Wall Street is fraught with conflicts of interest. While some are obvious or even freely admitted -- as is the case with those small-print disclaimers at the back of research reports acknowledging the existence of trading, investment banking, and other relationships with the companies being evaluated -- others are not so easy to discern.
Examples include the relationships that exist between well-known rating agencies and the companies (and their securities) whose creditworthiness they are are called upon to assess. Unbeknownst to many outside the industry, firms such as Standard & Poors, Moody's, and Fitch, which are generally seen as bastions of rigorously objective analytical prowess, are usually paid by those being evaluated.
That does not necessarily mean their ratings are suspect. Nonetheless, it is not surprising that credit rating agencies are rarely at the forefront in acknowledging a sudden change in a company's financial fortunes or a rapid deterioration in the overall credit environment.
Regardless, a Wall Street Journal report suggests we can add credit-assessors to the growing list of firms and individuals that have been hurt by the supposedly "contained" meltdown in the subprime lending market.
The meltdown in mortgages for risky, "subprime" borrowers is claiming its latest casualties: credit-ratings companies.
Trading in many bonds backed by subprime mortgages reveals a widening gap between investors' perception of their risk and the opinions of large ratings providers like Moody's Investors Service, Standard & Poor's and Fitch Ratings. Some subprime-mortgage bonds that were assigned investment-grade ratings as recently as 2006 are even trading at prices that imply they could be as risky as junk bonds. Yet most of their ratings haven't changed.
At the same time, the stock prices of Moody's Corp. (NYSE:MCO) and S&P's parent, McGraw-Hill Cos. (NYSE:MGP), have taken a hit over concerns that the turmoil in the subprime-mortgage market may spread to the broader market for mortgage-backed bonds or damp issuance of other types of debt products like collateralized debt obligations.
Moody's and McGraw Hill's shares are down 11% and 6%, respectively, since early February, versus a 1% fall in the S&P 500-stock index over the same period. Fitch is a unit of Fimalac SA of France.
For years, the ratings companies reaped profits by charging issuers for rating bonds backed by home loans to borrowers with weak credit, known as subprime mortgages. Many Wall Street firms also followed guidelines from the ratings companies when they bundled loans together and sold billions of dollars in highly rated securities backed by them.
The ratings providers "were at least as interested as the investment banks in getting the deals done because they would get paid for rating them," notes Ed Grebeck, CEO of Tempus Advisors, a debt-markets strategist in Stamford, Conn.
Executives at ratings companies deny a conflict exists. "Issuers pay us because investors believe our opinions about the risk of the assets have value," says Glenn Costello, a managing director at Fitch. He added that "it is still early to determine which bonds are going to be most at risk."
Stock analysts who track Moody's and McGraw Hill say subprime-related ratings revenue make up only a small part of their businesses and they don't expect the subprime issues to affect their forecasts of double-digit earnings growth at the companies this year.
To come up with ratings on mortgage bonds, ratings companies use financial models that consider historical default and loss rates among pools of mortgage loans and try to predict how newer loan pools will hold up under various economic scenarios. Forecasts and assumptions about interest rates and movements in home prices also are factored in.
The models help determine how many bonds backed by a pool of loans may be so insulated from losses that they can be rated AAA -- which connotes as little risk as a super-safe U.S. Treasury bond -- and how many are less protected and thus bear weaker ratings like A or BBB. The bonds usually are backed by loans whose value exceeds the bonds' principal so as to provide a cushion for expected losses among the mortgage pool.
Now, many of the ratings are being called into question as market prices of some subprime bonds suggest investors expect them to lose some of their principal.
"What's driving the market now is that defaults are coming significantly faster than historical simulations," says Brian Carlin, head of fixed-income trading at J.P. Morgan Private Bank.
If ratings companies have to downgrade a large number of subprime bonds issued in 2006, "it basically means they didn't do a good job rating them last year," says Thomas Lawler, a housing economist in Vienna, Va. "In other words, it would mean they completely misjudged the risk."
Ratings-company officials say their ratings still accurately reflect the probability of actual losses on mortgage bonds.
Actually, it sounds more like a serious "model failure" to me.