Rate the raters

Posted: March 21, 2011 in Burse
Tags: , ,

“In all kinds of ways, ratings agencies have extended their grip and lulled investors and institutions into a false sense of security.”
John Gapper, Financial Times, April 28, 2010

Most subprime and Alt‐A mortgages were held in residential mortgage‐backed securities (RMBS), most of which
were rated investment grade by one or more RA. Furthermore, collateralized debt obligations (CDOs), many of which held RMBS, were also rated by the RAs. Between 2000 and 2007, Moody’s rated $4.7 trillion in RMBS and $736 billion in CDOs. The sharp rise in mortgage defaults that began in 2006 ultimately led to the mass downgrading of RMBS and
CDOs, many of which suffered principal impairments. Losses to investors and writedowns on these securities played a key role in the resulting financial crisis.
Inflated initial ratings on mortgage‐related securities by the RAs may have contributed to the financial crisis through a number of channels. First, inflated ratings may have enabled the issuance of more subprime mortgages and mortgage‐related securities by increasing investor demand for RMBS and CDOs. If fewer of these securities had been rated AAA,
there may have been less demand for risky mortgages in the financial sector and consequently a smaller amount originated. Second, because regulatory capital requirements are based in part on the ratings of financial institutions’ assets, these inflated ratings may have led to greater risk‐adjusted leverage in the financial system. Had the ratings of mortgage‐related securities not been inflated, financial institutions would have had to hold more capital against them. On a related point, the ratings of mortgage‐related securities influenced which institutions held them. For example, had less subprime RMBS been rated AAA, pension funds and depository institutions may have held less of them.
Finally, the rapid downgrading of RMBS and CDOs beginning in July 2007 may have resulted in a shock to financial institutions that led to solvency and liquidity problems.
In addition, downgrades of monoline bond insurers such as Ambac and MBIA and other providers of credit protection such as AIG triggered collateral calls built into insurance and derivative contracts, exacerbating liquidity pressures at these already troubled firms. This led to ratings downgrades of the securities these firms insured, prompting increased
capital requirements at the firms which held these securities and – in the case of money market mutual funds only permitted to hold highly rated assets – sales of assets into an already unstable market.

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