links for 2008-04-27
The Subprime Market and Derivatives Once Again...

Roger Lowenstein on the Subprime Blowup

Roger Lowenstein almost makes me sorry for Moody's.

First: God! What a lousy lead!

Moody's - Credit Rating - Mortgages - Investments - Subprime Mortgages: In 1996, Thomas Friedman, the New York Times columnist, remarked on “The NewsHour With Jim Lehrer” that there were two superpowers in the world — the United States and Moody’s bond-rating service — and it was sometimes unclear which was more powerful. Moody’s was then a private company that rated corporate bonds, but it was, already, spreading its wings into the exotic business of rating securities backed by pools of residential mortgages...

I find it hard to imagine how anybody could think that this is an informative way to begin an article.

The body of Lowenstein's article is pretty good:

[S]uppose the security had a rating. If it were rated triple-A by a firm like Moody’s, then the investor... wouldn’t need to know what properties were in the pool, only that the pool was triple-A — it was just as safe, in theory, as other triple-A securities. Over the last decade, Moody’s and its two principal competitors, Standard & Poor’s and Fitch, played this game to perfection — putting what amounted to gold seals on mortgage securities that investors swept up with increasing élan.... By providing the mortgage industry with an entree to Wall Street, the agencies also transformed what had been among the sleepiest corners of finance. No longer did mortgage banks have to wait 10 or 20 or 30 years to get their money back from homeowners. Now they sold their loans into securitized pools and — their capital thus replenished — wrote new loans at a much quicker pace....

But who was evaluating these securities? Who was passing judgment on the quality of the mortgages, on the equity behind them and on myriad other investment considerations? Certainly not the investors. They relied on a credit rating. Thus the agencies became the de facto watchdog over the mortgage industry....

Moody’s and S&P... they reject the notion that they should have been more vigilant. Instead, they lay the blame on the mortgage holders who turned out to be deadbeats, many of whom lied to obtain their loans.... Moody’s recently was willing to walk me through an actual mortgage-backed security step by step. I was led down a carpeted hallway to a well-appointed conference room to meet with three specialists in mortgage-backed paper... the case they showed me, which they masked with the name “Subprime XYZ,” was a pool of.... All the mortgages in the pool were subprime.... In an earlier era, such people would have been restricted from borrowing more than 75 percent or so of the value of their homes, but during the great bubble, no such limits applied.

Moody’s did not have access to the individual loan files, much less did it communicate with the borrowers or try to verify the information they provided.... “We aren’t loan officers,” Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody’s, told me. “Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?” The loans in Subprime XYZ were issued in early spring 2006.... The investment bank provided an enormous spreadsheet chock with data on the borrowers’ credit histories and much else that might, at very least, have given Moody’s pause. Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs... 43 percent... did not provide written verification of their incomes... 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside.... 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences... all of the ARM loans in the pool were first mortgages (as distinct from, say, home-equity loans). Nearly half of the borrowers, however, took out a simultaneous second loan. Most often, their two loans added up to all of their property’s presumed resale value....

[T]he Moody’s analyst had only a single day to process the credit data from the bank. The analyst wasn’t evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them.... [T]he S.P.V. would float 12 classes of bonds, from triple-A to a lowly Ba1.... It was this segregation of payments that protected the bonds at the top of the structure and enabled Moody’s to classify them as triple-A....

However elegant its models, forecasting the behavior of 2,393 mortgage holders is an uncertain business. “Everyone assumed the credit agencies knew what they were doing,” says Joseph Mason, a credit expert at Drexel University.... Mortgage-backed securities like those in Subprime XYZ were not the terminus... were, in fact, building blocks for even more esoteric vehicles known as collateralized debt obligations, or C.D.O.’s.... Miscalculations that were damaging at the level of Subprime XYZ were devastating at the C.D.O. level....

When a bank proposes a rating structure on a pool of debt, the rating agency will insist on a cushion of extra capital, known as an “enhancement.” The bank inevitably lobbies for a thin cushion (the thinner the capitalization, the fatter the bank’s profits).... [I]n structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody’s has thousands of clients (virtually every corporation and municipality that sells bonds). No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. A deal the size of XYZ can bring Moody’s $200,000 and more for complicated deals. And the banks pay only if Moody’s delivers the desired rating. Tom McGuire, the Jesuit theologian who ran Moody’s through the mid-’90s, says this arrangement is unhealthy. If Moody’s and a client bank don’t see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as “ratings shopping.”...

[T]he analyst forecast losses for XYZ at only 4.9 percent of the underlying mortgage pool. Since even the lowest-rated bonds in XYZ would be covered up to a loss level of 7.25 percent, the bonds seemed safe. XYZ now became the responsibility of a Moody’s team that monitors securities and changes the ratings if need be.... [A] sliver of folks in XYZ fell behind within 90 days of signing their papers. After six months, an alarming 6 percent of the mortgages were seriously delinquent.... By the spring of 2007, 13 percent of Subprime XYZ was delinquent — and it was worsening by the month.... Poring over the data, Moody’s discovered that the size of people’s first mortgages was no longer a good predictor of whether they would default; rather, it was the size of their first and second loans — that is, their total debt — combined... credit scores, long a mainstay of its analyses, had not proved to be a “strong predictor” of defaults this time.... Amy Tobey, leader of the team that monitored XYZ, told me, “It seems there was a shift in mentality; people are treating homes as investment assets.” Indeed. And homeowners without equity were making what economists call a rational choice; they were abandoning properties rather than make payments on them.... By early this year, when I met with Moody’s, an astonishing 27 percent of the mortgage holders in Subprime XYZ were delinquent. Losses on the pool were now estimated at 14 percent to 16 percent — three times the original estimate. Seemingly high-quality bonds rated A3 by Moody’s had been downgraded five notches to Ba2....

Many of the lower-rated bonds issued by XYZ, and by mortgage pools like it, were purchased by C.D.O.’s, the second-order mortgage vehicles, which were eager to buy lower-rated mortgage paper because it paid a higher yield.... In 2006 and 2007, the banks created more than $200 billion of C.D.O.’s backed by lower-rated mortgage paper. Moody’s assigned a different team to rate C.D.O.’s. This team knew far less about the underlying mortgages than did the committee that evaluated Subprime XYZ.... [A]gencies rate pools with assets that are perpetually shifting. They base their ratings on an extensive set of guidelines or covenants that limit the C.D.O. manager’s discretion.

Late in 2006, Moody’s rated a C.D.O. with $750 million worth of securities. The covenants, which act as a template, restricted the C.D.O. to, at most, an 80 percent exposure to subprime assets, and many other such conditions.... Moody’s rated three-quarters of this C.D.O.’s bonds triple-A.... Moody’s had underestimated the extent to which underwriting standards had weakened everywhere. When one mortgage bond failed, the odds were that others would, too. Moody’s estimated that this C.D.O. could potentially incur losses of 2 percent. It has since revised its estimate to 27 percent.... A triple-A layer of bonds has been downgraded 16 notches, all the way to B....

However, the conclusion is very, very weak indeed:

[I]f the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves — not farm the job out to Moody’s.... Moody’s itself... like S&P, embraces the idea that investors should not “rely” on ratings for buy-and-sell decisions. This leaves an awkward question, with respect to insanely complex structured securities: What can they rely on? The agencies seem utterly too involved to serve as a neutral arbiter, and the banks are sure to invent new and equally hard-to-assess vehicles in the future. Vickie Tillman, the executive vice president of S&P, told Congress last fall that in addition to the housing slump, “ahistorical behavorial modes” by homeowners were to blame for the wave of downgrades. She cited S&P’s data going back to the 1970s, as if consumers were at fault for not living up to the past. The real problem is that the agencies’ mathematical formulas look backward while life is lived forward. That is unlikely to change.

The problem is not that the rating agencies' formulas look backward while life is lived forward. Rating agencies' business is to look backward: to say that this bond looks, historically, like that class of bonds which have in the past defaulted at such-and-such a rate. The proper business of investment is to take the rating agencies' work as a guide and ask two of the three standard questions:

  • What is there in the situation that could make things different this time--that could generate "ahistorical behavioral modes"?
  • How much of the risk that things are different this time are we willing to bear?

And then there is the third standard question:

  • If this is such a good deal for me to buy it at this price, why is the seller selling--why isn't it a equally good deal for the seller to hold on to it?

Without satisfactory answers to these three questions, you are not investing: you are gambling in Las Vegas and you are not the house--you are, indeed, on a blind date with destiny and she has just ordered the lobster.

Lowenstein's lament in his last paragraph is implicitly a demand that investors not only not have to have answers to these three standard questions, but that they not even be expected to ask them--that investors find somebody else to "rely" on in the cases of "insanely complex structured securities" and of "new and equally hard-to-assess vehicles in the future" that "banks are sure to invent," somebody else who can predict the future. That seems completely wrongheaded. If you truly do not want to ask the three standard questions and evaluate credit risk you should be in U.S. Treasuries (and even there you have to assess inflation risk and, unless you are planning to hold to maturity, monetary policy risk). And if you want higher yields than Treasuries offer--well, then you are back to asking your three standard questions again.

In my view, there seem to be six problems here, rather different than one would think from reading Lowenstein's last paragraphs:

  • First, the problem of private organizations where the higher-ups let their CFOs and their subordinates game them by letting them say "it's triple A" when they didn't have answers to any of the three standard questions. This seems to be a problem for shareholders and trustees to deal with.
  • Second, the problem of local government officials who were reaching for yield and saying "it's all in triple-A." This seems to be a problem for voters to deal with, or perhaps it's time to require that local governments use the Treasury as some form of fiscal agent.
  • Third, the problem of highly-leveraged large financial firms where the traders and portfolio managers asked the three standard questions with respect to CDOs and went ahead otherwise--either because they misjudged the risks, because they correctly concluded that the risks were acceptable but this time got caught, or because they correctly assessed the risks but indulged in moral hazard while thinking that they would have collected their bonuses and moved on by the time the thing blew up. This is a much more serious problem--but it has little to do with the rating agencies.
  • Fourth, the problem of the systemic risk--the fact that millions of jobs are now at risk--because of the fallout from problem three. The Fed and the Treasury are now trying to deal with this problem.
  • Fifth, the problem that a good many people who could afford to pay their mortgages and stay in their homes will not be able to do so because of crisis risk and default premia loaded onto their mortgage payments--a problem that Frank and Dodd are trying to deal with, that Obama and Clinton would deal with, and that McCain is trying to ignore.


  • Sixth, the problem that bond salesmen throughout the world have been deflecting customers' attempts to ask for answers to the three standard questions by saying, "it's triple A! And it offers you a higher yield than other triple A!" and that the rating agencies have been too eager to increase their business by making the fine print in their descriptions of what they do even finer.

Lowenstein's article is written as if problem six is in some sense the problem. And this seems to me to be badly misleading.