Tuesday, February 12, 2013

Finally: The DOJ Charges S&P With Fraud In Rating Sub-Prime Backed Securities

The DOJ is going after S&P for giving sub-prime mortgage backed securities AAA ratings in the run-up to our economic meltdown in 2008. This move is getting panned by many on the right as payback against S&P for downgrading U.S. credit rating to AA in 2011 - and that certainly is a reasonable conclusion, given that the DOJ has not similarly targeted either Moody's or Fitch, both of which were equally guilty of vastly over-rating sub-prime mortgage backed securities.

Regardless, this is a lawsuit that I sincerely hope plays out in public. The fraud perpetrated by the ratings agencies was wholly intertwined with an insane government policy to force banks into making loans that did not meet traditional colorblind lending criteria. The ratings agencies were both complicit in and victims of this policy. There are a lot of facts that need to come out. Moreover, it is an issue with direct application to today, as the Obama administration not merely continues, but actually has strengthened the same insane government policies that gave rise to the the subprime crisis and our 2008 economic meltdown.

To explain, the Community Reinvestment Act (CRA) was used by the left for 16 years to destroy color-blind lending standards and force banks to make sub-prime loans. Fannie and Freddie were used to create a massive market for these loans. Still, none of this would have worked if the credit rating agencies had not given AAA ratings to the securities containing these mortgages, as most if not all banks were limited to purchasing securities with AAA ratings. That is how the sub-prime contagion spread throughout world markets.

In 2008, I wrote a long post explaining the origins of our melt-down. As to the ratings agencies, I opined at the time:

One of the most questionable aspects of the subprime meltdown is how mortgage backed securities being pumped out by Fannie Mae and others, were vastly underrated as to the actual risk they represented. This is another horror story that centers on the tearing down of "outdated and arbitrary" lending criteria. From the information available today, it appears that, when the old standards were labled "racist" under Clinton, the rating agencies tried to adapt to the new "market innovations" without reliance on old standards. This from Stan Liebowitz of the University of Texas:

[Why were] the rating agencies were willing to give [risky loans] AAA ratings? . . .

[T]he housing price bubble that was caused in part by these relaxed underwriting standards tended to reduced defaults and obscure the impact of the standards while prices were rising because almost no one would default when they could, instead, easily sell the house at a profit. Rating agencies could suggest that these loans were no more risky than the old antiquated loans and provide empirical support for that conclusion, given the still low default rates at the time, although to do so was short sighted to the point of incompetence.

In fact, the rating agencies seemed overly concerned with the trees and lost sight of the forest. For example, a Wall Street Journal article (which is the basis for the following three quotes) reports on rating agencies’ benign treatment of piggyback mortgages (taking out a second mortgage to cover the downpayment required by the first mortgage). In previous decades, mortgage applicants unable to come up with the full downpayment and therefore thought to be more at risk of default, were required to pay ‘mortgage insurance’ which raised the interest rate on the loan. Piggyback loans allowed borrowers to avoid this mechanism, thus presumably making the loan riskier. Nevertheless, the article reports that rating agencies did not consider these loans more risky:

Data provided by lenders showed that loans with piggybacks performed like standard mortgages. The finding was unexpected, wrote S&P credit analyst Michael Stock in a 2000 research note. He nonetheless concluded the loans weren't necessarily very risky.

The finding was unexpected because it contradicted what had generally been known about mortgages by a prior generation of mortgage lenders—that when applicants made smaller downpayments, increasing the loan-to-value ratio, the probability of default increased. This finding contradicted common sense. Further, these measurements were being made at the front end of a housing price bubble (Figure 1 below shows that prices were rising smartly in 2000), likely biasing downward any default statistics. Relaxed lending standards also had a short enough track record that rating agencies could not know how they would perform in the long run or in adverse conditions, meaning that it isn’t clear that sufficient information existed to even rate these securities. So how did the rating agencies defend their counterintuitive ratings?

One money manager, James Kragenbring, says he had five to 10 conversations with S&P and Moody's in late 2005 and 2006, discussing whether they should be tougher because of looser lending standards… Other analysts recall being told that ratings could also be revised if the market deteriorated. Said an S&P spokesman: "The market can go with its gut; we have to go with the facts."

Whether such a myopic view of the “facts” was responsible for all or most of the excessively high ratings I cannot say, but these ratings were consistent with the views of the relaxed lending standards crowd. The real facts, of course, eventually soured the view of the rating agencies:

By 2006, S&P was making its own study of such loans' performance. It singled out 639,981 loans made in 2002 to see if its benign assumptions had held up. They hadn't. Loans with piggybacks were 43% more likely to default than other loans, S&P found.

In spite of their inaccurate ratings, the rating agencies, nevertheless, were making great profits from rating mortgage-backed securities, a quasi-sinecure created by the government which required many financial organizations (e.g., insurance companies and money market funds) to invest only in highly rated securities as certified by government (Security and Exchange Commission) approved rating agencies (NRSROs). There were only three such approved rating agencies for most of the last decade (S&P, Moody’s and Fitch). Given that government-approved rating agencies were protected from free competition, it might be expected that these agencies would not want to create political waves by rocking the mortgage boat, endangering a potential loss of their protected profits.

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