Credit Rating Agencies: Where did they go wrong?

Personally I believe that the credit rating agencies are the main factor which contributed to the collapse of the subprime mortgage crisis. Securitization was only a problem because the securities were given overly optimistic ratings which gave investors a false sense of security. Pools of Jumbo, Subprime and Alt A mortgages were magically transformed into securities with AAA ratings and the only excuses which I can fathom for these unrealistic ratings are either incompetence or greed. 

One of the major problems with these credit rating agencies is that they made money by charging private issuers for a rating. This created a conflict of interest as they were being paid by those who were judging them and were themselves competing with other rating agencies for profits. Many critics claim that this conflict of interest led agencies to award these AAA ratings to these complex securities which they did not properly understand.

These same rating agencies have failed before and will fail again. Thailand maintained an investment grade rating until 5 months after the Asian financial crisis, whilst Enron, the largest bankruptcy in US history at the time, had an investment grade rating until just days before it went bankrupt.

In May 2008, Moody’s acknowledged that it had given AAA-ratings to billions of dollars of structured finance products due to a bug in one of its ratings models (Jones, Tett, and Davies, 2008). In March 2007, First Pacific Advisors discovered that Fitch used a model that assumed constantly appreciating home prices, ignoring the possibility that they could fall. (Coval, J.D et al, 2008)

They have not learned their lesson and they have a lot to answer for when it comes to the subprime mortgage crisis. Bill Gross gave his view on the credit ratings agencies which I believe sums there role up appropriately.

“AAA? You were wooed Mr. Moody’s and Mr. Poor’s by the makeup, those six-inch hooker heels, and a ‘tramp stamp.’ Many of these good-looking girls are not high-class assets worth 100 cents on the dollar.”

Securitisation and Derivatives: What went wrong?

Securitisation is not a new development and has been very useful tool in the financial sector for a long time so what went wrong this time?

In the case of the current financial crisis this resulted in pooling together of various Jumbo, Alt-A, and Subprime loans. This is where the real mess happened. Somehow, mixing up a combination of these risky loans resulted in investments with AAA ratings. With low interest rates, these investments provided an exceptional level of return for the perceived level of risk. As a result of this these products were in high demand and could be traded without requiring a credit assessment.

Many investors hedged against the risk of default by purchasing a credit-default swap. Derivatives, described by Warren Buffet as "financial weapons of mass destruction" in early 2003 were had also exploded during this period. According to the International Swaps and Derivatives Association, in 2008 the estimated value of CDS’s in the market was $62 trillion.

So the Banks had removed these securities off their balance sheets and had insured themselves in case of them defaulting. However in 2007, when house prices began to fall and delinquencies increased there was also a fall in demand for subprime backed securities. The credit rating agencies suddenly realized that their investment grade ratings were incorrect and had provided a false sense of security to investors. This resulted in the credit rating agencies downgrading these securities which in turn caused investors to start selling them. Many securities fell below investment grade so demand for these products fell rapidly.

This led for the demand of insurers to meet their commitments to their CDS’s and guarantees. Many did not even know who was currently holding them and whether the holders can actually pay in the event of a negative credit event. It soon became quite clear that many insurers were unable to meet their commitments. These CDS’s were not regulated, not traded on an exchange, subject to re sale and subject to counterparty risk. For example when Lehman Brothers went bankrupt, any CDS protection it offered was nullified.

In my opinion, this was the primary cause of the subprime mortgage crisis in America coupled with the credit rating agencies inability to fairly rate such products that I will discuss next week

Securitisation and CDO's Explained

Firstly I just want to explain with the use of a few diagrams as to what securitisation and certain derivatives are and how they work, as understanding this is key to understanding how the sub-prime mortgage crisis escalated to the level it did.

Securitisation is a structured finance process that involves the pooling and repackaging of cash-flow-producing financial assets into securities (MBS’s, CDO’s, etc.), which are then sold to investors, removing from the institutions that originate them. General practise was for the originator to sell them to a Special Purpose Vehicle (SPV), removing them from their own corporate balance sheets, which was important since the Basel Capital Adequacy requirements had made it more costly for banks to keep assets on their balance sheets. This is one of the main reasons why it was so difficult to estimate the extent of bailouts required after the crisis.

These structured products were they sliced up into “tranches” in order to enable investors to decide upon their own exposure to risk. For example the details of C.D.O.’s are complicated, but basically they’re designed to transfer most of the risk of toxic loans to experienced investors, who earned a commensurate return for taking on the high level of risk, while leaving other investors with assets that were supposed to be, excuse the pun, as safe as houses.

Are Fannie and Freddie to blame?

Many people such as Peter Wallison believe that government intervention, through both the Government Sponsored Entities (GSE’s) Fannie Mae and Freddie Mac, and their affordable housing policies, was the main contributor to the crisis.

I agree with him that they were a significant factor but disagree that they were the driving force behind the crisis. The Clinton administration put pressure on the GSE’s to extend mortgages and loans the low and moderate income neighbourhoods set out in the CRA 1977. As a result of this, the GSE’s were pressured into making subprime loans which were more profitable than orthodox loans. This only served to bring further pressure from their shareholders to maintain these profits.

Fannie and Freddie were significant players in the U.S mortgage industry. By 2003, Fannie Mae and Freddie Mac accounted for 52.3% of all residential mortgage loans outstanding (Federal Reserve and Monthly Funding Summaries). However, between 2004 and 2006, research from the St Louis Fed shows commercial banks and investment banks were bigger direct players than the GSEs in the subprime market. In 2006, non-agency production of $1.480 trillion mortgage loans was more than 45 per cent larger than agency production. When the crisis hit, the GSE’s had lost significant market share and it was the commercial and investment banks which held the majority of the toxic mortgages.

I do not believe Fannie and Freddie caused the subprime crisis. They were a contributing player in the subprime market and they did purchase billions of subprime backed securities. They were also involved in buying the AAA pieces of structured deals but these were the least risky sections which were attracting all investors.  However, it is important to recognise that because of regulations, the GSE’s took on much less toxic loans than most banks. They were also not involved in the CDO market or other vehicles selling toxic parts of these instruments.

Was it the community Reinvestment act 1977?

Subprime lending was not only allowed to get out of control by the US government, it was encouraged. In 1977 the Community Reinvestment Act (CRA) was passed by the Carter Administration and the US congress.

The CRA was designed to make loans more accessible to low and moderate income neighbourhoods. This was implemented in a bid to stop Redlining and ensure that a certain percentage of banks’ lending portfolios were made in these neighbourhoods. If banks refused to open branches in these areas then any application for branch expansions in other more desirable areas were declined and they could also be hit with fines. This appears to be a fair and just way to reduce inequality so why are certain people blaming this for enabling the subprime crisis?

Those who blame the CRA, such as John Carney, point out that while it may have been enacted 25 years ago it was not a static piece of legislation. In 1995, regulators began to enforce the CRA in a very different way than they had in the past, and the federal government were given far more power to punish banks which did not comply with the CRA. 

However, blaming the CRA for the subprime crisis in not a substantial argument as there is evidence that loans made under the CRA program had a higher degree of supervision, carried lower rates, and were less likely to end up securitized into MBS’s according to a study by the law firm Traiger & Hinckley (PDF file here)

Serving the credit needs of low-medium income (LMI) borrowers is arguably the most important facet of a CRA performance examination. And looking at the small share of subprime lending that can be attributed to the CRA (especially to LMI borrowers) has led me to conclude that of all the factors contributing to the subprime crisis, this was the least significant.  The CRA did not make these other lenders, who did not fall under its jurisdiction lend, the profit motive did.

Amusing interview explaining the Sub-prime Crisis.

Beginning of the Crisis

The Global financial crisis has affected different countries in vastly different ways. However it is widely accepted that the beginning of the crisis arose as a result of the collapse of the US sub-prime mortgage market. Other countries also suffered housing booms and bubbles bursting, but it was this one which made it a global financial crisis. I intend on investigating the contributing factors which enabled the subprime market to expand to a level which was unsustainable and which resulted in the bailing out and collapse of various banks and credit institutions.

Looking back, it has to be asked, why did people and investors flock towards real estate? Sheila Crowley, president of the National Low Income Housing Coalition says that during the presidential terms of Clinton and Bush, “There was almost an obsession with getting the homeownership rate up”.

Home ownership was seen as the “American Dream” and programs implemented by those administrations made this dream a reality. This all sounds harmless, but as home mortgages became a huge source of profits for banks and investors, predatory lending became one of the primary factors in how the sub-prime mortgage market exploded so enormously and then collapsed catastrophically.

The increase in demand of financial companies for real estate assets was as a result of a combination of factors. Firstly they were hoping to move away from the volatile equity markets in which many of them suffered large losses due to the bursting of the dot-com bubble. Accounting scandals, such as Enron also made the equity market far less desirable for investors. These factors coupled with the Gramm-Leach-Biley Act ,signed into law by Bill Clinton in 1999 made investment in the housing market very attractive. Housing prices were increasing, interest rates were low and it appeared to be a safe and profitable investment. Even my old business studies teacher used to say, “Invest in land, God is not planning on making any more of it”.

Over the next few weeks I intend to investigate the sub-prime crisis, what factors are supposed to have caused it? and to what extent did each factor contribute to its collapse.