Who's to Blame for the Subprime Debacle?Published: September 12, 2007 in Knowledge@Emory
In July, the credit rating agencies in America warned that defaults on some home mortgages were rising unexpectedly. The announcement helped send the bond market reeling: those unexpected defaults meant that owners of mortgage-backed securities could expect a lower return on their investment, and in some cases even a loss. Soon, the impact of the announcement on the bond market spread to the stock market, which on Aug. 3 suffered its worst day since 9/11.
Although the shock seems to be wearing off now, some analysts believe that the news will continue to get worse rather than better. The arguments are now over just how extensive the damage will be. Ben Bernanke, the chairman of the Federal Reserve Board, has told Congress that the losses associated with subprime credit problems could cost between $50 billion and $100 billion. (This too may ultimately prove to be an underestimate: some Fed watchers thought it was significant that Bernanke cited estimates from outsiders, not economists in his own agency, suggesting that the Fed’s internal estimate may be still higher.)
As billions in investors’ assets vanished, and several hedge funds imploded, there was no shortage of finger-pointing on Wall Street and in Washington. Among the many players getting some share of blame were the people who gave the securities their stamp of approval—the bond rating agencies.
Pressure on the big three agencies, Fitch Ratings, Moody’s Investors Service, and Standard & Poor’s, has been intense. For example, McGraw-Hill, owner of Standard & Poor’s, has lost 26% off its stock this year. And there have been personnel changes: one of the latest was the president of the Standard & Poor’s division, who resigned Aug. 30.
Critics charge that the rating agencies gave investors a false sense of security about the credit-worthiness of the mortgage bonds they bought. Residential mortgage-backed securities are issued against the collateral of hundreds of home mortgages. Using complex financial models based on extensive data, the agencies forecast that the probability of the bonds’ default was extremely low, especially after some higher quality mortgages were included in the collateral to compensate for the riskier assets. But they guessed wrong, particularly when it came to the performance of borrowers with weak credit histories, the so-called subprime borrowers.
Some congressional leaders have called for an investigation. The issue: why, asks Sen. Chris Dodd (D.-Conn.), chairman of the Senate Banking Committee, did the agencies give "AAA ratings to securities that never deserved them?"
One possible reason, explains George Benston, a professor of accounting, economics, and finance at Emory University and its Goizueta Business School, is that structurally, there are problems in the way fixed-income securities are regulated. “Right now, the agencies are paid by the people who they rate, and so they have an incentive, clearly, not to be too harsh,” he explains.
In addition, some critics contend the agencies’ role in putting these complex issues together – a given issue of mortgage-backed securities typically takes the collateral of hundreds of homes – means that they were not just inspectors, but architects of the recent disaster.
Financial observers at Goizueta, however, have varying views on what caused the mortgage meltdown.
“I don’t think the rating agencies are all that much responsible for what’s going on,” says T. Clifton Green, an associate professor of finance at Goizueta who specializes in fixed income securities.
In Green’s view, the subprime crisis has much more to do with institutional investors’ appetite for high-yield bonds than with anything the rating agencies did. Low interest rates are great for borrowers, but for fixed-income investors, they mean low returns. “Investors were hungry for ways to improve yield,” he explains. “They just got a little sloppy in accepting risk.’
Narasimhan Jegadeesh, a professor of finance at Goizueta, also does not believe a conflict-of-interest was to blame for the rating agencies’ problems in assessing the value of the securities. “My feeling is it was an honest mistake,” he says. The real villain, in his view: the occurrence of a low-probability event – similar to the liquidity shocks that forced the liquidation of Long-Term Capital, a large hedge fund, in 1998.
“The impact of low-probability events such as the mortgage crisis that we now encounter can be best understood in the context of natural disasters like hurricane Katrina,” explains Jegadeesh. “Insurance companies factor in the low probability of experiencing devastations of the magnitude caused by Katrina when they set insurance premiums. Nevertheless, when such devastations do occur, these companies incur significant losses. Of course, the profits they make in good times more than offset such gigantic losses that occur infrequently.”
The credit markets today is a similar scenario, notes Jegadeesh. “The lenders in the market made profits in good times when the default rate was low. However, when the credit crunch hits the market, the lenders take a big hit. This is the nature of business in capital markets where investors choose to take risks. Investors make profits in good times and losses in bad times, and the credit spreads are set by the market so that, over time, these profits more than offset the infrequent losses. If you focus only on the losses and forget the profits made during good times, you miss the full picture.”
Ray Hill, a senior lecturer of finance at Goizueta, agrees adding that the mortgage issue is not a disaster but a “financial problem,” which further explains why the Federal Reserve hasn’t been an active participant in the issue. “The real economy (unemployment rate, GDP growth, etc) appears relatively healthy even though some investment funds lost money.”
With regards to the rating agencies, Hill also believes that the mistakes by the agencies are, well, overrated. “The rating agencies may have mis-estimated the default rates, but a lot of the "crisis" is the result of investors using too much leverage to acquire portfolios of mortgages. With high leverage, small mistakes are magnified. The rating agencies aren't responsible for that,” Hill explains. “Also, the agencies only assess the likelihood that the mortgages will be repaid. Part of the "crisis" was due to a change in the market's valuation of these mortgage portfolios, which don’t appear to be connected to default rates. Again, this is something the agencies explicitly disclaim responsibility for.”
But should the rating agencies be let off the hook? No, says Benston, who contends the agencies did play an important role in the current lending issue. “The question is: will their reputation suffer as a consequence? Well, I would hope so,” he says.
If Congressional hearings are held on the issue, as seems likely, Benston says they should serve to clarify the rating agency’s role in the years leading up to the current subprime issue. This may not be entirely bad for the agencies: more public awareness also may help the agencies tell their side of the story. Benston concedes that for some investors willing to take risks, the ratings may not have been a factor in their decision. “It’s quite possible that the agencies did provide all the information [needed to evaluate the securities] and the buyers just didn’t pay attention.”
However, Benston is not optimistic that government will be able to use that knowledge to regulate the rating agencies in a better way. “I don’t think there’s a way of changing the way they are paid because once it’s an opinion, it becomes a public good – no one will pay for it.”
Jegadeesh is also skeptical that the rating agency system could be changed for the better. “What are the alternatives?” he asks. A government-controlled process, for example, wouldn’t necessarily serve investors any better. ‘Just because the government hands out the check, I don’t think they would do the job differently,” contends Jegadeesh.
Major changes may still be coming for the rating agencies, however, regardless of what legislators do. Although the agencies have traditionally argued that they are not liable for the effects of a rating partly on the grounds that they have a journalistic privilege, some industry observers believe they could be vulnerable. Recently, judges in the Second Circuit of U.S. District Court, the federal court whose jurisdiction includes Wall Street, dismissed the agencies’ claim of journalistic privilege, according to Christopher Whalen, a bank analyst based in Croton-on-Hudson, NY. A weakening of that privilege and the fact that the agencies are paid only after the deal closes, as if the payment were a commission, could help a disgruntled investor prevail in a suit that holds that the rating agencies are in fact just another underwriter, he says.
The political climate too may work against the agencies. William Carney, a professor of law at Emory University and now a visiting professor at New York University Law School, says that before the intense scrutiny on subprime lending, he would not have thought such a potential suit against the agencies could be successful. Considering the current climate, however, the environment is probably more favorable for such a suit, Carney says.
If such a suit does prevail, it could be bad news for the agencies, Whalen adds, because they can’t afford the amount of insurance protection investment banks have traditionally carried to protect themselves from potential damages.
But would the agencies deserve a harsh court judgment? Most Goizueta experts don’t seem to think so.
In the end, says Jegadeesh, forecasts are always just a guess, no matter how complex the methodology it took to reach. “Regardless of how sophisticated the model is…you have to feed in that number.”