There were a lot of reasons for the 2008 credit crisis. Some of these included poor underwriting on personal mortgage loans, investors not doing their due diligence on investments, individuals lying on their mortgage applications, and government interference, to name just a few. Another cause resulted from credit rating agencies giving Collateralized Debt Obligations (CDOs) credit ratings that were not justified. This blog reviews a generic securitization, the role credit rating agencies play, and discusses whether the same incentives for fees between the issuer and the credit rating agency are still in place.
Securitization, sometimes referred to as Asset Backed Securities (ABS) or structured finance, is the process of creating a fixed income security that is collateralized or securitized by the cash flows from other assets, usually smaller, illiquid assets that are pooled together. These assets can be car loans, student loans, or mortgages, as well as a vast array of other types of loans, both personal and commercial. The pooled assets are sold to a trust which is sometimes referred to as a Special Purpose Vehicle (SPV). The trust then issues securities, which are backed by the underlying collateral that was sold to the trust. Therefore, the investor evaluates the underlying collateral to determine the probability of principal repayment as well as the ongoing payment of interest. As the old adage says, garbage in, garbage out!
The SPV/trust issues different securities commonly referred to as tranches or classes. A typical ABS structure is known as sequential pay. In these structures, the tranches are arranged in such a manner that the principal is paid to the senior most tranche while all of the other tranches receive interest only. Once the senior tranche is paid off, then the tranche next in line will start receiving principal while the other tranches continue to receive interest. The payment of principal and interest is guided by the “waterfall” which is found in the prospectus/offering circular.
Credit Rating Agencies
Prior to issuing the security, the underwriter, usually an investment bank, will approach a credit rating agency to rate the tranches. Leading up to the crisis, there were the big three credit rating agencies: S&P, Moody’s, and FitchRatings. Credit rating agencies get paid fees by rating fixed income securities including tranches from securitizations. Anyone who read the book or saw the movie The Big Short might recall that the incentives for the rating agencies should have been highlighted as a conflict of interest. Specifically, the underwriter would go to one agency and request a credit rating. If the credit rating was not deemed high enough, they would go to another credit rating agency to obtain a higher credit rating. Since fees from securitizations were a big money earner, the credit rating agencies were incentivized to give out higher ratings or lose the fees to a competitor and potentially personal bonus money as well! This is sometimes referred to as inflated bond ratings. Generally speaking, the fees are considered by many market participants to be a conflict of interest, i.e., the credit rating agencies are influenced to issue a higher credit rating in order to receive the fee.
Credit Rating Agencies Today
Today there are four more credit rating agencies including Morningstar, DBRS, Kroll, and AM Best, although the big three still control over 95% of the market1 (note that this percentage is for all of fixed income and not just securitization). In addition, Morningstar purchased DBRS earlier this year. In a recent article the Wall Street Journal2 points out that inflated credit ratings have not changed. Here are a few points from the article:
When rating a security higher than their three big competitors, Morningstar, Kroll and DBRS were around two rungs more generous, on average. Some ratings were a dozen or more rungs higher, potentially the difference between junk bonds and triple-A.
Moody’s, S&P and Fitch responded to increased competition by issuing higher ratings, according to two academics’ study of 2,488 securities rated between 2009 and 2014. One author, Colorado State University Finance Professor Sean Flynn, says “competition among credit-rating firms has, if anything, reduced the quality of credit ratings.”
Two fast-growing structured-bond sectors are Commercial Mortgage-Backed Securities, or CMBS, and Collateralized Loan Obligations, or CLOs. CMBS’s fund deals for hotels, shopping malls and other types of commercial properties. CLOs are backed by corporate loans to risky borrowers, typically to fund buyouts.
To better understand CLOs, go to https://www.gfmi.com/articles/collateralized-loan-obligations/.
Interestingly the article also states:
Investor reliance on credit ratings has gone from “high to higher,” says Swedish economist Bo Becker, who co-wrote a study finding that in the $4.4 trillion U.S. bond-mutual-fund industry, 94% of rules governing investments made direct or indirect references to ratings in 2017, versus 90% in 2010.
What about the lessons learned from the credit crisis? Here are some points from the Senior Supervisors Group Observations on Risk Management Practices during the Recent Market Turbulence Credit and Market Risk Management section3:
Those firms that were the most successful through year-end 2007 in dealing with the turmoil challenged their internal assumptions about the valuation and the behavior of products and markets by applying a wide range of credit and market risk measures and tools; equally important, they used judgment as well as these more quantitative techniques in deciding how to respond to market developments. (p. 12)
The use of information from primary market transactions may have given false comfort about the true value of retained positions in the absence of secondary market trading. In addition, some firms tended to rely too heavily on rating agencies’ assessments that complex securities, such as CDOs, were equivalent to the highest quality assets and consequently continued to value them at par for too long into the period of market turmoil. (p. 13)
There were many reasons for the financial crisis. One carryover seems to be inflated credit ratings on asset backed securities. However, while credit ratings might be a good starting point for determining whether to invest in a fixed income security, investors are still responsible for the due diligence on their investments and should not just rely on the credit rating agencies.