A symbiote’s life is not a happy one: Part 3, who influenced whom?
[Continued from yesterday's Part 2 and the previous Part 1.]
Fueling the rise of subprime lending were complex securities that investors bought in bulk because they had favorable ratings. As suggested by the Wall Street Journal, who rates the raters?
It’s Juvenal to worry about such things
Ratings result from algorithms, data, and judgment. Where’d the raters get their data?
Raters get their data from Mr. Data
As Sherlock Holmes said, in A Scandal in Bohemia, theorizing without data
That phrase should be graven in granite over the lintel of every rating agency, and etched in filigreed copperplate on every offering prospectus.
Underwriters, these people say, would sometimes take their business to another rating company if they couldn’t get the rating they needed.
“It was always about shopping around” for higher ratings, says Mark Adelson, a former Moody’s managing director –
“Come on, all the other agencies will do it with me.”
– although he says Wall Street and mortgage firms called the process by other names, like “best execution” or “maximizing value.”
‘Maximizing value’ sounds so much nicer.
Executives at both ratings firms and underwriters say the back-and-forth stopped short of bargaining over how to construct securities or over the criteria used to rate them. “We don’t negotiate the criteria. We do have discussions,” says Thomas Warrack, a managing director at S&P, which is a unit of McGraw-Hill Cos.
Nothing wrong with pitching endless hours of batting practice, learning exactly where the strike zone is.
It’s right in front of you
He says the communication “contributes to the transparency” preferred by the market and regulators.
If the results of that communication are public … but these pre-rating dialogs were not.
Some critics, such as Ohio Attorney General Marc Dann, contend the rating firms had so much to gain by issuing investment-grade ratings that they let their guard down. They had a “symbiotic relationship” with the banks and mortgage companies that create these products, says Mr. Dann, whose office is investigating practices in the mortgage markets and has been talking to rating firms.
They did. Symbiosis is not necessarily detrimental. Excessive coziness is.
There’s nothing wrong with what we’re doing
In assembling a security such as a mortgage bond, an underwriter first pulls together thousands of loans that will serve as collateral. Before marketing the security, the underwriter slices it into perhaps 10 “tranches” with varying levels of risk and return.
For an extended discussion of securitization, courtesy of the City of
The riskiest tranche has the highest potential return, but it ought to, because the buyer is taking a great risk: This tranche will absorb the first defaults that occur in the pool of mortgages. The next-lowest tranche is the second-hardest-hit by any defaults. Because of this structure, most of the higher tranches traditionally were considered well-enough insulated from defaults to merit investment-grade ratings — in some cases, triple-A ratings.
The process, in a bad market, is like prisoners walking the plank on a pirate ship.
Hyperbolic metaphor there, fellas. They’re not walking, they’re standing on it, and the security is being sliced away bit by bit. And they’re potentially chained together at the ankles.
You mean all my loquacity and erudition is yoked to these two yokels?
The holders of the riskiest securities are at the front of the line and go overboard first. What’s happening in the subprime-mortgage market is that investors further back than many imagined possible are going overboard as well.
Holders of the A debt feel themselves entirely safe … until the B piece holder implodes. Then they are prone to panic.
You bought the A securities and I didn’t!
For the holders of senior securities, the AAA rating convinced them there was negligible chance the plank could be sawn off anywhere near them. The AAA rating bred investor complacency — and also, appetite:
Got any more AAA’s?
Had the securities initially received the risky ratings that some of them now carry, many pension and mutual funds would have been barred by their own rules from buying them.
Notice how the rating agencies are interwoven into the system. Not only have the securities clustered around the minimum standards needed to achieve each rating step, the investment markets themselves have shifted to conform, allowing investments based on ratings criteria as a stand-in for individual risk assessment. Step functions have emerged where before there were continua. In the abstract, and in the long run, these are good things, because human beings are better with digital assessments than analog.
Many money managers lacked the resources to analyze different pools of assets and relied on ratings companies to do so, says Edward Grebeck, chief executive of a debt-strategy firm called Tempus Advisors. “A lot of institutional investors bought these securities substantially based on their ratings, in part because this market has become so complex,” he says.
Precisely — a rating distills complexity into a quantum. That’s huge value — if the distillation is right.
Back in 2000, piggyback mortgages were just one among a handful of new loan varieties that credit analysts were having to evaluate. Until that point, few borrowers used piggyback loans to stretch beyond their means. But lenders began proposing these structures as a way to make homes affordable as their prices rose.
Piggyback loans are inherently riskier than normal on three counts:
- Lending to borrowers who lack the down payment
- Adding to their debt burden
- Creating another layer of finance, which inhibits options
Lack of data — even lack of default history on a small subset — should itself have led the agencies to caution.
Because buyers putting less than 20% down may have less incentive or ability to avoid default, they normally had to buy private mortgage insurance to protect the lender if they fail to make the payments.
The cost of the private mortgage insurance generally undoing the rate benefit of higher leverage.
But as interest rates slid and home prices rose, plenty of lenders were willing to provide a second, piggyback mortgage for all or part of the 20%, without insisting on mortgage insurance.
The market moved, not just in character but also in volume.
We had a little shift in the market
The big mortgage buyers Fannie Mae and Freddie Mac wouldn’t purchase these piggyback deals, which didn’t meet their standards.
Instead, Fannie and Freddie bought securities issued by subprime lenders, making them enablers rather than direct participants.
But Wall Street firms would, because they found they could turn them into high-yielding securities. And there were plenty of buyers for such securities:
Like the GSE’s, among others — probably to their current regret, as they face their own large losses (but unlike private lenders, the GSEs can borrow directly from Treasury).
Data provided by lenders showed that loans with piggybacks performed like standard mortgages.
They performed well — in rising markets! What about falling markets?
The finding was unexpected, wrote S&P credit analyst Michael Stock in a 2000 research note. He nonetheless concluded the loans weren’t necessarily very risky.
Because his data said so — but his data were very limited, and a small sample size.
S&P didn’t let loans with piggybacks completely off the hook. S&P said in 2001 that it wouldn’t penalize a subprime mortgage pool so long as the value of loans with piggybacks didn’t exceed 20% of the overall value.
A prudent limit given that derivative securities are risk moonshine.
Any more than that, and it would impose a rating penalty, S&P said.
As we saw earlier, “rating penalty” translates to “millions of dollars’ less value.”
The firm notes that its assumptions “remained appropriate for several years.”
Earlier, I defended the agencies in spite of themselves; now I must go the other way. Absence of defaults during a remarkable, decade-and-a-half-long run of favorable macroeconomic conditions, is no proof of a good model, any more than one can conclude the roof doesn’t leak because the floor is dry after two weeks of sunny days.
Despite this limit, S&P’s stance was good news for underwriters and lenders.
Throughout this post, we’ve seen the interdependency between rating agencies and mortgage issuers. Changes in one induce changes in the other, as the newer approach to risk migrates up the value chain.
There are risks in swimming upstream
For underwriters, the S&P decision made it easier to create investment-grade securities based on pools of subprime loans.
And underwriters’ appetite for the loans, in turn, made it easier for lenders to originate them.
Got more loans?
Ecosystems are always interdependent. They are also interactive:
Trends then converged to create explosive mortgage-market growth. Falling interest rates — as the Federal Reserve sought to prop up the economy after the tech-bubble burst — made home financing less expensive.
Velocity in financial markets is intrinsically good. A car faces more risks than a walker, but nobody commutes on foot from
New technologies let bankers construct bonds from the payments of thousands of different mortgages.
Markets expand when fertilized with any of the following:
- Improved technology, especially communications.
- Clear rules.
- Expanded and diversified financial products.
Residential finance benefited from all three, and the result was predictable:
The fastest-growing segment was subprime loans.
Nothing is beneath me … but I am beneath you!
[Continued tomorrow in Part 4.]
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