Sunday, May 13, 2007

Rating Agencies and the Subprime Lending Meltdown

AIG’s announcement on May 10, 2009 (here) that it was taking a $128 million charge to allow for write-downs on subprime loans issued by its savings banking division illustrates how widespread the fallout from the subprime lending collapse is, and suggests the possibility that there may be further reverberations across the business economy ahead.

A May 2007 draft paper by Joseph Mason of Drexel University and Joshua Rosner of Graham Fisher & Co., entitled “Where Did the Risk Go? How Miapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruprtions” (here), attempts to explain how subprime lending became so widespread, how rating agencies helped fuel that growth, and how rating agencies conflicts and involvement in the deal process may have led to the understatement of risk involved for investors buying instruments backed by subprime loans. The authors also suggest a possible direction future litigation involving the rating agencies might take.

The lenders who originated subprime loans sought ways to shift these assets off their balance sheets. The likeliest buyers for these kinds of assets, pension funds and insurance companies, are required to invest in only investment grade securities. In order to sell subprime loans to these institutional investors, a number of mortgage backed instruments, including in particular collateralized debt obligations (CDO) were created from pools of subprime loans. The indispensable element for the success of these instruments was the willingness of the rating agencies to grant investment grade ratings to the instruments.

According to the authors, the rating agencies became very involved in the deal making process. And no wonder, because the issuers paid the rating agencies for the ratings. The business of rating CDOs and other mortgage backed securities became a very important part of the rating agencies’ business. For example, according to Fortune (here) Moody’s net income “went from $159 million in 2000 to $705 million in 2006, in part because of increases in fees from ‘structured finance.’”

The authors point out that the rating agencies’ role was not passive and not limited simply to expressing an opinion on creditworthiness. By the rating agencies own analysis, their role was “iterative and interactive,” and consisted of informing issuers of the “requirements to attain the desired ratings in different tranches and largely defining the requirements of the structure to achieve target ratings.” In other words, the rating agency helped the issuers to structure the deal so that the agencies could give the deal an investment grade rating which, once obtained, entitled the issuer to sell the instruments to institutional investors.

The ability to sell subprime loans as investment grade assets fueled enormous growth in the subprime loan industry. This in turn created greater access to credit for potential homebuyers, which in turn cause home prices to rise, which allowed the mortgage pools to show a very low default rate, which reinforced the apparent validity of the alchemy that transformed subprime loans into investment grade securities.

But the recent downturn in the residential real estate market and the deterioration of the subprime mortgages threatens this arrangement. Nevertheless, so far, the rating agencies have downgraded only a very small portion of the mortgage-backed securities. There may well be very good reasons for this, but one possibility that suggests itself if that the rating agencies are concerned about the cascading effects that would follow widespread downgrades. The investors who hold instruments would have to divest assets that fell below investment grade. This in turn would cause prices for these securities to plummet. The authors suggest that if home prices deteriorate further, CDOs and other instruments could cause “significant losses.” If the market for these instruments were to withdraw, a “major source of liquidity will evaporate,” leading to a tightening of credit, which creates the “potential for prolonged economic difficulties that could interfere with home ownership in the U.S.”

If investors lose significant money on assets they purchased in the belief that they were acquiring investment-grade investments, the authors believe that “among the possible responses” will be litigation against many of the parties involved, including the rating agencies. In the past, when rating agencies have been sued (for example, in connection with the Orange County bond default), they have successfully argued that their rating activities were protected by the First Amendment, as mere opinions of creditworthiness. But he authors argue that the rating agencies indispensable role in the creation of these mortgage backed securities, including in particular their “interactive” involvement in the structuring of the deals, made them participants in the transaction. This, according to the authors, suggests that there “does seem to be some basis to consider" that the rating agencies may have liability as “underwriters” under Section 11 of the Securities Act.

A May 11, 2007 Financial Times article entitled “Rating Agencies Could Be Liable for Losses” (here), discusses the author’s analysis further. A March 19, 2007 Fortune article entitled "The Dangers of Investing in Subprime Debt" can be found here.

Whether or not litigation against the rating agencies ultimately emerges or is successful, the larger threat of the collapse of the market for mortgage backed securities is a concern. Between 2003 and 2006, nearly a trillion dollars of CDOs were issued ($500 billion in 2006 alone). The deterioration of these assets could cause substantial investment losses for investors. And, as the authors point out, the availability of credit could be seriously affected.

To bring all of this back to the beginning, this analysis shows that there are many potentially significant ways the subprime lending collapse could unfold. While only time will tell, there certainly are a sufficient number of reasons to be concerned – and for The D & O Diary to continue to keep track of subprime lender lawsuits (here).

Blog Bites Man: It was one year ago this week that, in a fit of optimism and naïveté, I launched The D & O Diary. When I started this venture, I had no idea where it would lead. Armed only with a desire for self-expression and a healthy sense of adventure and curiosity, I took the plunge. It has been an amazing, eye-opening ride.

One of the great discoveries along the way has been finding out about the social and support network among bloggers. It has really been interesting getting to know or communicating with fellow bloggers such as Adam Savett of the Securities Litigation Watch, Broc Romanek of the CorporateCounsel.net, Susan Mangiero of the Pension Risk Matters blog, Lyle Roberts at the 10b-5 Daily, Bruce Carton at the Best in Class blog, Sam A. Antar at the White Collar Fraud blog, Francis Pileggi at the Delaware Corporate and Commercial Litigation blog, and Werner Kranenburg at the With Vigour and Zeal blog. There have been many other bloggers far too numerous to recount here with whom I have communicated or corresponded during the year. It has truly been a pleasure interacting with my fellow bloggers.

In addition to other bloggers, the blog has also brought me into contact with interesting and interested readers from around the world. Some of my favorite blog posts originated as comments or links provided to me by one of my readers. I am very grateful to everyone who has communicated with me and I hope readers out there will continue to send me their thoughts, comments, suggestions and links.

One aspect of my readership which I truly had not anticipated is its cosmopolitan composition. While it is not surprising that I might have readers in, say, France or Italy, I do find myself wondering exactly what it is about my blog that interests readers in, say, Mongolia, Suriname, Vietnam, Ghana, Moldova or Kyrgyzstan? The Internet is an amazing thing….

Portrait of an Artist as a Young Blogger: There are those benighted souls who might dare to question the ultimate value of an ephemeral occupation like blogging. Admittedly, it might later be said of our age of blogging, as Edward Gibbon said of the state of Roman literature after the age of the Caesers, "[a] cloud of critics, of compilers, of commentators darkened the face of learning, and the decline of genius was soon followed by a corruption of taste." What is blogging after all but criticism, compilation, and commentary, and of a particularly self-indulgent variety to boot?

But even if blogging is mere self-indulgent compilation and commentary, it serves a deep need for self-expression, and fulfills the spirit of inquiry that lives within all of us. Might we not say, to paraphrase David Hume’s comment on philosophizing, that if a man reaped no advantage from blogging, "beyond the gratification of an innocent curiosity, yet ought not even this to be despised, as being as accession to those few safe and harmless pleasures which are bestowed on the human race." If blogging is self-indulgent, if it is mere compilation and commentary, it at least affords a safe and harmless means to gratify innocent curiosity – for author and reader alike.

And for those readers who may have already observed that the preceding two paragraphs represent prime examples of self-indulgent compilation and commentary, to you are vouchsafed the deeper truths of the inner blogosphere.

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