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Ratings Quality Questioned

Graham Fisher & Co. report examines agencies

July 2, 2007


A recent study slammed the three major credit ratings agencies, noting their evaluation of risk in residential mortgage-backed securities and collateralized debt obligations has been skewed because of conflicts of interest and the misapplication of inappropriate bond rating methods. Among the criticisms outlined in the report was the primary reliance on issuers for data, the low frequency with which tranches are re-rated and inadequate prepayment modeling.

The agencies have lagged behind market movements when reassessing RMBS and CDO ratings, said the authors, Joseph R. Mason, associate professor of finance at Drexel University's LeBow College of Business and a visiting scholar at the FDIC, and Graham Fisher & Co. Managing Director Joshua Rosner.

An even greater concern, they said, is that the process of creating MBS and CDOs requires the ratings agencies to become part of the underwriting team, leading to legal risks and even more conflicts because of the routine use of "the rating agencies publicly available models to pre-structure deals." In this way, the agencies are taking "an active part of the structuring of the deal." Thus their liability could become tied to the liabilities of other "underwriters", opening them to possible litigation tied to the current crisis, the two warn.

Increased lending to risky borrowers has led to more complex RMBS with more grades, which, in turn, has increased the opacity of RMBS, with the rating agencies thus able to play a greater role in the market, Mason and Rosner maintained.

"The lack of liquidity, transparency, history and available data coupled with unprecedented complexity has made it difficult for all but the most well funded, well staffed and most sophisticated to analyze the markets or assets," they wrote. "This has further increased market reliance on the CRAs."

But agency models, despite their complexity, do not include sufficient models for prepayments, they said, pointing out that, "unlike default risk, there is no industry standard to measuring prepayment risk."

The agencies have failed to re-rate MBS tranches as frequently as they should, according to Mason and Rosner, who pointed out that, in the short term, asset ratings adjust more slowly than market prices. "If rating agencies do not observe such deterioration before they are observable in markets, and re-rate existing assets only infrequently, should investors be bound to their process?" they asked.

This infrequency lead them "to wonder if the rating staff would have the necessary capacity to review and update their ratings if there were a significant increase in asset volatility, a deterioration in the macro-economic environment or a liquidity event."

But when rating adjustments do occur, they pointed out, "rated tranches with the same ratings but of different issuance dates may have meaningfully different risk profiles" as a result.

And while housing data for 2004 and 2005 suggested that "increased home price appreciation could be at its end, leaving losses to accumulate in pools for some time," they said, there were far fewer downgrades than upgrades on MBS tranches, possibly because actual losses on securitized pools were extremely low.

Moody's, in a statement, said that it is "highly confident in the accuracy and predictive value of our credit ratings."

Spokesman Anthony Mirenda, director of corporate communications, noted that "Moody's has an ongoing monitoring process to continually review all securitizations and take rating actions as appropriate. CDO ratings purposefully include a 'buffer' to account for a certain amount of expected deterioration in credit quality of the assets in the CDO, and we take rating actions if and when we expect the buffer is insufficient to support the current rating."

Agency forecasts also come under criticism as Mason and Rosner pointed to how the agencies have kept revising their assumptions downward and their loss expectations downward, "tacitly admitting that the scenarios they have been peddling were unrealistically positive."

The agencies also were criticized for relying primarily or solely on the information provided by issuers during the ratings process.

"We find reason to ask," they noted, "why agencies are not expected to seek out more information than provided to them by issuers or to verify even the non-financial data provided by the issuers."

This includes, they explained, such important loan information as debt-to-income, appraisal type and the identity of the originating lender.

Structured finance rating methodologies have frequently been changed, they observed, but when coupled with "the apparent inconsistencies in the application of these ratings criteria between new and existing structured-finance asset classes," those changes "may significantly impair both the integrity of rating scales and support undue risk taking."

As a result, they add, there is "significant" uncertainty about the meaning of original ratings.

MBS rating problems are amplified in CDOs, they maintained, because CDO ratings are based on the ratings of the MBS or MBS tranches that are brought together to create a CDO. And while the CRAs claim they cannot effectively rate CDOs, the ratings they have done has led to growing acceptance of CDOs by investors despite their "considerable market risk."

"The RMBS market is built upon the shaky statistical predictability of mortgage pool performance," they said. "The CDO market then builds upon the shakier foundation of the statistical predictability of RMBS performance to provide additional market liquidity."

Further, they added, "Changes in mortgage origination and servicing make it difficult to evaluate the risk of MBS and CDOs."

Mason and Rosner concluded that "significant increases in public access to performance reports, CDO and MBS product standardization, and CDO and MBS securities ownership registration can help decrease the existing over-reliance on rating agency inputs to rate and ultimately value securities"

Jerry DeMuth is an award winning journalist who has been reporting for four decades.

e-mail Jerry at [email protected]

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