The Federal Reserve Bank of New York is out with a report which shows the credit ratings agencies did in fact rubber stamp “shitty” mortgage backed securities (MBS). This report is going to hurt firms like Moody’s (NYSE: MCO) which are already under investigation by the Securities and Exchange Commission. S&P (NYSE: MHP) and Fitch will be shaking too.
If you’re not interested in academic reading on this nice holiday weekend, here is your Cheat Sheet to the NY Feds findings:
- We study credit ratings on subprime and Alt-A mortgage-backed-securities deals issued between 2001 and 2007, the period leading up to the subprime crisis.
- Prior to the crisis, 80-95% of a typical subprime or Alt-A mortgage-backed-securities deal was assigned the highest possible triple-A rating, making these securities attractive to a wide range of domestic and foreign investors.
- Highly rated securities in each deal decrease in mortgage credit risk, suggesting that ratings contain useful information for investors.
- However, MBS issued since 2005 have experienced historically large downgrades, by 3-10 rating notches on average.
- The study found evidence of significant time variation in risk-adjusted credit ratings, including a progressive decline in standards around the MBS market peak between the start of 2005 and mid-2007.
- Critics interpret these facts as evidence of important flaws in the credit rating process, either due to incentive problems associated with the “issuer-pays” rating model, or simply insufficient diligence or competence.
- Rating standards will decline when security issuance volume and revenues are high relative to reputational costs of errors.
- There was significant underperformance (high mortgage defaults and losses and large rating downgrades) among deals with observably higher risk mortgages and a high level of opaque low documentation loans.
- Policy Conclusion: regulation of rating agencies should be particularly alert to credit booms such as the one recently observed in the subprime market.
Click here for the full report: MBS Ratings and the Mortgage Credit Boom.