The Role of the Credit Rating Agencies in the Sub-prime Mortgage Crisis, the

Collapse.

The Sub-prime mortgage crisis refers to the boom in sub-prime mortgage lending, the securitization of these into mortgage-backed securities, and the collapse of this market in 2007, leading to the bankruptcy of Lehman Brothers, the collapse of Bear Stearns, AIG, and other financial institutions, followed by the worst economic contraction since the Great Depression. This lending bubble was long in the making. The surge in mortgage origination began in 2001, it peaked in 2003. However, the expansion of the sub-prime mortgage market, and its derivatives (RMBS, credit default swaps, CDOs, etc), supplanted the conventional mortgage market, and continued to grow until it completely collapsed by the end of 2007 to mid 2008.

In discussing the sub-prime mortgage crisis, it is really not possible to separate this from the housing bubble. The easy credit market which was super-charged by poorly and often fraudulently originated sub-prime mortgages, fueled a boom in housing prices. This bubble was, for a variety of reasons, far greater in size, (and therefore in its impact when it burst), than any prior bubble in history. The impact was global. While great real estate bubbles have occurred locally throughout history, none of them have come close to the size of the US housing bubble and its derivative mortgage bubble.

The causes of the sub-prime mortgage crisis are complex and involved many players. As noted in "The Sub-prime Problem: Causes and Lessons" Adelson & Jacob, 2008, "Like the fall of Rome, and the sinking of the Titanic, there are many causes of the sub-prime

problem. There were so many actors in this tragic play. There were the mortgage originators, the banks, the government housing agencies (Fannie Mae & Freddie Mac), Wall Street investment banks, greedy and unsophisticated investors, the rating agencies, government policy makers, and government regulators. It became global, as foreign financial institutions and investors purchased the securities that financed this debacle. But, there is no doubt that without the AAA blessing of the rating agencies that they granted to the mortgage-backed securities, the market disaster could not have occurred.

As the rate of home ownership increased, the number of qualified borrowers decreased. So, lots of "clever" people from the government to Wall Street, to the rating agencies, found a way to help unqualified borrowers (people with low credit scores FICO (myFICO website) participate in the dream of owning a home. They created loans with so called "teaser interest rates". These were loans with low initial interest rates, which would rise over time.

Conventional loans required a borrower to show income and there was a limit on the amount borrowed based on loan-to-value. Instead these new loans, required little or no documentation, and had LTV‘s that sometimes exceeded 100% of the value of the home.

These mortgages were known as sub-prime mortgages. The rating agencies helped by, rating the majority of the securities and their derivatives that were backed by these mortgages, AAA. Naturally, the resulting increase in demand for housing fueled a further increase in home prices, which in turn fueled a further increase in a demand for housing.

The sub-prime mortgages that were financing these home purchases were not held by the banks, but were instead packaged into mortgage-backed securities and sold worldwide.

Sometimes the lower rated bond classes were re-packaged into CDO‘s (collateralized debt obligations), and sold to investors who failed to do their own analysis, but instead relied on the rating agencies. When buyers for the securities could no longer be found, the search was on for "the greater fool" and he was found in municipalities in Norway, and retail investors in Hong Kong. Bill Gross the head of PIMCO, one of the largest fixed income funds said of the ratings agencies, " AAA? you were wooed, Mr. Moody's and Mr Poor's, by the makeup, those six-inch hooker heels, and a "tramp stamp" (Gross 2010).

In 2006, the housing bubble began to burst. The low teaser interest rates on the sub-prime mortgages, began to reset upwards, and homeowners could not make the payments.

Foreclosure rates increased, and home prices fell. Home sales decreased, because there were not enough buyers to hold back the tsunami. The banks and investors were stuck with mortgages and mortgage-backed securities that were worth a tiny fraction of their initial value, and even homeowners who had not lost their homes to foreclosure, had negative equity in their homes. One of the largest insurance companies, AIG, faced huge losses, collapsed, and had to be supported by the government. Fannie Mae and Freddie Mac had to be taken over by the government. Lehman Brothers and Bear Stearns went out of business.

Merrill Lynch had to be acquired by Bank of America. One of the largest savings banks, Washington Mutual had to be acquired by JP Morgan. Wachovia Bank was purchased by Citigroup, and Countrywide Savings, the largest originator of home mortgages went bankrupt. And, now, 6 years later, home prices in the US have finally begun to bottom out, and US financial institutions are finally recovering.

One of the most corrosive behaviors in the credit rating market is known as "rating shopping". This can occur when an issuer seeks to engage a rating agency to provide a rating for their new issue. The role of choosing which rating agency to use is delegated to the investment bank which is working for the issuer to sell its debt. In the structured finance market, the investment bank might also be the sponsor of the securitization (effectively, the issuer).

The issuer is interested in obtaining the highest possible rating (or the lowest level of credit enhancement in the case of structured finance), from the most respected rating agency. This is because, this will result in the lowest cost of funds. The investment bank will try to optimize the choice of rating agency by weighing the trade-off between using a rating agency from whom it would be easier, in terms of rating criteria, to get a high rating, versus how investors would view a rating from that agency. It comes down to the interest rate that the issuer will pay. The higher the rating the lower the interest rate as discussed earlier. But, if investors view the rating agency as having easy criteria, they may tell the investment bank that they need compensation in the form of a higher interest rate.

Rating shopping is where the issuer, after discussing a possible rating engagement with one rating agency, decides to try another rating agency in order to, perhaps, get a higher rating.

They then might call back the first agency, and point out the better treatment of the competing rating agency. The first agency, is then, strongly incentivized to match the rating of the second agency, by adjusting their criteria and opinions, so as not to lose the business and market share. This is known as the "the race to the bottom". The practice was rampant during the run up to the crisis as rating agencies competed fiercely for business..

One of the accusations made against the rating agencies, is that they actually helped the issuers to structure the transactions, that, they went ahead and rated. That's like a student creating his own exam, and then grading it! The idea is that the issuer would show the rating agency a transaction that it was considering, and propose a structure and credit enhancement. Then rating agency would discuss, maybe negotiate, with the issuer, how to get most AAA bonds. This has not been proven one way or another. But, the government was so unhappy about this possibility that they passed a rule prohibiting this behavior (Appendix 2).