n Apr 23, 2:08=A0am, Papadillos <papadil...@hotmail.com> wrote:
New York Times Magazine
April 27, 2008
MAGAZINE PREVIEW
Triple-A Failure
By ROGER LOWENSTEIN
This article will appear in Sunday's New York Times Magazine.
The Ratings Game
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.
Obscure and dry-seeming as it was, this business offered a certain magic.
The magic consisted of turning risky mortgages into investments that would=
be suitable for investors who would know nothing about the underlying loan=
s.
To get why this is impressive, you have to think about all that determines=
whether a mortgage is safe. Who owns the property? What is his or her
income? Bundle hundreds of mortgages into a single security and the
questions multiply; no investor could begin to answer them. But suppose th=
e
security had a rating. If it were rated triple-A by a firm like Moody's,
then the investor could forget about the underlying mortgages. He 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
=E9lan. For the rating agencies, this business was extremely lucrative. Th=
eir
profits surged, Moody's in particular: it went public, saw its stock
increase sixfold and its earnings grow by 900 percent.
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.
Mortgage volume surged; in 2006, it topped $2.5 trillion. Also, many more
mortgages were issued to risky subprime borrowers. Almost all of those
subprime loans ended up in securitized pools; indeed, the reason banks wer=
e
willing to issue so many risky loans is that they could fob them off on Wa=
ll
Street.
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.=
In a practical sense, it was Moody's and Standard & Poor's that set the
credit standards that determined which loans Wall Street could repackage
and, ultimately, which borrowers would qualify. Effectively, they did the
job that was expected of banks and government regulators. And today, they
are a central culprit in the mortgage bust, in which the total loss has be=
en
projected at $250 billion and possibly much more.
In the wake of the housing collapse, Congress is exploring why the industr=
y
failed and whether it should be revamped (hearings in the Senate Banking
Committee were expected to begin April 22). Two key questions are whether
the credit agencies -- which benefit from a unique series of government
charters -- enjoy too much official protection and whether their judgment
was tainted. Presumably to forestall criticism and possible legislation,
Moody's and S.&P. have announced reforms. But 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 obta=
in
their loans.
Arthur Levitt, the former chairman of the Securities and Exchange
Commission, charges that "the credit-rating agencies suffer from a conflic=
t
of interest -- perceived and apparent -- that may have distorted their
judgment, especially when it came to complex structured financial products=
.."
Frank Partnoy, a professor at the University of San Diego School of Law wh=
o
has written extensively about the credit-rating industry, says that the
conflict is a serious problem. Thanks to the industry's close relationship=
with the banks whose securities it rates, Partnoy says, the agencies have
behaved less like gatekeepers than gate openers. Last year, Moody's had to=
downgrade more than 5,000 mortgage securities -- a tacit acknowledgment th=
at
the mortgage bubble was abetted by its overly generous ratings. Mortgage
securities rated by Standard & Poor's and Fitch have suffered a similar wa=
ve
of downgrades.
Presto! How 2,393 Subprime Loans Become a High-Grade Investment
The business of assigning a rating to a mortgage security is a complicated=
affair, and Moody's recently was willing to walk me through an actual
mortgage-backed security step by step. I was led down a carpeted hallway t=
o
a well-appointed conference room to meet with three specialists in
mortgage-backed paper. Moody's was fair-minded in choosing an example; the=
case they showed me, which they masked with the name "Subprime XYZ," was a=
pool of 2,393 mortgages with a total face value of $430 million.
Subprime XYZ typified the exuberance of the age. All the mortgages in the
pool were subprime -- that is, they had been extended to borrowers with
checkered credit histories. 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 in their loan applications. "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, wh=
at
percent will pay their loans?"
The loans in Subprime XYZ were issued in early spring 2006 -- what would
turn out to be the peak of the boom. They were originated by a West Coast
company that Moody's identified as a "nonbank lender." Traditionally, peop=
le
have gotten their mortgages from banks, but in recent years, new types of
lenders peddling sexier products grabbed an increasing share of the market=
..
This particular lender took the loans it made to a New York investment ban=
k;
the bank designed an investment vehicle and brought the package to Moody's=
..
Moody's assigned an analyst to evaluate the package, subject to review by =
a
committee. The investment bank provided an enormous spreadsheet chock with=
data on the borrowers'
