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Saturday, July 28, 2007

Wounded Innocence 1, Seasoned Vigilance 0

by Tanta on 7/28/2007 09:12:00 AM

Mr. Ubiquitous, Joshua Rosner, got some op-ed space in the New York Times the other day. (Perhaps he's gotten a bit impatient with merely being Gretchen Morgenson's go-to guy on this topic and wants the byline.) So open up the paper with me, and read:

FOR five months, it has been clear that
Ack! Ack! Ack! (Sorry, friends, but that coffee that just came out of my nose was hot).
rising delinquencies and foreclosures, coupled with higher interest rates on adjustable mortgages and declining home price appreciation, would undermine the market for mortgage securities. Yet it took Moody’s Investors Service, Fitch Ratings and Standard & Poor’s, the three leading agencies that rate long-term debt, until this month to react to this looming financial crisis, which involves more than $1.2 trillion of subprime mortgages originated in 2005 and 2006 alone. As one investor asked during a recent S.&P. conference call, “What is it that you know today that the markets didn’t know three months ago?”
The S&P analyst in my dreams replied: "Well, Bob, we knew you knew this three months ago but you bloody weren't going to sell any of it until we downgraded it, so we had a pool going in the office to see how long we could play chicken with you. Sorry you're so upset, but I won $100 off you just this morning, so this wasn't an entire waste of time. If Mr. Market is so damned much smarter than we are, why weren't you happily playing ratings arbitrage? Don't tell me you're still long? Ha ha ha ha ha--excuse me. Next question?"
The two largest credit rating agencies, Moody’s and S.&P., announced two weeks ago that they are reviewing and lowering ratings on many of the $17.2 billion in residential mortgage-backed securities. They are doing the same for the pools of these loans known as collateralized debt obligations. The effort is, to use a well-worn but apt phrase, too little, too late. But it is not too late for regulators and legislators to take steps to restore investor confidence and to ensure the future of these markets.
I assume all readers of this blog understand what "restoring investor confidence" means. If you don't, would you like to buy some cheap mortgage-backed securities?
The subprime crisis has not been averted. In fact, it is still largely ahead of us. The downgrades represent only a small fraction — about 2 percent of the mortgage-backed securities rated for the year between the fourth quarters of 2005 and 2006 — of what the rating agencies suggest could be a mountain of bad debt held by investors, including pension plans, banks and insurance companies. The agencies are primarily downgrading assets with expected losses that are already working their way through the pipeline. They are not projecting future losses.
Of course they're projecting future losses. That's why so many of them went on that "Watch Negative" thingie. Tanta begins to think there might be something tendentious going on here.
Nor do the downgrades apply only to lower-rated securities. Some even relate to the performance of debts that are rated AAA, meaning the agencies judged them to be of the best quality — bulletproof.

The credit ratings agencies play a more important role in debt markets than stock analysts do with regard to equities. No one was told they could buy a certain stock only if, for example, an unscrupulous stock analyst said it was a “buy.” But regulators require banks, insurance companies and pension managers to purchase only high-quality debts — and the quality is judged by ratings agencies.
"Bulletproof"? The regulatory distinction is between "speculative grade" and "risk free"? Those banks and others are holding reserves and risk-based capital against their "investment grade" assets because S&P promised that the money was both "invested" and "sewn into the mattress" at the same time? I must have been watching Star Trek reruns when that news got posted on Yahoo! Finance.
Fitch, Moody’s and S.&P. actively advise issuers of these securities on how to achieve their desired ratings. They appear to be helping investment banks, hedge funds and fund companies, all of which have a fiduciary obligation to investors, to develop the worst possible product that would still achieve a certain rating.
Really? Tell it to the people who got an IO 2/28 with a 6.50% margin and a prepayment penalty, brother. There's a big, competitive contest for "worst possible product."
S.&P. has stated that it now has reason to “call into question the accuracy of some of the initial data provided to us.” This suggests that S.&P. may have chosen either to merely accept the data offered it by issuers without doing its own due diligence. Or worse, S.&P. could have ignored other information because it might have hurt revenues by reducing the number of assets it could have rated.
Those data tapes had doc type codes on them, dude, which did appear in your prospectus. Which part of "stated income" has you confused? What exact kind of "due diligence" did you think was going to help with that problem? ("Let's see . . . originator claims the borrower's income is unverified and unverifiable. Hmmm . . . well, that looks right to me. Next file!")
The Securities and Exchange Commission, working with Congress if necessary, should require the credit rating agencies to regularly review and re-rate debt securities. Rating agencies are typically paid by issuers and only for initial ratings, which leads to much of the shoddy analysis and questionable timing in the re-rating of securities.

Training and qualification standards for ratings analysts should also be required to help create consistent, objective, transparent and replicable methods. Moreover, rating agencies should put in place automated and objective systems, based on the changing value of underlying assets, to continuously re-rate debt structures.

Lastly, many accountants and government officials endure a “cooling off” period before they can work for a client. A similar delay for ratings analysts would greatly enhance the integrity and independence of the rating process. Right now, nothing stops a ratings analyst from taking a lucrative job at a bank whose deal he has just rated.

Each of these actions would serve the interest of investors large and small, public and private. Unless the government acts, the credit ratings agencies will stand on the sidelines of the coming crisis, doing nothing until it’s already happened.
Don't get me wrong. I'm all in favor of investors having to shell out money for due diligence. I have this idea that increasing the up-front cost of risk-taking (rather than leaving it all "back-loaded") might introduce a tad bit of market discipline. I could also work up some enthusiasm for stock analysts who stop punishing mortgage originators for having too much of that "operational expense" like Quality Control analysts who haven't been laid off yet. And simply licensing mortgage brokers and forcing them to have basic fiduciary requirements would warm the cockles of my disgusted little heart.

It is possible that after all that, I could get talked into shedding a few precious, glistening tears for hedge fund investors who do not themselves wish to be regulated, but who wish the rating agencies to be regulated, so that they can chase yield with no risk. But, you know, before I get behind any regulatory policy that "protects" these guys from the for-profit rating agencies onto which they happily off-load the unglamorous parts of being a Big Money Investor, I want to know what they're holding, and how those hedges are doin'. Open kimono for me, open kimono for you.

Ed. Note: I wrote this the other day* but forgot to publish it. As Mad-Eye Moody** would say, "Constant vigilance!"

*Hat tip, AS!

**No relation to the rating agency