How Subprime Junk Got the “Good Housekeeping” Seal of Approval Part II

In yesterday's blog, I detailed how the nation's big-three credit rating agencies: Moody's, S&P and Fitch, played a big role in sustaining the boom in subprime by providing investment-grade ratings on mortgage backed securities.

These high ratings implied that subprime securities were a can’t-miss proposition – riskless investment-grade bonds that apparently “couldn’t fail” – yet carried a higher yield that similarly rated government bonds – it was almost too good to be true. That’s because it wasn’t.

“The idea that the rating agencies are impartial in the world of structured finance is a joke,” says one analyst interviewed for the Bloomberg article. Bond issuers received specific “guidance” from the rating agencies on how best to structure sub-prime securities so as to win the highest rating.

Wall Street firms even received software from the ratings agencies to “show them how to meet the requirements” for an investment-grade rating. Then Wall Street paid these firms for its seal of approval.

Triple-A Rated to Junk Bond Status in Just Eight Months

Billions of dollars worth of sub-prime mortgage backed securities were stamped with Triple-A ratings by Moody’s, S&P and Fitch – the highest possible seal of approval. This gave institutional investors the green-light to pile into these bonds, assuming they were as safe and secure as government bonds.

Of course, that was just an illusion. One sub-prime backed batch of bonds with over $700 million worth of securities “was rated Baa3, an investment-grade rating, by Moody's when issued in 2006. Now, its rated Caa1, seven levels deep into junk-bond territory.”

These bonds, which sold at 100-cents on the dollar less than two years ago, are now priced at 32-cents on the dollar – as nearly one-third of the sub-prime mortgage loans backing the bonds have already defaulted.

Another scary case-study was provided by a recent Wall Street Journal article. In March 2007 Merrill Lynch assembled a $1.5 billion collateralized debt obligation (CDO) much of it backed by subprime mortgage derivatives – not even actual loans.

Yet, over 90% of the securities in this portfolio received credit ratings of "A" or better. In fact, more than one-billion dollars worth were rated AAA. In November 2007 – just eight months later – the entire CDO was downgraded to junk.

AAA Ratings For Sale?

“The essential conflict,” according to former Securities & Exchange Commission chairman Arthur Levitt, “is they are being paid by the people that they rate, they are working with the people they rate.''

In October, the State of Connecticut (home of many hedge funds now sitting on big subprime losses) opened an investigation into the ratings agencies. It has subpoenaed Moody’s, S&P and Fitch to determine their role in the sub-prime debacle.

A few years ago, it was New York State that successfully prosecuted its case against Wall Street’s tainted research. I suspect the next sub-prime shoe to drop will be the share prices of Wall Street’s “big-three” credit ratings agencies. Yet another casualty of the subprime market shock.

Comments

[dman]

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