Roger Lowenstein on the Bond Rating Agencies

Here is the article that Eben was talking about the other day in class regarding the rating agencies' conflict of interest with their clients as a culpably contributing factor to billions of dollars in bank write-offs and tens of thousands of jobs lost.

A great passage relevant to our reading of Arthur Leff's Ponzi scheme is reproduced below. What do you think of the conclusion at the end of the first paragraph?

"The analyst wasn’t evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle — a ghost corporation with no people or furniture and no assets either until the deal was struck — would purchase the mortgages. Thereafter, monthly payments from the homeowners would go to the S.P.V. The S.P.V. would finance itself by selling bonds. The question for Moody’s was whether the inflow of mortgage checks would cover the outgoing payments to bondholders. From the investment bank’s point of view, the key to the deal was obtaining a triple-A rating — without which the deal wouldn’t be profitable. That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. “People say, ‘How can you create triple-A out of B-rated paper?’ ” notes Arturo Cifuentes, a former Moody’s credit analyst who now designs credit instruments. It may seem like a scam, but it’s not.

"The secret sauce is that the S.P.V. would float 12 classes of bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have first priority on the cash received from mortgage holders until they were fully paid, then the next tier of bonds, then the next and so on. The bonds at the bottom of the pile got the highest interest rate, but if homeowners defaulted, they would absorb the first losses.

"It was this segregation of payments that protected the bonds at the top of the structure and enabled Moody’s to classify them as triple-A. Imagine a seaside condo beset by flooding: just as the penthouse will not get wet until the lower floors are thoroughly soaked, so the triple-A bonds would not lose a dime unless the lower credits were wiped out.

"Structured finance, of which this deal is typical, is both clever and useful; in the housing industry it has greatly expanded the pool of credit. But in extreme conditions, it can fail. The old-fashioned corner banker used his instincts, as well as his pencil, to apportion credit; modern finance is formulaic. However elegant its models, forecasting the behavior of 2,393 mortgage holders is an uncertain business. “Everyone assumed the credit agencies knew what they were doing,” says Joseph Mason, a credit expert at Drexel University. “A structural engineer can predict what load a steel support will bear; in financial engineering we can’t predict as well.”"

-- JesseCreed - 27 Apr 2008

The reason it is not a scam is that the bonds made out of the combinations of mortgages represent different levels of priority in getting paid the money produced by people making payments on all those mortgages. A bond issued for the first 10% of the revenue would be sure to pay off even if 90% of the mortgages defaulted. That one would surely be triple-A, and would bear a low interest rate. Later segments of the stream of revenue from the mortgages would be sure to pay even if lower proportions of the mortgages stayed current, and those would bear lower ratings and higher rates of return. The rating agency and the packager of the bonds run the numbers and try to agree where the loss risks are, aggregately, and then structure a stack of bond offerings that parcel out those risks, with appropriate rewards for taking them. If everything is as it looks and the risk ratings agreed to are right, the Aaa parts are in fact triple-A, while the Baa or Bbb parts are also there in appropriate array. That's not a scam. But if the risks are misrepresented it's a scam, and if they're only misunderstood, it's a catastrophe waiting to happen.

-- EbenMoglen - 27 Apr 2008