Thursday, August 16, 2007

How Rating Agencies Abetted The Sub-Prime Mortgage Situation

Yesterday's Wall Street Journal carried a fascinating article concerning how S&P's and Moodys' rating of so-called 'piggybacked' sub-prime mortgages, in 2000, led to today's credit turmoil.

Amazingly, the ratings agencies first allowed the CDOs backed by these mortgages to be investment grade, then changed their minds last year. It evidently took five or six years for S&P and Moodys to sample and test the payment history of such mortgages, leading them to downgrade them to junk status.

Now, as Wilbur Ross said on CNBC yesterday morning, nobody should simply blame a rating agency for their own bad investment decision. And I agree with that.

However, when buyers included institutions which could not buy those CDOs with today's ratings, but could earlier, you have to wonder how much the agencies' appetites for fees led them to inappropriately collaborate with the issuers, and look the other way over an obviously riskier type of home loan.

While issuers observed S&P guidelines for how much, apparently 20%, of a CDO could be sub-prime mortgages, over time, some just incurred the rating penalty and stuffed much more of the sub-prime originations into CDOs.

The result is something which I was not aware was now common- that CDO would contain a mix of types of home loans. Thus, evaluating these would have become a nightmare for any purchaser. And, again, thus why an S&P or Moodys rating became so important.

Unless, of course, the buyers should have perhaps just passed on paper like this at all.

And therein lies the lesson, per Wilbur Ross's comment which I quoted in yesterday's post,

"Rather than microscopically price risk correctly to the nth degree, CDOs have, instead, allowed originators to bury risk in amongst tranches of some portfolios of loans, and, in some cases, further mix them with other types of loans. That's not how the instruments were originally marketed, but that's how they now are used."

Adults who should have known better chose to buy this paper, to earn returns which they thought were not really all that risky.

Honestly, I am not at all sure the Fed should be doing much to bail these non-bank institutions out.

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