The line of thinking that underlies an investigation by New York attorney general Andrew Cuomo is a challenge to conventional wisdom about the financial crisis. The prevailing view is that since credit ratings were one of the single biggest points of failure in the crisis, the ratings agencies were one of the biggest, if not the biggest, perp.
Now this crisis had many parents, with the cast of characters including Alan Greenspan, Bob Rubin, Phil Gramm, Gaussian copula models, negative basis trades, captured regulators, undercapitalized banks and dealers, and of course, ratings agencies.
And the ratings agencies DO deserve a lot of blame. They played a compromised role in the structured credit market, via assisting in the design of deals they ultimately rated. In addition, the traditional ratings system which is hard wired into a lot of investment processes does not translate very well into structured credit deals. As Joe Mason and Josh Rosner demonstrated in a 2006 paper, structured credit transactions inherently are exposed to the risk of more dramatic downgrades than a corporate bond. So an AAA rating for those deals was NEVER as solid as an AAA on a corporate or municipal bond, even before considering the impact of a housing bubble, lousy origination standards, and design of some deals to favor the interest of the short side.
But the rating agencies have managed to argue a First Amendment exemption, which so far has made them judgment-proof (although a recent decision challenged that view in a structured credit case). So Cuomo could be argued to be unfairly targeting the banks due to his inability to pursue the ratings agencies.
But the Cuomo investigation is honing in on a crucial issue: did the banks misrepresent the assets in the deals rated? That has the potential to be a Big Deal, since it could result in bad ratings and the resulting losses being attributed to bad information from banks, who could be sued, and conveniently also are deep pockets.
The issue of misrepresentation is a common thread in many current and potential lawsuits. It is at the heart of the SEC’s case against Goldman. It also forms the basis for Fannie and Freddie action against the four biggest mortgage originators in the US: Bank of America, Citigroup, JP Morgan, and Wells Fargo. These banks had represented contractually that the mortgages underlying the bonds they sold to the agencies met certain standards, when they didn’t. The losses to these banks resulting from these false claims is $5 billion for 2009 and higher numbers are expected in 2010.
A New York Times story on Cuomo’s probe covers a lot of ground that will be familiar to readers of the blog: that low and behold, the banks tried to game the ratings! Since banksters try to game everything, this is hardly news:
At Goldman, there was even a phrase for the way bankers put together mortgage securities. The practice was known as “ratings arbitrage,” according to former workers. The idea was to find ways to put the very worst bonds into a deal for a given rating. The cheaper the bonds, the greater the profit to the bank.
While this behavior is to be expected, and the rating agencies should have been on guard, this sort of thing is another matter:
A central concern of investors in these securities was the diversification of the deals’ loans. If a C.D.O. was based on mostly similar bonds — like those holding mortgages from one region — investors would view it as riskier than an instrument made up of more diversified assets. Mr. Cuomo’s office plans to investigate whether the bankers accurately portrayed the diversification of the mortgage loans to the rating agencies.
Yves here. On the one hand, correlation was a crucial input into structuring these deals, and one big reason so many supposedly AAA bonds failed was the underlying assets were highly correlated. A story earlier this week in Bloomberg on a Merrill CDO provides support to the Cuomo thesis:
Neo CDO Ltd. was a complex construction. More than 40 percent of its holdings were slices of collateralized debt obligations sold by Merrill, according to Moody’s Investors Service and data compiled by Bloomberg. Many of those were CDOs made up of other CDOs backed by bonds linked to home loans. About one-sixth of Neo was invested in junk-rated debt.
Yves here.This deal was managed by Harding, widely seen as captive to Merrill. While the assets Harding selected presumably adhered to the restrictions set forth in the offering memo (limits on the % by rating, on regional and servicer concentrations, etc). it seems astonishing that a deal would be 40% CDO squared, 1/6 junk, and still have a AAA tranche that was 75%+ of total par value (which I would imagine it did). Normal mezz CDOs (ones made mainly of BBB subprime bond tranches) usually had only 10% maximum from other CDOs; so-called high grade CDOs, which were made from “better” cuts of subprime (A, AA, and junior AAA) did permit more CDO squared, but even then, the usual limit was 30%. And to have so much from the same issuer was also unusual.
Moreover, banks themselves often did these deals off their correlation desks. That further raises the possibility that the banks were arbing the correlation risk against their investors (in other words, they could be narrowly truthful in insisting, as Goldman and Magnetar do, that they weren’t designing the deals to fail; they were designing the deals to have highly correlated exposures. But that would mean if they got in trouble, they WOULD fail, as oppose to merely be somewhat impaired).
On the other hand, we argued in ECONNED that the use of correlation models on mortgage bonds was misguided:
ABS CDOs were the financial equivalent of turning pigs’ ears into silk purses, and in the end, they worked about as well. How could anyone at the time have convinced himself that these junior exposures to low credit quality instruments could produce AAA-rated paper? The problem is that procedures that made some sense on first generation securitizations were dangerously misleading here. It’s easy to blame rising real estate prices and ratings agencies, but the real roots lie again in flawed economic models.
Recall the discussion of correlation risk from chapter 3. The theory, developed by Harry Markowitz and William Sharpe, was that investors could create an optimal portfolio that suited their appetite for risk. But to do that, they needed to find investments whose prices moved differently, and they needed to have precise information about how these prices would move in relationship to each other (“covary”) in the future. In other words, this was a clever idea that would seem to have little practical application, except that a whole industry of faux science was constructed on this flawed foundation.
The way this approach was applied to structuring collateralized debt obligations was particularly dubious. The ratings agencies, the monoline insurers, and many investors looked at the risk of default using correlation models. But correlation is a concept in financial economics used to estimate overall portfolio risk based on price movements of the instruments in that portfolio in relationship to each other. If the price of one holding increases 5% in a day, another could change in a whole range of ways: up even more, up but not as much, no change, or down a lot or a little.
But if one loan defaults, the next will either default or not default. Only simple binary outcomes are possible. Thus using Markowitz/Sharpe-type models to analyze defaults was fundamentally wrongheaded.
Yves here. The interesting bit is from a legal standpoint, the logical response for the investment banks would be to say the credit agency models were bunk, the way that correlation models that were developed in the corporate loan market were repurposed to the asset backed securities market was problematic. But the difficulty here is the banks were hawking correlation products and correlation trading strategies; they were even deeper into these approaches than the rating agencies. So Cuomo may indeed be able to land a very solid blow if his inquiry does establish that the investment banks misrepresented
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The payment model of the ratings agencies is the main factor behind these faulty ratings of the models.Same thing in the accounting arena. If you are rating a product for a customer , you will have all the incentive in the world to make it a better rating instead of a bad one.Same thing in accounting where you rate/pass the financial statements.
The payment model is an external symptom of the more universal inner disease. The rating agencies exist, in much the same way that many “branded” high priced attorneys and accountants exist, as CYA mechanisms for agents handling OPM. As Yves has mentioned elsewhere, the core problems of agents handling OPM are intractable. The incentives will always be for the agents to find ways to directly or indirectly pay people to take on the risks of being wrong. The agents can point to the rating agency, the lawyer, or the accountant and say, “See, I did my due diligence. I hired Shearman & Sterling (or Moody’s or E&Y), for Christ sakes” and then Shearman (or whoever) diffuses the risk further among many attorneys (while trying to keep at least one fall guy in the back pocket). These mechanisms just happen, in small and large scales, in much the same way as the fractals one sees everywhere in nature, like the grooves cut into a mountain by water running downhill. This is pervasive and scoops up a lot of people who have no idea this is why the money flows around like it does.
Sorry, no solutions here, just trying to better identify the problem.
There were all sorts of problems with the rating agencies. So the answer to the headline is Yes and No.
Did internal conflicts prompted by their free structure lead to bad ratings? Yes.
Did a “race to the bottom”/ratings shopping lead to bad ratings? Yes.
Did general incompetence lead to bad ratings? Yes.
Did fraud and deceptive practices on the part of issuers lead to bad ratings? Yes.
Did the fact that rating agencies were effectively being asked to do an impossible task (rate highly structured derivative products with very limited historical credit default data composed of innovative new underlying assets that also had limited historical data, eg 2 yr neg am option ARMs) lead to bad ratings? Yes.
The rating agency problem is huge.
Anyone who watched Carl Levin’s hearing on the rating agencies knows the agencies were not “duped”. Management at Moody’s and S&P built a model designed for the high ratings sellside and even buyside clients wanted making a mockery of the process. Resources for model upgrades were held back, models were made available to Wall Street so they could better arb them and the companies incentivized its managers to favor volume over accuracy. The fact that the agencies can claim first amendment protection is absurd. At the very least they should be held to a similar standard to that of auditors.
Makes me wonder whether the law can be used as a weapon in an econmic war. I guess the answer is, yes.
Sechel I could not agree with you more. The Levin hearings were very fruitful in zeroing in on that point. The rating agencies knew that their models were constantly being gamed and they chose not to care. They have to be incentivized to care about being accurate. Right now, they have no incentive to stop their models from being gamed.
I kind of understand the problem of ratings arb (and I think these guys do a good job of articulating the problem http://ratingsreform.wordpress.com/2010/01/08/%e2%80%9cgaming%e2%80%9d-the-ratings-system-or-the-observer-effect/) but it’s not a case where Saint Joan doesn’t understand what she’s done wrong. These are very sophisticated analysts playing in a very sophistcated dog-eat-dog environment. They know the game. They can’t claim to be shocked that their models are being arb’ed!
Y’know……….back in the good ole days………those being the 1970s………Investors actually paid the ratings agencies for their services.
It was AT THE BEHEST of the S.E.C. that the current model came into existence.
So, once again….we come full circle……..and blame the S.E.C.
Chad,
I know it was a long time ago, but bond and commercial paper issuers paid ratings agencies even back in the 1970s. The investment bank managing the offering might have paid the ratings agency fee up-front but it was ulitmately paid by the issuer.
Investors paid a monthly/quarterly fee to access reports on those ratings.
It was in the 1980s when structured transactions became popular (‘AA’ rated mortgages converted to CMOs) that investment banks began paying ratings agencies directly as the issuer was just an SPV.
The real reason for the change was the photocopier. Investors would copy the ratings and pass them to their buddies. It destroyed the rating agencies’ ability to make money from investors. IIRC Xerox copying started to become reasonably available in the early 1960s.
I work in the industry and Yves is correct here. Once you could copy the research, the investor pay model fell apart. SEC had nothing to do with it. If the NRSRO regs were pulled tomorrow, you would still have an investor pay model. In fact some RAs have been trying to have those pulled, it would not affect the business, though it would make life hard on the regulators. What the regulators did was outsource their work to the RAs. Which is not entirely their fault for they do not have the budget to do the work themselves.
But I also suspect that the regulators like it this way, for they can easily displace blame. Remember Basel II, RAs were barely consulted and if they did make a serious effort I as well as others would have told them the way they used ratings were wrong, but apparently they were not interested in what we had to say back then. I even tried contacting the team that created Basel II and found the BIS just hired a bunch of consultants that left after its completion.
With that said, I can not argue with Yves, we were duped or perhaps a better word is one Yves herself coined, Econned. We should have known better and some did, but they were in the minority, now they are in charge. However regulation is still necessary. Incentives are like erosion, even the strongest rock has fissures in it, where water will collect freeze, expand and ultimately, over the course of time, turn the rock to dust. I just hope legislators find smart former analysts willing to fix the system and not clueless academics who will make it even worse.
A caveat that is always put forth in Finance 101 is: ‘diversification does not reduce systemic risk’. It astonishes me that all these business school educated people who worked for ratings agencies, regulators, investment banks, etcetera, seem to have forgotten this the moment they walked out the door of the academy. I think it really calls the value of our system of education into question.
At the risk of belaboring this point: the reduction of risk allowed by combining mortgages into a collateralized mortgage obligation made mortgage investors comfortable. They would pay more for a bundle of mortgages than they’d pay for an individual mortgage, because they perceived the bundle as less risky. After all, it was rated AAA. This helped jump start a reduction in interest rates, and soon more homeowners could afford houses, driving up home prices, which made mortgage securities seem less risky still. This drove up prices of mortgage securities, which lowered interest rates again in a virtuous circle.
If the people who put all this together had simply remembered that diversification doesn’t reduce systemic risk, the disaster might have been avoided.
Jim,
I differ with you on the systemic risk point as far as ABS CDOs are concerned. The problem with them was not systemic risk, it was massive correlation in the exposures + cliff risk (going from say 8% defaults in an underlying mortgage pool would change the payout on the BBB tranche, which is what went into “mezz” CDOs, from 100$% to 0.
You didn’t see AAA CLOs, or AAA munis or AAA sovereigns or AAA corporate bonds go from AAA to CCC in a single downgrade. That was common with CDOs. You didn’t see them go to zero in value. Even Lehman bonds in its default were estimated to be worth eight cents on the dollar. Most corporate recoveries are higher than that.
So your criticism of the correlation models is specific to their use in CDOs right?
No, I have a whole section in Ch. 3 of ECONNED on the problems with correlation as used in financial economics. Even Markowitz and Sharpe have renounced it!
The problem is that the effect of the use of correlation measures as a risk reduction tool is that they assume the correlations are stable. They aren’t, as we know, and worse, things that were formerly weakly correlated move together when markets are roiled, when you MOST want safety.
It’s one thing to diversify and hope for the best, knowing it’s better than putting your eggs in one basket. But the use of models leads people to have more faith in diversification as a way of reducing risk than is warranted. The result it they take on more risk than they realize.
Yves,
Can I ask you Yves what you think a credit rating means? Any investor in credit-risky debt – or indeed commentator on credit rating – really ought to know that, and I doubt that many do. I am not entirely sure that I know either, but I think it needs a fairly sophisticated understanding of probability.
By the way, there is something wrong with the link to the Rosner and Mason paper (which I was hoping might shed light on my question above).
The link to the Mason/Rosner paper is in the post I pointed to, but here it is separately:
http://hudson.org/files/publications/Hudson_Mortgage_Paper5_3_07.pdf
Your question is an important one. There is the formal definition, which is verbal for each grade, but does relate to an expected default level. This came under some scrutiny during the monoline meltdown phase, since the agencies had said pretty much forever that ratings meant the same thing regardless of type of bond, when municipalities in fact has much lower defaults across all ratings grades.
IIRC expected default of an AAA security is ~ a bit over 1% for a muni bond and a teeny bit over 2% for a corporate.
But an AAA is SUPPOSED to mean you don’t need to think about it, any idiot can buy it and be safe. That’s why these debates about investors not evaluating the risk of AAA instruments is so nutty. AAA is supposed to be SO blue chippy as to not need to be evaluated. It is widow and orphan paper.
And an AAA (or any bond) should not drop a bunch of ratings categories on a single downgrade, absent massive accounting fraud. That was another problem with ABS CDOs made largely from BBB subprime bonds. They had massive cliff risk, they could and did collapse in value. That should have made it impossible for them to be AAA rated.
But at the time Greenspan was pounding the table saying that there had never been a national bubble in housing so if you bought into that then uncorrelated assets might have been halfway safe…in that the AAA CDO squared deals might not have gone to zero but just been battered. Of course even without a national housing bubble BBB tranches of subprimes still would probably be a disaster. I believe I have read that the rating agencies were only allowing for maybe a 100-150% increase in defaults from the uber low levels of 05-07. Even without correlation those levels of default were unbelievable even then unless you believed subprime would act like prime or near prime (I guess prime defaults are up about 300-400% from their lows but ratings agencies can be forgiven for not putting those levels into their models). In short, if you bought into a bunch of complete BS and didn’t do any critical thinking, it would be easy to convince yourself AAA CDO’s were gold…especially if you are using someone else’s money.
One thing I would be interested in was to what extent did the ratings agencies do sensitivity analysis on these complex deals…that should have shown that they were unstable in that if defaults went much above expectations they would get wiped out completely as opposed to just a decaying…as Yves says how many binary defaults could there be when you are using BBB tranches that are built to take losses from CDOs, which were in turn built to take losses from BBB tranches of CMOs?
I’m struggling to understand what Cuomo is saying was misrepresented. If he’s truly talking geographical diversification, then I don’t see how his case has a leg to stand on, except possibly for some CDOs squared (and maybe not even then). The CDOs were backed by bonds rated by the same agencies – they knew exactly what the geographical diversification was.
Besides, one of the key problems with CDOs of ABS was that it turned out geographical diversification didn’t matter! The bonds were highly correlated regardless of their geography.
The correlation may have been by channel…by originators known to be particularly bad.
“That has the potential to be a Big Deal, since it could result in bad ratings and the resulting losses being attributed to bad information from banks, who could be sued, and conveniently also are deep pockets.”
Uh, I am all for letting the big four go bankrupt (or more accurately, acknowledge that they are bankrupt) but when we say “deep pockets” aren’t those bankers’ pockets filled with our money???
The fact that banks conveniently have deep pockets does not sit well with me either. Essentially, that is a misnomer, or wrong word, properly understood, banks conveniently have deep taxpayer pockets.
So, by suing and fining the banks, the government rewards itself with a share of the profits from the ongoing transfer of wealth. The scheme is a public-private partnership that only serves to amplify the total cost to the taxpayers.
You might find the nuances of the legal arguments interesting and good theater, but it really amounts to nothing more than a value added cost to the consumers/taxpayers.
Question: can someone explain simply what the distinction is between a systemic risk, versus a correlated risk?
If these CDO’s are bad due to being composed of fraudulent mortgages, is that a systemic risk (fraudulent mortgages are overall, i.e., overall risky) or is a correlated risk (bad CDO’s are correlated with fraudulent mortgages?)
thanks in advance
Fresno,
My take on correlated risk is that when composing the CDO, it was required that the pool of mortagages be diversified as defined by correlation. So one example of mortgages that you would not expect to be correlated would be based on geography. We have had property bubbles in Houston in the 80s and California in the 90s but housing in other areas were not affected by those bubbles. So when you construct the CDO you would want to include mortgages from different regions because you wouldn’t want all of the mortgages to be affected by a bubble in one region.
Of course the CDOs would have used far more complicated mathematics to determine correlation of the assets but that is the essential idea. Also, as Yves mentions above, you could have hidden correlation that wouldn’t be apparent in the math…ie if the banks suspected that channel correlation would matter at some point, they could take a pool of assets that would not look correlated by traditional measures (because correlation is based on the past) but would likely blow up later, for example taking mortgages mostly from one originator that you knew had terrible standards which had so far been hidden due to rising asset prices allowing anyone who got in trouble to refi or sell their house (although that would have shown up as prepayments on the CDO even good credits were refi-ing with abandon so that also would have been hidden)
Systemic risk, on the other hand is risk that is system wide and cannot be diversified away. So if you play by all the economic and finance theory out there, you diversify all of the individual risk that you can have…default risk of a company, default risk of a particular country, risk of a stock market in a single country going down, etc and what you are left with is the system risk which cannot ever be removed. For example, an asteroid hitting the earth and destroying the planet is undiversifable systemic risk because we can’t leave the planet, or for a finer tuned example global warming can’t be diversified away. And you can also define the system to be smaller than global, so for example the S&P 500 or the Russell 3000 have diversified away the risk of individual stocks and of individual sectors and left you with the systemic risk of US stocks in general without having to worry about a single company going bankrupt, or a bubble in oil prices affecting energy stocks, or a downturn in consumer spending killing retail stocks, etc.
Not quite the answer I was looking for, but I think I can infer what you would say from what you wrote. The point is that a credit rating is some measure of default risk – I believe risk of (any event of) default in S&P’s case, and risk of default loss in Moody’s case – and NOT (credit-driven) variability of value, which is what really concerns most investors. As a portfolio manager, I once tried to compare the riskiness of a portfolio of bank deposits with a portfolio of government bonds, and there was no straightforward answer. In my view, a major cause of the financial crisis was that both the sell and the buy side, knowingly or unknowingly, exploited this uncertainty, and could have done so whether or not the rating agencies had been doing their job rigorously.
PS I meant to attach this comment to your reply to me Yves. Thanks for the Mason/Rosner link.
Oh, the ratings were never meant to be treated as pricing models. In fact, when all that illiquid paper started to go bad, there was some consternation in the press that the rating agency models had been used for pricing (marking positions) when that had never been their intended use. Similarly per the comment in the post, the reverse happened (which may have fed this confusion) the rating agencies in structured credit products used concepts derived from portfolio construction that relied on expected market PRICE moves to create CREDIT DEFAULT models).
I think infering default probability from market prices is not unreasonable, under certain assumptions about the efficiency of market pricing (ie what the market knows about asset and liability values). I believe that is how the KMV measure of default risk works, but I do not know the details. That of course gives a very volatile measure of default risk, which is disliked as administratively inconvenient.
I’m not sure that I understand the thrust of the post. I wouldn’t be surprised if the ratings agencies were duped, however this post doesn’t help me to see why they were duped.
-isn’t it the job of the ratings agencies to see if there is correlation risk? how could the IB’s “Misrepresent” correlation risk to the ratings agencies? Did the agencies just take their word for that? if so, what the hell do ratings agencies do?
-I didn’t see an example above where the ratings agencies were told there was geographic diversification in a CDO when in fact there was not
-I don’t see a problem with the ratings agencies giving the IBs the “formula” for how to create an AAA product. that seems transparent enough to me. sort of like school. Learn these 10 things and do them correctly and you get an A. Similarly: “we at Moody’s think an AAA CDO should look something like this” and the IBs made it.
the problem wasn’t that the ratings agencies gave the IB’s the formula, the problem is that the ratings agencies didn’t know or didn’t care about what they were doing. (captured).
====
This post triggered a thought for me. I have figured out a way to make these synthetic CDOs and naked CDS bets go the way of the dinosaur…
make it illegal to give them AAA or AA ratings.
That will knock out significant amounts of “demand” for them.
Why not RICO + fraud? When is “First Amendment” a f*-ing defense to fraud?
I don’t care if every piece of paper, every email, every defendant takes the stand and testifies that they just made honest mistakes in their models. I don’t buy it. Show the jury the money they were making and thus how their “flawed” models were no mistake. Houses sometimes go down in value. Houses bought on Ponzi finance eventually go down in value. It’s guaranteed.
What I do not understand is why the rating agencies are listened to from any perspective given thier absolute complicity in the financial fiasco fraud game.
This is the biggest failing of the current financial reform packages. They seem to say nothing about ratings. I have come to the absolute view that it has to be buyer beware and there is a need for absolute transpaency so the investors have a chance.
“At Goldman, there was even a phrase for the way bankers put together mortgage securities. The practice was known as “ratings arbitrage,” according to former workers. The idea was to find ways to put the very worst bonds into a deal for a given rating. The cheaper the bonds, the greater the profit to the bank.”
Yet another reason to shut them down.
“Ratings arbitrage” as in the banks were definitely out to dupe the ratings agencies, and as they were well bribed to be duped, the ratings agencies allowed themselves to be duped, colluding with the banks in intentional fraud.
Book ’em all.
Ratings arbitrage, which was by no means exclusive to Goldman (it was very much the essence of constructing a CDO at all – not just RMBS CDOs), wasn’t about duping the agencies, it was about gaming them. The agencies’ methodologies say (simplifying a bit) that a portfolio that meets these criteria (eg average and minimum ratings, geographical diversification, maximum arrears) will get a AAA tranche of size x. So you pick the highest yielding bonds that meet those criteria. That allows you to pay more interest on the bonds and get a higher equity return. Almost by definition, the highest yielding bonds are going to be the crappiest.
It’s a difficult situation to avoid, absent investor discipline. You could make the agencies’ methodology more of a black box, but is that really what we want?
the point about ratings arbitrage is that the standards set by the ratings agencies were arrived at through consultation with (or, more accurately probably, upon suggestion by) the investment banks. So instead of setting the standards in ways that would ensure diversification, they are set in ways that can easily be gamed. Put a lot of crappy, high return mortgage loans (or BBB tranches of CDOs) in and stir in one really good loan that brings the average just up to where it needs to be to satisfy the standard. You know it’ll fail quickly, but it still “looks good” on the ratings chart because the chart is so poorly drawn.
Ginger,
Thanks for
“Ratings arbitrage, which was by no means exclusive to Goldman (it was very much the essence of constructing a CDO at all – not just RMBS CDOs), wasn’t about duping the agencies, it was about gaming them.”
That’s the seminal description of Ibanking, period. Substitute Regulatory, for Ratings or Tax for Ratings, or Public Debt ratio/Euro treaty for Ratings and the sentence pretty much sums up the entire reason de etre for the banks.
Does gov’t support of this serve any public interest?
Probably not, unless you define ‘the public’ as only those that matter. The banks get it,they need to satisfy their public, their clients, (wealthy individuals). It seems the govt’s get it too.
If I remember correctly, during some of the congressional hearings the ratings analysts questioned indicated they joked among themselves that they would slap a “AAA” rating on something even if it was a “herd of cows”. Sounds like they knew what was in this stuff.
That would be “structured by cows” and that was a CLO and is doing just fine. In fact, if more securities were structured by cows than investment bankers, we would not have a problem.
Is not “misrepresentation” simply a more polite term for “fraud”…oh right, there is a “knowing” element – or is wilful blindness enough?
Perhaps somebody ought to ask a Judge.
One of the things that has always puzzled me on the slicing & dicing of the original portfolio was the bottom end rating. If the top end was cut off and turned into a AAA CDO, shouldn’t the rating agencies have downgraded the remaining portfolio — since that is where the risk was now concentrated?
While certain behavior “is to be expected,” that does not mean it should be tolerated, let alone lionized.
It seems that the real reason people on Wall Street get paid the big bucks is because they find creative ways to cheat their customers.
How does an economy work when you can’t trust the guys holding the money?
I don’t believe that the rating agencies were duped. I believe that they were complicit.
I always viewed credit ratings as being with respect to the probability of default. After default comes the extent and probability of loss; that is, will there be a loss and how much. This leads to the estimation of an expected price at liquidation which is generally half the normal market price. This latter sequence is separate and apart from the credit rating itself. Note too that the agencies make no representation as to any level of expected loss that may be attributable to any rating level.
In general CDOs were comprised of income streams that were of the first loss category. That is, in the event of default, these are income streams that will go to zero immediately. Because of the foregoing, the prudent investor/speculator should be more concerned about the subordination percentage than the credit rating.
As I see it, the bulk of structured finance paper that was rated should not have been rated at all. Quite simply, the rating agencies had no experience upon which they could establish probabilities of default. From the foregoing I conclude that there is no model that could reasonbly have been aplied.
I am struck by the fact that there is so much preoccupation with such concepts as correlation risk and attempts to mitigate systemic risk which can only be insured against. This leads to the CDS which now introduces the necessity of evaluating the CDS seller and his capacity to perform.
It appears to me that what lays before us is group think that is deluded in its belief in spread sheets and algorithms to the exclusion of common sense.
Cuomo is chasing moon beams; nonetheless, a little heat on the perpetrators of this massive financial fraud is welcome.
“I always viewed credit ratings as being with respect to the probability of default”
And you were always wrong because the agencies have always said they were relative measures of default. Why is that? Because if a sector has 30% of its issuers default and another sector has 1% of its issuers default, default rates for each rating category of the stressed sector will be higher.
“This latter sequence is separate and apart from the credit rating itself. Note too that the agencies make no representation as to any level of expected loss that may be attributable to any rating level.”
Moody’s supposedly has it in their ratings, S&P has a separate recovery rating for speculative grade issues.
“Because of the foregoing, the prudent investor/speculator should be more concerned about the subordination percentage than the credit rating.”
SF credit ratings were derived from subordination as well as over collateralization and credit substitution. All of that failed which is why the AAA tranches were breached. The breaches were significant enough that the degree of subordination or overcollateralization required to protect the AAA tranche would have made the deal uneconomical. The assumption that blew everything up for RMBS was the percentage of sub-prime borrowers that would default when they had less than 0 equity. The reason why the assumption was wrong was due to two sources. One was lack of history which you can beat the RAs over the head with, the other was fraud in the borrower statistics given to the RAs which is where the “Duped” came from in Yves’s title.
“As I see it, the bulk of structured finance paper that was rated should not have been rated at all. Quite simply, the rating agencies had no experience upon which they could establish probabilities of default. From the foregoing I conclude that there is no model that could reasonably have been applied.”
That is a fair point for SF ratings that used PDs derived from other ratings.
“I am struck by the fact that there is so much preoccupation with such concepts as correlation risk and attempts to mitigate systemic risk which can only be insured against. This leads to the CDS which now introduces the necessity of evaluating the CDS seller and his capacity to perform.”
Most CDOs were cashflow CDOs which were not like Abacus which was a synthetic CDO. Synthetics have both correlation risk and counter-party risk. The counter-party risk was not the main driver of defaults for synthetics, though that’s not to say there were no issues.
“It appears to me that what lays before us is group think that is deluded in its belief in spread sheets and algorithms to the exclusion of common sense.”
Yup nailed that one.
Everyone should be aware that fraud at the Wall Street level percolates down to the street level. In the Cleveland, Ohio area, local prosecutors have indicted several groups of people for committing mortgage fraud. This is fraud with a capital F, not loans to people who then lost their jobs. The result is boarded up houses, vacant houses serving as drug dealer hangouts, etc. At the street level, the alphabet soup of RMBS, CDO, swaps, and derivatives translate into a miserable life including violence. This is where the fee skimming started on its journey to Wall Street.
Much like a casino, the dealer often comes out and plays from time to time. Hard to imagine a dealer wanting to play a game they know the player can’t win.
fyi:
for additional info on the role played by the rating agencies read Jesse Eisinger’s August ’07 report:
http://www.portfolio.com/news-markets/national-news/portfolio/2007/08/13/Moody-Ratings-Fiasco
or Roger Lowenstein’s April ’08 essay:
http://www.nytimes.com/2008/04/27/magazine/27Credit-t.html?_r=1
These journalists have no market experience who are not the worse I have seen but they do not have a firm grasp of the subject matter. If you want to see a firm grasp of subject matter looks like, go here
http://www.securitization.net/pdf/Publications/Sub-prime_Problem_8Jan08.pdf
Both those guys now work for a rating agency.
Now, you do not need market experience to understand this stuff, but there is a steep learning curve that journalists on a deadline seem unable to surmount.
**The final sentence appears to be unfinished.** It doesn’t read well.
In my view, mortgage bond pricing reliability changed dramatically, in process, over the decade. All the stuff that Greenspan (et-al) ignored, which has been well discussed, was part of erosion.
But there were other things happening in US economy over time which affected these things more. Briefly…
a) accellerating offshoring (and H1-B) of hi paying, skilled jobs, manufacturing etc.
b) a curve from a) got steeper, more & more ex-professionals turned to real-estate to replace lost income.
c) by mid > late ’06, intersection of a)/b) had conspired to create a bubble in US economy where the remaining supporting economy had been very significantly eroded: eg. it was generating profit from off shore operations for WS, but greatly diminished income for main street.
d) And lastly, with all of above, geometric peril added by huge volume of various flavors of ARM(s)… a condition which even modicum of common sense was sufficient to see writing on the wall.
So anyway, seems clear to me value of these things was eroded as much by things happening outside of housing market as it was by quality of these bonds. The fact that a few were making so much $$ at expense of eroding US real economy, and that our captains of finance chose to keep it that way until the well was dry…
It is for this reason that Obama’s disappointed me the most: he’s let the ass holes keep their bully pulpit (“socialism” etc.) thus perpetuating forces which brought us to the brink, and simultaneously built recovery on the same shaky ground. With some fortitude and honesty, he could’ve called a spade a spade, laid ground for a firm foundation, and spent all those $$b’s investing directly in some stuff we really need here to jumpstart *real* economic activity.