How Ratings Agencies Fool Investors
The Wall Street Journal today has another excellent front page story, describing how the ratings industry has fueled the current mess. One might think that the ratings industry would be an impartial arbiter of financial strength, but, in reality, companies pay the ratings agencies. If a company does not get a welcome rating, they take their business elsewhere to get a more favorable rating. Because the ratings agencies making their living by giving ratings, the companies have an incentive to rubber stamp these securities as financially sound. Here are some extracts from the article.
Lucchetti, Aaron and Serena Ng. 2007. “How Rating Firms’ Calls Fueled Subprime Mess: Benign View of Loans Helped Create Bonds, Led to More Lending.” Wall Street Journal (15 August): p. A 1.
“In 2000, Standard & Poor’s made a decision about an arcane corner of the mortgage market. It said a type of mortgage that involves a “piggyback,” where borrowers simultaneously take out a second loan for the down payment, was no more likely to default than a standard mortgage. While its pronouncement went unnoticed outside the mortgage world, piggybacks soon were part of a movement that transformed America’s home-loan industry: a boom in “subprime” mortgages taken out by buyers with weak credit.”
“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. The task is more complicated. Moreover, through their collaboration with underwriters, the rating companies can actually influence how many such securities get created.”
“Moody’s Investors Service took in around $3 billion from 2002 through 2006 for rating securities built from loans and other debt 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.”
” 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, although he says Wall Street and mortgage firms called the process by other names, like “best execution” or “maximizing value”.”
“”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. He says the communication “contributes to the transparency” preferred by the market and regulators.”
“The big mortgage buyers Fannie Mae and Freddie Mac wouldn’t purchase these piggyback deals, which didn’t meet their standards. 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: With interest rates low, many investors were in search of higher-yielding instruments.”