Credit Market Fall-Out #25 – The Rating Agencies

Based on articles in the WSJ ( #1, #2, and #3) earlier this week it appears that now that the Congress is back from vacation they plan to tackle the “mortgage mess”. Amongst a whole list of issues that will be tackled from predatory lending to efforts to save home owners from themselves Congress will be tackling rating agencies. The following is an excerpt from the Opinion Page of the WSJ written by someone from the S&P rating agency. Having graded loans when I worked at banks, I can say that the “political” pressure can be very intense. I am not sure how the rating agencies will do in the bright lights, but I am dying to see the alternative to the current system (if they come up with one).

The fallout over subprime mortgages has provoked a rush to judgment, and some are now blaming the credit-rating agencies for the recent market turbulence. These charges reflect both a misunderstanding of the work carried out by rating agencies, and a misrepresentation of the overall credit performance of securities backed by residential mortgages.

Much of the recent commentary has missed several critical facts. For example, our recent downgrades affected approximately 1% of the $565.3 billion in first-lien subprime residential mortgage-backed securities (RMBS) that Standard & Poor's rated between the fourth quarter of 2005 and the end of 2006. This represents only a small portion of the mortgage-backed securities market, which in turn represents a very small part of the world's credit markets. Additionally, our recent downgrades included no AAA-rated, first-lien subprime RMBS -- and 85% of the downgrades were rated BBB and below. In other words, the overwhelming majority of our ratings actions have been directed at the weakest-quality subprime securities.

The fundamental service provided by a rating agency such as S&P is to issue an independent opinion on the creditworthiness of securities, which speaks to the likelihood that investors will receive payments of interest and principal on time. Our ratings are based on the facts available to us at the time these opinions are made.

Ratings are designed to be stable. Unlike market prices, they do not fluctuate on the basis of market sentiment. But they can and do change -- either as a result of fundamental adjustments to the risk profile of a bond or the emergence of new information. Ratings are not recommendations to buy, sell or hold a particular security. They simply provide a tool for investors to assess risk and differentiate credit quality.

Rating agencies such as ours often are criticized for being paid by the issuers of the bonds we rate. Investors value this approach because it enables us to make our ratings widely available for free -- providing access to information that helps them make informed investment decisions. Today, investors and others can access, evaluate and even criticize the hundreds of thousands of ratings that we make publicly available each year. While rating agencies that use a subscription-only model do not typically make their ratings public, our approach promotes transparency of our criteria and our opinions.

Furthermore, this approach does not affect how we assign our ratings. Our criteria are publicly available, non-negotiable and consistently applied. In fact, we do not rate financial instruments that do not meet our criteria. Like newspapers and other media, we maintain a separation between the analytical and commercial activities associated with any given rating, to ensure the independence of our opinions. We also specifically structure our analysts' compensation so that it is not dependent upon the fees related to the ratings they assign.

Most important: Reputation and integrity are our most valuable long-term assets, which would make it imprudent for S&P to provide anything other than fair, objective and independent ratings opinions. A report published by two Federal Reserve Board economists in December 2003 recognized this, saying there was "no evidence" of rating agencies acting in the interests of issuers due to a conflict of interest.

Indeed, the report concluded that "rating agencies appear to be relatively responsive to reputation concerns and so protect the interests of investors." Numerous other studies have come to similar conclusions.

As part of the ratings process, we do engage in open dialogue with bond issuers. This dialogue helps issuers understand our ratings criteria and helps us understand the securities they are structuring, so we can make informed opinions about creditworthiness. We strive to make sure issuers and investors are fully aware of how we determine creditworthiness and believe that all parties are better served when the process is open and transparent.

Credit enhancement plays an important role in our ratings, helping to offset potential losses by providing a security with excess cash flow. To achieve an investment-grade rating, therefore, we require a security with a relatively weaker pool of collateral to have a higher level of credit enhancement than a security backed by a stronger collateral pool.

These are the basics of the rigorous process that we employ whenever we issue a rating -- regardless of the risk level and regardless of the type of investment vehicle. Indeed, in the RMBS market, our process involves an analysis of individual loans, a simulation of the cash flow generated by the deal, a review of both originator and servicer operational procedures, and a surveillance process that enables us to monitor performance.

Recently, there's been considerable attention devoted to so-called "piggyback" loans -- where a second loan is used to make the down payment on a home. We recognized an inherent risk in mortgage pools that were too heavily weighted with such loans as far back as 2001, and we announced at the time that any subprime pool in which piggybacks accounted for more than 20% of total loan value would face a ratings penalty.

We began to see evidence that conditions in the mortgage market were changing -- including looser lending practices, the slowing housing market and the deterioration of subprime credit performance -- and that some mortgage loans within RMBS might pose greater risk. As a result, we continued to review our ratings. In April 2006, S&P informed the market that it was raising the level of credit support required for riskier subprime deals and adjusting its surveillance standards for RMBS.

This evaluation continued, with a focus on whether high levels of mortgage payment defaults by borrowers in some loan categories might have been isolated events or indicative of market trends. When these default levels persisted, we provided the market with additional guidance highlighting our more negative outlook, and continued to take ratings actions including the downgrades of roughly 500 first-lien subprime RMBS since July 2007.

Should we have acted sooner?

For those who would say "yes," it is important to remember that unlike many others in the capital markets -- who can take action on the basis of speculation -- we base our opinions on documented facts. We are continually reviewing and refining our processes, and we make adjustments to our ratings when the facts demonstrate the need to make adjustments, and not a moment sooner. And while we always strive to move with all deliberate speed, our highest priorities are the thoroughness of our processes and the integrity of our ratings. Our actions in the subprime market have been fully consistent with these priorities.

A rising rate of mortgage defaults has been an unfortunate byproduct of the downturn in the housing market, and while they are painful for all involved, they do remind us of something elementary about capital markets: Risk can never be entirely removed from an investment. By offering products that feature a range of risk, issuers give investors the opportunity to achieve varying levels of return. Helping investors assess that risk is part of the value that rating agencies bring to the market.