how much turmoil in the housing market would be needed to force downgrades of the AAA and AA ratings that have been left untouched in this round of downgrades and constitute the bulk of the principal value of most mortgage-backed deals. Moody’s also said in an interview that it had no such estimate.


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  1. Anonymous

    I happen to work at a rating agency, but I will clarify right now that i do not work in RMBS or in the CDO group. However, I am very familiar with these structures and I think you’re being a bit maverick.

    I don’t know what exact context the quoted analyst at S&P was speaking to, but I can easily see how that could have been misinterpreted. Many of these securities—especially CDOs—are very unique in both structure and in the nature of the underlying assets, resulting in securities characterized by idiosyncratic risk. This makes any answer to a question like that impossible without placing a confidence band around your reply that renders it useless.

  2. Yves Smith

    Actually, I beg to differ with you. Rating agencies have presented their ratings as meaning the same thing across all types of credit products. Yet as pointed out in considerable detail in a paper “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions,” by Joshua Rosner and Joseph Mason. (paper here http://hudson.org/files/publications/Hudson_Mortgage_Paper5_3_07.pdf, our discussion of it here http://www.nakedcapitalism.com/2007/06/worries-on-valuing-repackaged-debt.html), the ratings scheme used by rating agencies, which was developed for corporate debt, does not translate well at all to MBS.

    The rating agencies can be quite specific as to what would lead to a downgrade of an AAA or AA rated corporate bond. The fact that they cannot say so with a CDO says they have mislead investors about what a rating for those instruments means. As the paper describes in gory detail, the methodology used for rating corporate securities has been misapplied to mortgage backed instruments, which inherently leads to more frequent and bigger downgrades.

    If the rating agencies had defined a different sort of AAA rating, say a “CDO-AAA” and defined what that meant, your point would be valid. But your very statement actually proves the validity of the comment you found objectionable. If these instruments have so much embedded leverage that their behavior is “idosyncratic,” then issuing conventional ratings is inappropriate. You can’t have it both ways.

    If you are inclined to reply, I suggest you read the Rosner/Mason paper first. Otherwise, we will be talking past each other.

  3. Anonymous

    I will certainly reqd it. I know full well that ratings are intended to map to specific meanings, sick as EL, I was speaking to the way in which the housing market could have a larger effect on, say, a bond structured with entirely sumorime collateral with a one AAA tranche versus a bond with significant prime collateral with a AAA and a super senior AAA.

    Don’t mistake my comment as overly defensive, there are some wrong ratings out there, and as the information flows in corrective action will be taken. Excuse grammar I am on a BB.

  4. Yves Smith

    Thank you. And apologies if I sounded a bit sharp. It is easy to attribute tone to online writing when it may not have been intended.

    In fairness, the agencies may not have realized back when they started rating MBS that their behavior would be sufficiently different so as to stretch the meaning of the ratings. As you go incrementally down a path, it’s hard to step back and see how the all those changes have added up (and even if they did recognize it, it might have been deemed too disruptive to implement a different regime for MBS after the product was established). And as you know full well, these instruments have gotten plenty hairy over time.

  5. Anonymous

    Cheers. You are likely right there. We all know full how well models work that rely on historical data to generate probability distributions, but our methodologies are inline with those used by other market participants.

    Although some blaim does lie tith the rating agencies, my view (which is likely biased) is that the originators are ultimately to blaim. The rating groups currently taking blaim could not foresee the extent to which underwriting standards slipped in the mortgage industry last year until it was too late.

    However,I see how we would make an easy target.

  6. a

    “…our methodologies are inline with those used by other market participants…”

    Now I feel better. “Street practice” is the ultimate justification for anything.

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