A symbiote’s life is not a happy one: Part 2, the happy duo
[Continued from yesterday’s Part 1.]
In the subprime mess, everybody involved looks somewhere between shady and naïve:
- Aspirant borrowers signed up for loans, often making questionable or few disclosures on their applications
- Mortgage originators booked themselves fees for placing people in loans they would be unable to pay on a reset
- Underwriters sliced them into securitizations, passing along the risk like the Old Maid (as the Economist put it this week), and distilling risk moonshine.
Trust us, it’s pure from the source!
To these unlucky three add a fourth contributor, as hypothesized (but not hypothecated!) by the Wall Street Journal:
S&P, Moody’s Investors Service and Fitch Ratings gave top ratings to many securities built on the questionable loans, making the securities seem as safe as a Treasury bond.
As sound as the government that backs it
Also helping spur the boom was a less-recognized role of the rating companies: their collaboration, behind the scenes, with the underwriters that were putting those securities together.
‘Collaboration’ — another loaded word in this context.
I swear, I never collaborated with the underwriters!
Underwriters don’t just assemble a security out of home loans and ship it off to the credit raters to see what grade it gets. Instead, they work with rating companies while designing a mortgage bond or other security, making sure it gets high-enough ratings to be marketable.
Despite all my instincts, I find myself rising to the rating agencies’ defense. Raters are like the modern Delphic oracle: as long as you can pay the price, you can keep asking the question. So mortgage packagers, who are always seeking the optimal saddle point of highest rating and lowest cost, will ask the same structuring question over and over and over, in exactly the same manner as astronauts or pilots practicing in a simulator before they take the controls for real.
Keep practicing until you find the solution
Keep trying until you find the combination that gives you the best result. That’s not ‘collaboration,’ it’s experimentation, and by itself it’s good rather than bad.
The result of the rating firms’ collaboration and generally benign ratings of securities based on subprime mortgages was that more got marketed.
The ratings have value — big value. Because of the risk curve, an AAA rating is worth money — big money, as shown in the boxed example.
Whenever there are regulatory or capital rules, markets always move right to their edge. That’s good, not bad. AAA and AA ratings become cluster points — products converge on the cluster point, since all things rated the same should be priced the same.
Effective ratings produce a kind of risk standardization, which helps markets.
Securities are graded on a curve
What doesn’t help is the agencies suffer from ratings inflation the way the Ivy League colleges have suffered grade inflation. Allowing financial instruments to get too big for their britches is very dangerous, because paraphrasing Richard Feynmann, “the law of economic gravity will not be fooled.”
The credit-rating firms are used to being whipping boys when things go badly in the markets. They were criticized for being late to alert investors to problems at Enron Corp. and other companies where major accounting misdeeds took place.
Well, they were late.
Yet they also sometimes get chastised when they downgrade a company’s credit.
Come along quietly, now, sir, we’re downgrading your credit
A rating agency’s lot is not a happy one,
The firms say that since first asked to rate securities based on subprime loans more than a decade ago, they’ve done the best they could with the data they’ve had.
“Lack of data is a valid defense, your honor.”
“In that case, learned counsel, should they not have assigned a rating lower than triple-A?”
“The housing market has proven to be weaker than a lot of expectations,” says Warren Kornfeld, co-head of residential mortgage-backed securities at Moody’s.
That’s a different argument. But shouldn’t you have anticipated that markets could go down as well as up?
I didn’t know they went this way
This summer, the firms downgraded hundreds of mortgage bonds built on subprime mortgages. They say those bonds represent only a small part of the subprime-mortgage market.
Translation: Give us a break — we only screwed up a little.
The subprime market has been lucrative for the credit-rating firms. Compared with their traditional business of rating corporate bonds, the firms get fees about twice as high when they rate a security backed by a pool of home loans.
Twice as much reason to be generous, or twice as much work?
The task is more complicated.
Moreover, through their collaboration with underwriters, the rating companies can actually influence how many such securities get created.
Just as a hen is only an egg’s device for making another egg, the rating agencies’ adjudication of the risk levels of various securities imparts a reverse-engineering stimulus to the types and quantities of securities. If the market wants AAA’s, then AAA’s flourish, and the rating agencies’ disinterested evaluation of a myriad of complex financial products becomes critical to maintaining the system’s integrity.
The underwriters, in turn, assiduously tailored securities to meet the concerns of the ratings agencies, say people familiar with the process.
Yep, just barely AAA
Nothing wrong with that, is there?
Though they are supposed to be disinterested, the rating agencies were certainly not uninterested in mortgage debt pools:
Moody’s Investors Service took in around $3 billion from 2002 through 2006 for rating securities built from loans and other debt pools.
That’s a staggering figure. Six hundred million a year in fees for rating the pools!
That’s a lot for rating pools
This “structured finance” — which can involve student loans, credit-card debt and other types of loans in addition to mortgages — provided 44% of revenue last year for parent Moody’s Corp.
That was up from 37% in 2002.
From a minimal share, rating structured financial instruments became Moody’s anchor product. Both Moody’s and S&P jumped in with both feet, rating virtually everything in sight:
By itself that’s fine, but in the lust to rate, did the agencies’ become too friendly with their subjects? Ecosystems create symbiosis; entities that depend upon and support each other’s existence. Symbiotes are an advanced form of meta-organism, with tendencies to allow themselves to be spoon-fed:
When Wall Street first began securitizing subprime loans, rating firms leaned heavily on lenders and underwriters themselves for historical data about how such loans perform.
Data … mmmm, data
It’s not far from the well-tended symbiote to the fellow traveler, the keiretsu, or the cartel
[Continued tomorrow in Part 3.]
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