The Role of Credit Agencies in the Financial Crisis

We had a good question regarding the role credit agencies have played in creating this financial mess. By "credit agency" we don't mean Experian, Equifax or Transunion which I wrote about earlier this week. While those focus on consumer credit profiles and scores, there are a few more "agencies" that had a direct impact in fueling this crisis and they are household names: Moody's and Standard & Poor's.



Actually, there are a few others like Fitch, but Moody's and S&P are the big dogs in this business. What business is that, you ask? These companies act as a sort of consultant to the financial industry. They evaluate the credit quality of companies and give them a credit rating. For example, Warren Buffet's company, Berkshire Hathaway, is rated the highest or safest at AAA (U.S. government "treasury" bonds are AAA). The next notch down would be AA, then A, then BBB, etc. When a company issues bonds, the agencies rate them so investors have an independent assessment of a company's credit worthiness. By "credit worthiness" we mean how likely is the company to default on its loans, bonds or obligations.

For decades, these two agencies were THE authority on "ratings". A downgrade could affect a company's ability to raise capital, its stock price and sometimes its ability to conduct business as usual. Back in the late 1990's, both companies saw a business opportunity they called "structured finance".  This was the name they gave to Wall Street's securitization business. Securitization is when assets are pooled together (securitized) into one security and sold to investors. Mortgage Backed Securities (MBS), Collaterized Debt Obligations (CDOs), Asset Backed Securities (ABS) and lots of other convenient acronyms evolved to describe this business. Let's say for example, that CitiGroup pools 1000 mortgages into an MBS. S&P or Moody's (or both) would examine the features of this pool. They would look at loan-to-value ratios, interest rates, credit scores on each loan, geographic concentration of loans, etc. and determine how likely this particular pool or MBS is to return investors money without default. They would rate the MBS.

The rating was very important because many institutions (and these trade in large denominations, so individuals are not in this market; big money only) are required to hold high quality assets. It also made the market quite liquid because many players did not have the resources in terms of analytic manpower or expertise to evaluate the securities as the agencies could. They couldn't do their own thorough research, so they relied on the agency rating.

Here is where a few big problems creeped in. The first problem was that data needed to reasonably assess the credit worthiness of such securities did not exist in sufficient form. Much of this was new and data series did not go back very far. Accurate housing data only recently became available and no series encompassed events like the Depression of the 1930's or war of the 1940's. In other words, lots of assumptions were being made.

Why would the agencies risk their reputations based on inadequate data? This is the crux of the second problem: their compensation. Moody's and S&P get paid to rate each security by the issuer. See the conflict of interest? Say CitiGroup wants to issue new bonds. Citi pays a fee to Moody's to rate the bonds. Each time Citi issues a new bond, Moody's gets paid (every issue is different due to different maturities and seniority in the capital structure). This had never really been a problem with traditional ratings though until securitization came along. Guess who became the biggest issuer of new paper in the past decade? Yup- Fannie, Freddie, Citi and the rest of Wall St who were happily and voraciously securitizing assets.

Now, let's be clear: I am not saying the agencies deliberately gave false ratings. If that happened, I'm sure a lawsuit will reveal it in due time. We are noting however, that the agencies had every incentive to convince themselves they were capable of rating these securitizations. Indeed they went after the business aggressively. Regular old ratings are not a fast growth business- but the future of finance was seen in the rapidly growing volume of securization.

In fact, one problem was that they rated many securities as "AAA", but in the notes was an explanation that a AAA rating on a securitized mortgage pool was not the same a AAA Berkshire. Same nomenclature, different definition. Do we blame the dumb buyers of these who didn't do their own homework? Or do we blame the agencies? Or both?

As you might imagine, a false confidence in the safety of many of these securities helped spread their use. More and more capital was being funneled into them, fueling the bubble. If a "sub-prime" mortgage security is rated AAA because of [insert a half dozen reasons here] and yields 5% more than "regular" AA bonds, you would be a fool not to play right?

It is my opinion that investors must do their own homework. Why pay someone to manage assets if they aren't doing the research themselves? Those institutions that didn't do their homework did an enormous disservice to their investors, but that doesn't excuse the agencies either. In fact, they should be ashamed and it wouldn't surprise me if Congress forced them to change their compensation model to avoid the conflict of interest.

Happy Thanksgiving everyone.