Credit Rating Agencies: Then and Now

Michael Lewis wrote the best seller, The Big Short, about the recent mortgage-driven credit bubble and crash. In it he tells the story of several interesting characters who foresaw the coming disaster and made plenty of money in the process. Parts of the book cover the protagonists’ attempts to figure out what is going on. They see people investing a lot of money in financial instruments that to them look like certain money losers. What looks like garbage to them is getting AAA ratings from the rating agencies. Lewis lets us in on some of the things they learned about how these agencies were operating.

Steve  Eisman is the person who queries the agencies for their information and their models. Here is one of his first discoveries.

“....he called S&P and asked what happened to default rates if real estate prices fell. The man at S&P couldn’t say: Their model for home prices had no ability to accept a negative number. ‘They were just assuming home prices would keep going up,’ says Eisman.”

That bit of insanity helps explain the even greater craziness that followed. Lenders were handing out floating-rate subprime mortgages as fast as they could. Someone would get a mortgage at say 8 percent which would go up to say 12 percent after a short period. It did not matter if a default followed because the risk had been passed on, and if housing prices continued to rise they could always refinance it and rack up new fees in the process. This is the sort of dangerous behavior that one would expect a rating agency to warn a potential investor about. This is what actually happened.

“Eisman learned that the rating agencies simply assumed that the borrower would be just as likely to make his payments when the interest rate on the loan was 12 percent as when it was 8 percent—which meant more cash flow for the bond holders. Bonds backed by floating-rate mortgages received higher ratings than bonds backed by fixed-rate ones—which was why the percentage of subprime mortgages with floating rates had risen, in the past five years, from 40 to 80.”

This was the final result of Eisman’s attempt to ascertain what information the rating agencies possessed.

“Ernestine Warner was working with the same rough information available to traders like Eisman. This was insane: The arbiter of the value of the bonds lacked access to relevant information about the bonds. ‘When we asked her why,’ said Vinny, ‘she said “The issuers won’t give it to us.” That’s when I lost it. “You need to demand to get it!” She looked at us like We can’t do that. We were like, “Who is in charge here? You’re the grown-up. You’re the cop! Tell them to fucking give it to you!!!”’ Eisman concluded that ‘S&P was worried that if they demanded the data from Wall Street, Wall Street would just go to Moody’s for their ratings’.”

In an earlier post I had referred to the rating agencies as “fools and knaves.” Emotional generalizations are sometimes justified by the magnitude of the foolery and knavery.

There is an informative article out of Reuters that dwells on the past mistakes of the agencies and elaborates on how their position came to be so prominent and institutionalized in spite of a poor track record.

“They are embedded in the regulatory structures that dictate operations of banks and many pension and mutual funds, giving them a central role in the world financial system.”

“Much of this stems from the unwieldy acronym NRSRO. A "national recognized statistical rating organization" is an entity that, in the view of the U.S. Securities and Exchange Commission, is qualified to rate companies and their various financial obligations.”

“Governments and financial institutions around the world have required that any credit investment be officially rated by such an organization. In other words, an NRSRO has to say a bond is investment worthy before many banks, mutual funds and national treasuries can buy it.”

The system has bizarre conflicts of interest built into it. The rating agencies charge the issuer of a bond for the rating they provide for it. As Eisman assumed above, this is great motivation to provide the rating the customer wants.

“They have profited handsomely. In the three-year period ending in 2007, the height of the credit boom, S&P's operating profit rose 73 percent to $3.58 billion compared to the three-year period ending in 2004. The comparable gain for Moody's over the same period was 68 percent to $3.33 billion.”

The situation is different with sovereign debt. In that case the raters are being asked to grade those who have the power to regulate them. This can lead to some interesting situations. There was a story out of Italy today claiming that the Italian government had confiscated materials from S&P’s and Moody’s’ offices in Milan with the aim of "verifying whether these agencies respect regulations as they carry out their work.” Italy and the Italians are mad and conspiracy theories are beginning to appear tying the raters to hedge fund operators and others.

Can you still remember the time when economics was dull?