Credit Ratings Agencies Role in Subprime Creation

One of the more shocking things, I find, in the U.S. credit crisis is that over half of the mortgage-backed bonds outstanding (in dollar terms) had the highest credit rating of AAA (as reported by the Wall Street Journal). By comparison, only about a dozen U.S. corporations, such as General Electric and Berkshire Hathaway, have the AAA rank. What led Standard and Poor’s, Moody’s, Investors Service, and Fitch to be so lenient with mortgage-backed bonds?

Capitulation to conflicts of interest is one thesis. Bond issuers pay fees to have their securities rated. Furthermore, the fees are twice as high for mortgage-backed bonds as corporate bonds. Combine this fee arrangement with the explosive growth in the mortgage-backed bond market, and it could be argued the temptation was greater for standards to be relaxed – as Ohio State’s Attorney General indicated in connection with his decision to commence an investigation (also investigating: the SEC, U.S. Senate and House committees, and the states of New York and Connecticut).

Additionally, as reported in the Wall Street Journal, a close relationship is said to have arisen between the credit rating agencies and the issuing investment dealers. The dealers regularly sought the agencies’ input when creating new issues, which effectively put the rating agencies in a position to influence the size of the market from which they drew lucrative revenues. At the same time, the dealers were shopping around for evaluations, inviting a “race to the bottom.” And since mortgage-backed bonds were a relatively recent innovation, assessments of creditworthiness ended up relying on data and techniques provided by the dealers.

I understand less than 5% of subprime mortgage securities have had credit downgrades to date, so there could be more of the iceberg under water. I'll remain a bear on financial-industry exchange traded funds like iShares Dow Jones Regional Banks (RKH) and Select Sector SPDR-Financial (XLF), as outlined in earlier posts starting with the “Avoid/sell U.S. bank stocks” entry on June 2, 2006. But a time will come when the valuations will be too tempting to pass over.