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Borrower Behavior Shift Blamed for Bad Ratings

Borrower Behavior Shift Blamed for Bad RatingsSenate hearings on failure to predict subprime performance

September 27, 2007

WASHINGTON correspondent for

WASHINGTON, D.C. — The credit reporting agencies told Congress yesterday that a shift in borrower behavior prevented them from accurately predicting the performance of subprime loans backing residential mortgage-backed securities. One agency laid the blame on mortgage brokers and lenders for not doing their job. But senators suggested a major conflict of interest exists while the chief U.S. securities regulator is moving forward with an investigation.Yesterday’s hearing focused on the role credit rating agencies have on the subprime credit markets.

Anomalies in subprime borrower behavior prevented the application of historically-rooted assumptions, Moody’s Investors Service and Standard and Poor’s told the Senate Banking Committee.

Subprime loans made from late 2005 through early 2007 behave differently from loans made in prior times even when the loans share the same credit characteristics, Vickie A. Tillman, Executive Vice President, S&P Credit Services, told lawmakers.

Tillman said borrowers with high FICO scores in more recent loans behave more like borrowers with lower FICO scores in loans made in 2004 and 2005. For example, in the past, homeowners paid off their mortgages before paying off their credit cards — a fact that no longer appears to be as true as it once was, Tillman said.

Historically-rooted behavioral patterns that served as the foundation for analysis lack their prior value, she told the banking committee.

Michael Kanef, head of the Asset Backed Finance Rating Group at Moody’s, blamed borrower and lender behavior, noting they didn’t anticipate accelerated deterioration in mortgage quality, especially with certain originators, “or the rapid transition to restrictive lending,” Kanef said.

Moody’s said brokers and lenders didn’t uphold lending standards until early this year when many lenders went out of business and those lenders who remained too quickly tightened lending standards making it tougher for borrowers to refinance causing defaults to worsen.

Kanef said Moody’s has acted swiftly. He told the politicians that Moody’s has downgraded 5 percent of the $460 billion subprime mortgage-backed securities rated in 2006. Moody’s downgrades from 2002 through 2006 amounted to 2.1 percent by dollar volume in the subprime RMBS sector and 1 percent by dollar volume for all of RMBS.

Critics have suggested that with credit rating agencies being paid by the companies they rate to provide ratings — the issuer-pay model — that undue influence and conflicts of interest have prevailed. Many of the subprime MBS that were downgraded were initially given high ratings.

The ratings agencies said they have policies and procedures in place to manage the conflicts and told lawmakers that other suggested means of compensation for ratings such as the “investor pays” models also have disadvantages.

One senator, unhappy with the response to his question regarding conflicts of interest, suggested that “ethics is being trumped in this area.”

Several senators told the panel that the ratings were flawed. “We provided our best opinion,” Kanef responded.

Moody’s called for broker licensing, more disclosure by lenders and borrowers, the tightening of due diligence standards for underwriters, independent third-party verification by accountants and for stronger representations and warranties from originators and issuers on the loans included in a securitization pool.

Looking in-house, Moody’s told committee members that it has made changes to its analytical methods such as increasing delinquency and loss expectations and asking for more loan data such as the borrower’s credit history, the presence of escrow for taxes and insurance and levels of cash reserves.

S&P said it has increased its surveillance of RMBS transactions and downgraded those classes that did not pass its newly initiated test scenarios, modified its approach for ratings on senior classes in transactions in which subordinate classes have been downgraded and implemented changes in transactions closing after July 2007 that would result in greater credit protection for rated transactions and will increase its review of lenders’ fraud-detection capabilities.

One senator asked, “If you don’t see yourselves as having any responsibility, why make changes?”

Meanwhile, the Securities and Exchange Commission told lawmakers at the same hearing that it is moving quickly under a law enacted only last year that allows the commission to examine the agencies.

The SEC said it quickly granted status to the credit rating agencies under a newly enacted federal law that allows the commission to examine registered credit rating agencies activities in residential mortgage-backed securities, an examination undertaken in response to the recent events in the mortgage markets.

Commission Chairman Christopher Cox said the commission is examining whether the nationally recognized statistical rating organizations were influenced by RMBS issuers and underwriters to publish higher ratings and whether conflict of interests were properly managed in determining credit ratings for RMBS. Moody’s and S&P have applied for NRSRO status.

Cox said, acting upon President Bush’s request, the President’s Working Group on Financial Markets is also examining the role of credit rating agencies in lending practices, how their ratings are used and how securitization has changed the mortgage industry. The commission is taking a lead role in that study, Cox said.

Lisa D. Burden is a legal analyst for and holds a law degree from the University of Maryland. She is currently a freelance journalist who previously wrote for Institutional Investor publications and the Baltimore Daily Record.

e-mail Lisa at:

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