On April 13, 2011, the US Senate Permanent Subcommittee on Investigations (2011) , chaired by Senator Carl Levin (D-Mich.), released a post-mortem analysis entitled,
In light of the subcommittee's report, coupled with the lingering public outrage over the 2008 financial crisis, it is easy to envision a caricature of greedy investment bankers colluding with unscrupulous credit raters to cook the ratings on investments in order to line their pockets at the expense of unwary investors. However, the truth likely is more complicated, and the reasons for the poor performance of the credit rating agencies is likely more subtle. In particular, the nature of the credit ratings process, coupled with structural elements behind the industry, make for an environment in which unconscious biases in professional judgment are likely to arise, and which are likely to have a negative impact on the quality of credit ratings. This type of bias is particularly difficult to deal with, because those who exhibit it do not believe that they are making poor judgments or compromising their integrity in the decisions that they make.
The following analysis focuses on events that occurred in the USA and in its financial markets, and on the related US Government reforms. However, the relevant issues are not unique to the USA. Accordingly, the analysis also applies to almost any country in which credit ratings play an important role in financial markets.
During the first part of the 2000s, credit rating agencies played a key role in the securitization of US residential mortgages and in the marketing of related financial derivatives, whose values were based on those mortgages. Essentially, investment banks like Goldman Sachs purchased residential mortgages from originators, including commercial banks, and mortgage companies such as Countrywide. The investment banks then repackaged these mortgages in the form of bonds and sold them to investors. The benefit of doing so, according to the banks, was the diversification of risk. In other words, if a particular lender held a $300,000 mortgage note, it would stand to gain if the mortgage was paid off according to schedule, but it would stand to lose if the borrower defaulted; essentially an all or nothing proposition. The idea behind residential mortgage backed securities (RMBS) was that it would be more efficient to spread this credit risk around. For instance, the local bank could sell the mortgage to an investment bank (typically for more than face-value). If it wanted to replace its exposure to the real-estate market, it could, for instance, buy $300,000 worth of RMBS. The benefit of doing so is that it would receive interest payments, much like if it held the original mortgage. But, rather than having the entire $300,000 investment linked to a single property, its investment would be spread across hundreds, or even thousands, of properties from different geographic regions. In the event of a default, lots of investors would suffer very small losses, rather than one investor shouldering the entire burden on its own.
The investment banks devised clever ways to assign the cash flows from the underlying mortgage payments to the related RMBS – to construct bonds with varying degrees of credit risk. Bonds that had the highest priority for receiving payments carried the least risk, and offered the most conservative return. Bonds with lower priorities carried more risk, and offered higher returns. The investment banks hired credit rating agencies to evaluate their RMBS packages, and to assign credit ratings to each type of bond. The importance of doing so was that certain institutional investors, such as pension funds, were the source of substantial demand for bonds, and were contractually limited to purchasing only the safest debt securities. The banks worked hard to structure the packages of RMBS such that most of the bonds would receive a triple-A rating, signifying a very limited risk of loss of principal. These bonds then could be sold to institutional investors, and to others who were sufficiently risk-averse. The bonds that did not make the grade often were combined with the riskiest pieces of other RMBS packages, and re-sliced – to further diversify the new pieces – and re-submitted to the same ratings process. Interestingly, enough, the majority of these new, and increasingly diversified, securities (known as collateralized debt obligations or CDOs) often received the coveted triple-A rating from the agencies; also making them eligible for purchase by pension funds and other conservative investors.
The ratings process typically commenced with an investment bank hiring a credit rating agency to rate a package of RMBS or CDOs. In the case of RMBS, the agency would examine the structure of the securities, including how cash flows were assigned to each bond, and the degree of cushion built-in to the offering. For instance, a $300,000 RMBS offering might be backed by mortgages with a face value of $306,000, providing a 2 percent default cushion before any of the bonds would begin to suffer; the greater the cushion, the safer the bonds, and the greater the chance of receiving a triple-A rating. In addition, the agencies typically examined spreadsheets of loan data for the underlying mortgages, looking for things like credit scores of the borrowers, loan to value ratios, geographic location of the collateral, etc. Data from these spreadsheets was fed into proprietary quantitative models to arrive at conclusions about potential losses associated with particular bonds. Analysts for the agencies used the quantitative data as input to arrive at their ratings. If the investment banks were not happy with, for instance, the proportion of an offering receiving triple-A status, they had the opportunity to modify the contents, such as increasing the default cushion, or swapping-out specific mortgages. The revised packages would then be reanalyzed...