Much has been written, and there will be more to come, about the failure of Moody's Investors Service and Standard & Poor's to anticipate the subprime mortgage debacle. At the end of the day, many investors bought securities that carried an inappropriate and unexpected degree of risk, and many lost money when the securities were downgraded. This is not the first time that the ratings agencies have been called on the carpet. In the wake of the Enron and WorldCom bankruptcies, investors and regulators alike jumped on the firms for failing to foresee these catastrophes.
What can be done?
A law professor at Columbia University who testified before the Senate Banking Committee in September on these matters, John Coffee, has some thoughts. "We want more competition, and especially new participants that are paid by subscribers rather than by the issuers, as Moody's was, initially," he says.
The number of significant players in the ratings business has been limited in part by the Securities and Exchange Commission, which has designated only a handful of firms as Nationally Recognized Statistical Rating Organizations, awarding them legally significant status. Mr. Coffee especially advocates the development of firms such as Philadelphia-based Egan-Jones, which was finally awarded NRSRO status last November after 10 years of waiting.
Four hundred investment concerns pay fees to Egan-Jones in order to receive its ratings. Not only does it not accept fees from issuers, it does not provide other services such as consulting. "The new agencies aren't as conflicted," Mr. Coffee says. "However, the issuers won't use them or give them information."
To solve this problem, Mr. Coffee recommends that the SEC require that any financial information provided to a ratings agency be made available to all the agencies — rather like the way that all securities analysts must be given the same financial disclosures. This application of regulation FD (prohibiting selective disclosure of material information) would help level the playing field, Mr. Coffee says.
Mr. Coffee also argues that the agencies must be given some incentive to provide interim updates. "Currently, the agencies usually give a rating only when they initially rate a security. Consequently, when they do provide a downgrade, it's a big shock. They should make ratings quarterly or annually, providing a continued flow of information. One of the problems is that they receive no money for interim adjustments. It's just like securities analysts. It might cost more, but this system is dysfunctional."
The head of Egan-Jones, Sean Egan, says his firm is "providing timely and accurate ratings for the benefit of investors. The big agencies don't get penalized for being wrong — we do."
Does the approach work? Mr. Egan is delighted to report that his firm has beaten Moody's and S&P to the punch a number of times, downgrading Enron and WorldCom months ahead of the competition, for instance. How about the latest debacle? Egan-Jones has not historically provided research on structured finance, but it has covered some of the ancillary players such as mortgage insurer MBIA. Where is it on MBIA? Mr. Egan says it began downgrading the company's credit as early as 2001. In a 2002 report it cautioned that the company had "$66 billion of CDOs it has insured. Over the next six quarters we expect higher default rates and lower recoveries on those loans." Because of concerns over its exposure to mortgage-backed loans, the stock has fallen in the past year from a high of $76 and closed yesterday at $13.40.
What is the firm's current rating on MBIA? "We rate the company BB with a negative watch," Mr. Egan says. "Moody's and S&P still have them at AAA." He sounds practically gleeful.
Moody's may be trying to change its image. The company announced recently that America was in peril of losing its triple-A credit rating over the next decade because of rising health care and Social Security costs. Doesn't this anticipatory "heads-up" to American officials seem a bit premature? A cynic might think that the folks at Moody's are jumping eagerly ahead here to make up for having been so behind the curve in downgrading mortgage-backed securities.
In an era when investors are more frequently seeking recompense from those perceived as accountable for losses, the ratings agencies might come under increased duress. At a recent discussion about distressed debt hosted by Debtwire, a senior industry official who asked not to be identified said: "I don't think the ratings agencies are on top of it." No kidding.
On Monday, representatives of the ratings agencies appeared before the European Parliament to defend against charges that they had failed investors. Reuters quotes Barbara Ridpath of S&P as saying: "We recognize some investors had been using ratings inappropriately." Hmmm. As in, taking them seriously?
It is not just European legislators who are taking a hard look at the ratings process. The SEC is again reviewing the relationship between Wall Street and the ratings agencies. The main problem is that the companies issuing securities are also paying for the ratings. In the case of collateralized debt obligations and other asset-backed securities, if the ratings were not attractive enough, the securities were not created, and there were no fees paid. The incentive to inflate the rating is painfully clear.
Could the agencies have foreseen the meltdown? An online chronicler of news on the sector, MortgageDaily.com, reported in January 2005 on a subprime study by the University of North Carolina's Center for Community Capitalism. The paper looked at the nine-fold increase in subprime lending between 1994 and 2003 — to $332 billion from $35 billion — and the fact that the percentage entering into foreclosure was running at the end of 2003 at 10 times the rate for all mortgages. "A little over one fifth of first-lien subprime refinance loans originated in 1999 entered into foreclosure by December 2003," the study said.
Also in January 2005, S&P announced that the issuance of residential mortgage-backed securities in 2004 had climbed to $864.2 billion, a 47% year-over-year gain, fueled primarily by subprime and second mortgage liens of nearly $412 billion, up 91% from a record 2003 total. Here's the good part: Of more than 12,000 outstanding credit classes at the start of 2003, 99.4% were at the same rating level or higher by year-end. There were, during the year, 1,425 performance-related upgrades and only 69 downgrades. In other words, S&P thought the industry looked just terrific.
It wasn't until the spring of last year that Moody's and S&P finally began to become more cautious about the CDOs that were built on the foundation of weakening asset-backed securities. We all know what happened next.