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Public Wants Reform For Companies That Rated Mortgage Securities

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By JOE MYSAK, Bloomberg News

Published: November 3, 2007

Hey, don't let off the rating companies so easily.

Imagine, that's what I heard after writing a headline that said: "Let's All Blame The Rating Companies For Every Thing."

That's not enough, it seems. But what do you expect when estimates of losses in the subprime mess seem to climb almost weekly? On Oct. 25, The New York Times carried a story putting the figure at $400 billion, which, it noted, was a lot bigger than the $240 billion (adjusted for inflation) the savings and loan crisis cost more than a decade ago.

There's still a lot of pain to go. My basic point was, this is what happens when a bubble bursts and people look around for someone to blame. The real problem was with cheap money, and with bankers giving away loans to bad borrowers.

Au contraire, some readers said. The rating companies played a real role in the entire subprime mortgage securities collapse because they rated the packages of securities.

What's more, my readers said, the companies graded these particular creations with almost no historical data to base their ratings upon, and with the active cooperation of the bankers who put them together. And, of course, they stood to gain handsomely, earning fees on the boom in new, rated transactions.

The rating companies have denied any collaboration or improprieties took place. The Securities and Exchange Commission says it is looking into whether issuers and bankers unduly influenced ratings, Chairman Christopher Cox told Congress on Sept. 26.

The basic idea with the subprime-backed securities, as I understand it, was that you could bundle a bunch of mortgages together in different batches, and allocate all defaults to one batch, making the others AAA. So you could set up a deal, say, where 20 percent of the debt was subordinated and the rest gets a AAA rating.

Well, it hasn't worked out that way, now, has it? This is why the rating companies have been putting these things on watch, or downgrading them, and by more than the customary level or two.

Analysis Didn't Work

"When an asset class rating regime collapses within a few years of introduction, it seems clear that a fundamental misunderstanding of the structure occurred," wrote Robert Fuller, a principal at Capital Markets Management, a financial consulting firm in Hopewell, N.J., in an e-mail.

"Simply put, the rating companies did not analyze well and as a result assigned an incorrect rating," he wrote.

Fuller knows something about the rating process. He was a managing director in public finance at Standard & Poor's from 1990 through 1997.

What makes the rating companies especially culpable, critics say, is that their AAA ratings meant that certain investors could buy those securities who might otherwise be prohibited or shy away from such potentially explosive stuff.

Call It Unresponsive Or Complicit

Fuller was quite restrained in his remarks. Most of the others were unprintable. The message was the same, though: The rating companies really didn't do a good job on this one.

Know this: Some people on Wall Street, presumably the ones who didn't help set up these kinds of deals, or sell them, are really annoyed at the rating companies. They say this isn't just the usual case of being late and unresponsive; the rating companies were complicit in the subprime meltdown, bordering on the irresponsible.

It's one thing, after all, for subprime borrowers to be thrown out of their homes. It's quite another for other separate groups - including Wall Street firms, yes, but also state and local pension funds - to lose money because of the manic securitization of those mortgages.

This little episode has a way to go. If I had to bet, I'd say that we're much closer to the beginning of the real estate revaluation than to the end. For bankers, this means more losses ahead, lower bonuses, job losses.

And, if my e-mail is any indication, retribution. There are a lot of people who normally wouldn't press for reform of any aspect of the securities business, who seem likely to press the case against the rating companies. They want retribution, and they want resolution.

By that I mean they want the full, behind-the-scenes story, a comprehensive, definitive report, presumably with some agency of the government's imprimatur on the cover. How did this happen? Why didn't they save us from ourselves? Who's responsible?

Rating company critics may get some kind of regulation, but I don't think they are going to get resolution, especially not from the SEC. The housing collapse seems more like a case of cupidity and stupidity, rather than outright fraud. But you never know. Someone's got to pay for those $400 billion (and climbing) in losses.

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