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Rating agencies set criteria to establish credit enhancement levels that ultimately lead to ratings on bonds. The rating agencies generally rely on historical statistical analysis to set ratings. The rating agencies also generally rely on numeric descriptions of loans like loan-to-value ratios and debt-to-income ratios to make their determinations. Rating agencies generally do not review loan files or “re-underwrite” loans. Rating agencies also do not share in the economic costs of loan defaults. The rating agencies’ methodology allowed for the inclusion of loans of dubious quality into sub prime mortgage pools, including low documentation loans for borrowers with poor payment histories without the offsetting requirement of high down payments.
The rating agencies also established criteria for Collateralized Debt Obligations that allowed CDO managers to produce very highly leveraged portfolios of sub prime mortgage securities. The basic mechanism for this was a model that predicted that the performance of sub prime mortgage pools was not likely to be highly correlated. That is, defaults in one pool were not likely to occur at the same time as defaults in another pool. This assumption was at best optimistic and most likely just wrong.
In the CDO market the rating agencies have a unique position. In most of their other ratings business, a company or a transaction exists or is likely to occur and the rating agency reviews that company or transaction and establishes ratings. In the CDO market, the criteria of the rating agency determine whether or not the transaction will occur. Let me explain further. A CDO is like a financial institution. It buys assets and issues debt. If the rating agency establishes criteria that allow the institution to borrow money at a low enough rate or at high enough leverage, then the CDO can purchase assets more competitively than other financial institutions. If the CDO has a higher cost of debt or lower leverage, than it will be at a disadvantage to other buyers and will not be brought into existence. If the CDO is created, the rating agency is compensated for its ratings. If the CDO is not created, there is no compensation. My view is that there are very few institutions that can remain objective given such a compensation scheme.
CDO investors also relied upon the CDO manager to guide them in the dangerous waters of mortgage investing. Here again investors were not well served by the compensation scheme. In many cases CDO managers receive fees that are independent of the performance of the deals they manage. While CDO managers sometimes keep an equity interest in the transactions they manage, often the deals are structured in such a way that the equity of the deal can return the initial equity investment even if some of the bonds have losses. Moreover, many of the CDOs were managed by start-up firms with little or no capital at risk.
