Ratings Agencies Under Fire

[TJ_98370]

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And the finger pointing continues....

Does anyone really believe that Mr. Investment Banker and Mr. Hedge Fund Manager did not know exactly what they were getting into?



Moody's and Standard & Poor's have come under heavy criticism for failing to predict the subprime blowup, writes Fortune's Bethany McLean......

.....Hedge fund managers aren't the only ones demanding answers as estimates of global losses due to U.S. subprime mortgages mushroom to as much as $150 billion. While out-of-date banking regulations and lax federal oversight didn't help matters, it was the complicity of the rating agencies -- Standard & Poor's, Moody's, and Fitch Ratings -- that enabled the boom.

Now European regulators are probing whether they underestimated risk, and many expect U.S. investigations and investor lawsuits to follow.

DISGUISED RISK

Here's how it worked. After buyers with less than stellar credit were approved for a mortgage, lenders would bundle a bunch of iffy loans and sell them to investment banks, which would repackage these into Franken-loans and sell them to investors.

By working hand-in-glove with the rating agencies -- which were paid large fees for their involvement -- institutions managed to get masses of these mortgage-backed securities rated investment grade. All of a sudden risky consumer loans were reconstituted into -- presto! -- something seemingly no more risky than a government Treasury bond.

The whole concept, says hedge fund manager Bill Laggner, is "lunacy." Michael Burry, who runs hedge fund Scion Capital and was one of the first to aggressively bet against supposedly investment-grade securities based on subprime mortgages, says his thesis was that "the rating agencies were horribly wrong." In a letter to investors he compared them to investment banks during the dot-com bubble. "They were money-grubbing and sorely in need of an ethical compass," he wrote

Until recently the rating agencies insisted that everything was fine. The problem is that their models relied on historical data, and for newly popular things like "liar loans" and "piggyback" mortgages, there were no real historical data. Suddenly, in July, both Moody's and S&P downgraded billions of dollars of securities, and S&P said it was "adjusting" its rating process.

Even today the rating agencies have downgraded only a sliver of the securities based on subprime mortgages. All three defend their ratings, and they point out that they told investors not to rely solely on them.......

.........Josh Rosner, a managing director at research firm Graham Fisher, co-authored a paper in February in which he predicted "significant losses" in even investment-grade securities because the agencies' models were so far off. He also expects that rating agencies will face litigation as a result of the role they played in creating these instruments.

The bigger question may be an existential one. Asks Jim Chanos, the head of Kynikos Associates, which has a short position in Moody's stock: "If the rating agencies will downgrade only when we can all see the losses, then why do we need the rating agencies?"
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[rose-colored-coolaid]

[biliruben]

[TJ_98370]

[rose-colored-coolaid]

[TJ_98370]

[explorer]

[TJ_98370]

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It looks like the ratings agencies might get spanked............



Credit-ratings firms will need to explain their investment grades on questionable mortgage-backed securities, a top Republican says.

U.S. legislators will ask rating agencies why they made "mind-boggling" decisions to award investment grades to questionable mortgage-backed securities, the leading Republican on a Senate committee said on Monday.

Richard Shelby, the ranking member of the Banking, Housing and Urban Affairs Committee, said this would help them decide whether any new regulation was needed.

"There will be hearings..., there will be calls for more regulation," Shelby told a news briefing in Brussels. "My first thought is let's not over-regulate the market, the market will regulate itself."

But he said credit-rating agencies would have to bear more responsibility in the future in assigning financial health ratings, and the market should be more transparent when it comes to revealing exactly who bears investment risk.

"How did they reach the conclusion that these packages of subprime questionable loans could be deemed ... investment rate bonds?" he said. "It's just mind-boggling."

Shelby said banks would increase their mortgage rates in the coming weeks, exacerbating a credit crisis that has snowballed in recent weeks as defaults on risky U.S. subprime mortgages hit banks across the globe.

"I think it will get worse before it gets better," he said. "There will be firms that will not survive. I don't think we should bail them out."..........
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[mike2]

I have a feeling that the baby boomers in the vp positions at these firms were thoroughly convinced that any period of rapid price inflation would certainly be followed by wage inflation. However, as we now know that didn't happen and doesn't look likely to happen anytime soon. Hence the models that predicted a mild leveling of prices as wages 'caught up' were bogus.

I can't really blame them (well, not entirely) seeing as how throughout recent history wage inflation has followed price inflation. Who knew this time would be different?

Sorry to pick on the baby boomers again, it's just that in numerous conversations with people in the 40-60 yr old age group there seems to be a widespread belief that inflation will eventually level things out. The real effects of globalization haven't sunk in to the collective BB mindset as of yet.

[TJ_98370]

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Shocking revelation! Congressman Shelby says that there may be "conflict of interest" and "transparency" problems related to how U.S. credit ratings agencies do business.



The U.S. home-loan crisis is going to get worse before it gets better, a member of the Senate banking committee said yesterday, claiming that U.S. credit-rating agencies bear some responsibility for the mortgage-industry debacle.

Sen. Richard C. Shelby of Alabama, the senior Republican on the Banking, Housing and Urban Affairs Committee, said hearings likely this fall may look into possible conflicts of interest, since the agencies are paid by the same banks whose debts they rate for resale.

Standard & Poor's Corp., Moody's Investors Service Inc. and Fitch Ratings have all come under increased scrutiny because of ratings given to mortgage-backed securities.
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"The credit-rating agencies have played a central role in the subprime debacle. I think they have to shoulder some responsibility here," he said. "How could they claim these loans, once they were packaged, were investment grade? A lot of people bought them because of the ratings they gave them."......

.......The subprime crisis has highlighted how the global financial system has changed. Banks that used to hold the loans they authorized now repackage them and sell them to others, allowing investors across the world to take on the risk. A rash of bad mortgages in the U.S. now has the potential to bring down banks in Germany or South Korea.

Mr. Shelby told reporters in Brussels that the rising number of defaults on loans will be exacerbated in the next three to five months as repayment rates on many loans granted in 2005 and 2006 rise after initial fixed-rate periods.

"A great percentage of the subprime loans were made ... two years ago, '05 and '06," he said. "As those loans go up, the chances of them becoming non-performing ... will be much greater."

"I think you are going to have a problem. The question is: Can a lot of loans be worked out ahead of time, ahead of the crisis. Will the lenders be willing to do this, and who's holding the debt too? I don't know who's got it. It's not the local bank," he said.

Mr. Shelby called for more transparency within the financial system to make clear who holds the risk......
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[TJ_98370]

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For months, securities backed by risky mortgage loans have been in trouble. Now, the credit-rating agencies that once blessed those securities as safe investments are in trouble, too.

The stock of Moody's Investors Service, one of the major raters, is down about 40 percent from its 52-week high on heavy trading. Members of Congress are calling for hearings and more oversight of the rating firms. And institutional investors and industry observers have blamed the agencies for being months late in downgrading a slew of residential-mortgage-backed securities that soon imploded, prompting hedge funds to collapse, foreign governments to intervene and mortgage firms to lay off tens of thousands.

"This is akin to a slow-moving train wreck," said Sean Egan, managing director and co-founder of Egan-Jones Ratings, a Haverford, Pa., rating firm, who has been a vocal critic of the three rating firms that dominate the field -- Moody's, Standard & Poor's and Fitch Ratings. Egan noted that the major rating agencies faced similar criticism when they maintained solid, investment-grade ratings until just weeks before WorldCom collapsed in 2002.

"We've seen this movie before," he said......

......The rating firms are paid to rate bonds and other securities issued by banks and other financial institutions. The ratings are a kind of report card, with a top score of Aaa at Moody's, to give investors an idea of the creditworthiness of an investment, or the likelihood it may default.

What is less understood is how the agencies rate more complex securities, such as those backed by a pool of home loans. An underwriter, like a bank, assembles a pool of mortgages and divides them into "tranches" or levels, with different degrees of risks and returns. Investors buy those securities, banking on the underlying assets in the pool -- the monthly loan payments of the mortgage borrowers. The higher the risk, the better the potential return. The rating agencies grade the various tranches, part of a fast-growing line of business called structured finance.

The housing boom in 2005 created a huge market for subprime loans and for securities backed by such risky mortgages. But those loans began to unravel about a year ago. The first signs: borrowers defaulting on their mortgages. Things worsened by the fall. "The rating agencies themselves for a year were putting out warning signs . . . significant reports highlighting the risks, and yet they weren't downgrading," said Joshua Rosner, managing director of Graham Fisher & Co., a New York financial research firm for institutional investors. He said the raters, in effect, were "wearing blinders."

Rosner said that part of the problem is that the raters were acutely aware of their power in the capital markets and hesitated to downgrade securities backed by subprime loans. "They were afraid their actions themselves could roil already weak markets," he said.

The other problem, he said, is that the big three credit raters are paid by the very firms they rate. Scholars in the field have frequently noted what they consider this inherent conflict of interest in the raters' business model. After decades of inaction, Congress last year passed a credit rater law to foster competition and enhance regulatory oversight.......