Felix Salmon

The farce of structured credit ratings

By Felix Salmon
May 17, 2010

Structured credit ratings history repeats itself, the first time as tragedy, the second time as farce:

Standard & Poor’s cut to junk the ratings on certain securities, backed by U.S. mortgage bonds, that it granted AAA grades when they were created last year…

The reductions were among downgrades to 308 classes of so- called re-remics… About $150 million of the debt issued last year, as recently as July, with top rankings were lowered below investment grades.

I consider myself pretty cynical when it comes to structured finance, but this comes as a shock even to me. S&P knew, when it was rating these re-remics, exactly where it had gone wrong in the first round of structured-credit ratings, yet somehow was unable or unwilling to fix the problems in that group.

Tracy Alloway quotes S&P citing significant deterioration” in the performance of the underlying mortgages as the reason for the downgrade — but the whole point of a triple-A-rated mortgage-backed security is that it’s robust to such deterioration. If it isn’t, then it should never have been rated triple-A in the first place.

If we needed one more reason to strip all official recognition from credit ratings, this is it. S&P and Moody’s are clearly completely incompetent, and no one should base any investment decisions on the random series of letters they apply to bonds. If the CDO fiasco wasn’t enough to make them change their ways, then nothing will be.

15 comments so far | RSS Comments RSS

I agree fully to your piece. For a rating to move from triple A to junk status within a year is beyond belief. Historically the chances of a triple A rating being rated below invested grade was below 1%. The credit market needs to come with metric that detrermines what “investment grade” means and should not be connected with the rating agencies.

Posted by BahM | Report as abusive

This is indeed pretty farcical.

But without rating agencies…… who other than big investment companies/funds that have their own in-house muscle to do due-diligence can buy these things?

Posted by MarshalN | Report as abusive

BahM, how about this scheme: If the markets are working the way they should – or rather, the way they are claimed to work – the riskiness of an investment should be a function of the return on investment. It might not be a linear function, but if, say, the bonds of corporation X are paying 200 bp more than those of corporation Y, it’s because corporation X is more risky than corporation Y. Otherwise X could borrow more cheaply, or Y would have to pay more to borrow.

So, we set the rating of a bond or any other investment strictly from the rate of return. If we want to keep the current lettering scheme, the lowest-return bonds are the AAA ones; then for every increment in return, we drop the grade a little. Maybe a 50 bp difference equates to one grade, or maybe some other system.

Of course this will mean that it will no longer be possible for, say, pension funds to invest in AAA securities that return eight percentage points a year more than treasury bonds, since such instruments will not exist, by definition. But again, remember where my argument is coming from: If the markets are really working right, there is no way that those high-yield securities are really AAA.

Posted by KenInIL | Report as abusive

Agree with BahM and would add; What happened to these mortgages in the past year that was so unpredictable. The economy isn’t great but it is definitely ahead of worst-case scenarios we heard last year.

Posted by Mr.Do | Report as abusive

One would only know ROI ex post and the rating has to be determined ex ante. My reommendation will be to use the CDS market with the sellers have adequate collateral. In that case there will be some alignment between risk and reward. For a third party to issue a rating with “no skin in the game” should not be the way forward.

Posted by BahM | Report as abusive

Felix is exactly right in that structured finance AAA ratings are a joke, at best, and severely destructive at worst. They give a false sense of certainty in credit risk and necessarily drive correlation of supposedly risk free assets higher.

MarshaIN, the managers who use them to make investment decisions should be fired or forced to undergo credit analysis trading. They are simply not doing their fiduciary responsibility to their investors.

Posted by jakethesnake | Report as abusive

@Jake: It was mostly in jest

Posted by MarshalN | Report as abusive

There are two choices to solving the rating agency debacle:

1. Remove the benefits in the accounting rules for “investment grade” ratings, especially the AAA ratings (kind of like having a “free market”); or

2. Make the individual raters inside the agencies true professionals like engineers, architects and land surveyors where they need to put their personal signature/seal on the ratings. Government building rules, such as building codes and ordinances typically require PE stamped drawings on professional land surveyor stamped property maps. Despite the monopoly this provides to these professions, we do not have a surfeit of expensively designed buildings that collapse because people didn’t bother doing design calculation nor are they routinely put on the wrong parcels of land because the surveyors assumed that everybody knew where the property lines were and didn’t do the necessary research. The use of professional engineers, architects, and land surveyors has done an excellent job of protecting the public over the past century.

Posted by ErnieD | Report as abusive

S&P and Moody’s are clearly completely incompetent, and no one should base any investment decisions on the random series of letters they apply to bonds. — Felix Salmon

So classic. I love it.

Posted by fixedincome | Report as abusive

So what’s the alternative to the random series of letters they apply to bonds ? I see two possibilities.

1) a public ratings agency (*not* a public option). Have the SEC rate bonds.

2) Use the prices of CDSs. Now I don’t think regulations can refer to the market prices of CDSs, which shoot up in a panic causing banks to have to liquidate assets justifying the panic. However, if Goldman Sachs were willing to issue CDS on 10% of the securities at a price typical of CDS on AAA corporate bonds, I’d be willing to buy them (Provided Goldman Sachs promised not to buy CDS on 20% etc).

The point is that as noted by MarshalN only a few big firms have the muscle to rate. We have learned it is unwise to trust raters who don’t put their money where there mouths are. Very few big firms have enough money to put where the major mouth investors respect from raters is.

This will not be cheap. If to issue a security that pension funds can buy, you have to find some entity willing to insure 10% of it (with guarantees that they don’t hedge that risk) then it will be very costly to issue a security.

That’s life. In the real world you don’t get something for nothing and rarely get something hugely valuable for almost nothing. For decades we got immensely valuable ratings from Moody’s, S&P and Fitch for almost nothing. Our luck has run out and it’s time to face reality as it almots always is.

A public rating agency would be better unless and until another George Bush is elected President. But I mean it would be socialism and we can’t have that.

Posted by robertwaldmann | Report as abusive

uh the reference to a public option and my use of “there” for “their” were both snark aimed at Matt Yglesias. I no how to spell (he’s lying).

Posted by robertwaldmann | Report as abusive

perhaps, if the expense of performing due diligence on that type of asset is too high, that the market for that type of asset can disappear. It’s not as if structured debt products are essential to society.

Posted by rootless_e | Report as abusive


It used to be that bonds were relatively simple (although not easy) where they were really just an extension of going to the bank and applying for a loan. The analysis was fairly similar where many buyers could go through the financial analysis to see if the bond was likely to be paid back.

However, the securities market has now created all of these Frankenstein monsters that only exist because of the ratings agencies. Without AAA ratings, those securities could not survive and see the light of day. The rating agencies either need to do their job or be made irrelevant.

The buyers also need to do more work on what securities should be bought and which ones should not. It seems like the accounting rules have been set up to give the buyers a free pass on having to do their own homework. We are now paying the price.

Posted by ErnieD | Report as abusive

Exactly. There is no reason why pension funds and banks should be considered to have done fiduciary duty when they purchase products that they don’t understand on the basis of ratings that they have every reason to know are meaningless. Let them put the money into government bonds.

Posted by rootless_e | Report as abusive

It seems to me that calls to “fire the stupid” buy-side managers are missing the point. Those guys face the same moral hazard issues as everyone else in the system, participating in the upside but only being fired on the downside. Naturally, they make the riskiest investments allowed; that doesn’t mean they are fooled.

Let the market measure the risk; yes, that would be nice. But check out this Kamakura analysis of DTCC corporate CDS data: http://kamakuraco.com/Company/ExecutiveP rofiles/DonaldRvanDeventerPhD/KamakuraBl og/tabid/231/EntryId/195/Corporate-Credi t-Default-Swaps-and-Non-Dealer-Trading-V olume.aspx. Of about 2,000 reference names, only 72 had daily non-dealer volumes over 5 trades in the period examined. Inter-dealer trades accounted for about 5/6 of total volumes. Sure, that’s miles better than an agency rating, but there is still plenty of scope for the handful of broker-dealers to mess with the market (JPM had over half the market share, the top 5 over 97%.)

Also, you have to do something to break the feedback loop between investor demand and credit rating. Otherwise, you will wind up with RMBS redux: investment will drive down spreads, thus validating itself, until one day it suddenly doesn’t.

Posted by Greycap | Report as abusive

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