Credit rating agencies (CRAs), firms which rate debt instruments/securities according to the debtor's ability to pay lenders back, played a significant role at various stages in the American subprime mortgage crisis of 2007–2008 that led to the 2008 financial crisis and the Great Recession of 2008–2009. The new, complex securities of "structured finance" used to finance subprime mortgages could not have been sold without ratings by the "Big Three" rating agencies—Moody's Investors Service, Standard & Poor's, and Fitch Ratings. A large section of the debt securities market—many money markets and pension funds—were restricted in their bylaws to holding only the safest securities—i.e. securities the rating agencies designated "triple-A".
The pools of debt the agencies gave their highest ratings to included over three trillion dollars of loans to homebuyers with bad credit and undocumented incomes through 2007.(the raw material of the debt securities) Hundreds of billions of dollars' worth of these triple-A securities were downgraded to "junk" status by 2010,McLean, Bethany and Joe Nocera. All the Devils Are Here, the Hidden History of the Financial Crisis, Portfolio, Penguin, 2010 (p.111)$300 billion collateralized debt obligations (CDOs) issued in 2005–2007 (over half of the CDOs by value during that time period) that rating agencies gave their highest "triple-A" rating to, were written down to "junk" by the end of 2009. (source:) and the writedowns and losses came to over half a trillion dollars.
This led "to the collapse or disappearance" in 2008–09 of three major investment banks (Bear Stearns, Lehman Brothers, and Merrill Lynch), and the federal government's buying of $700 billion of bad debt from distressed financial institutions.
Impact on the crisis
Credit rating agencies came under scrutiny following the mortgage crisis for giving investment-grade, "money safe" ratings to securitized mortgages (in the form of securities known as mortgage-backed securities (MBS) and collateralized debt obligations (CDO)) based on "non-prime"—subprime or Alt-A—mortgages loans.
Demand for the securities was stimulated by the large global pool of fixed income investments which had doubled from $36 trillion in 2000 to $70 trillion by 2006—more than annual global spending—and the low interest rates from competing fixed income securities, made possible by the low interest rate policy of the U.S. Federal Reserve Bank for much of that period. These high ratings encouraged the flow of global investor funds into these securities funding the housing bubble in the US.
Mortgage-related securities Ratings were/are vital to "private-label" asset-backed securities—such as subprime mortgage-backed securities (MBS), and collateralized debt obligations (CDO), "CDOs squared", and "synthetic CDOs"—whose "financial engineering" make them "harder to understand and to price than individual loans".
Earlier traditional and more simple "prime" mortgage securities were issued and guaranteed by Fannie Mae and Freddie Mac—"enterprises" sponsored by the Federal government. Their safety wasn't questioned by conservative money managers. Non-prime private label mortgage securities were neither made up of loans to borrowers with high credit ratings nor insured by a government enterprise, so issuers used an innovation in securities structure to get higher agency ratings. They pooled debt and then "sliced" the result into "tranches", each with a different priority in the debt repayment stream of income.Here's how a CDO works| Upstart Business Journal| December 5, 2007 The most "senior" tranches highest up in priority of revenue—which usually made up most of the pool of debt—received the triple A ratings. This made them eligible for purchase by the pension funds and money market funds restricted to top-rated debt, and for use by banks wanting to reduce costly capital requirements under Basel II."under Basel II, a AAA rated securitization requires capital allocation of only 0.6%, a BBB requires 4.8%, a BB requires 34%, whilst a BB(-) securitization requires a 52% allocation"
The complexity of analyzing the debt pool mortgages and tranche priority, and the position of the Big Three credit rating agencies "between the issuers and the investors of securities", is what "transformed" the agencies into "key" players in the process, according to the Financial Crisis Inquiry Report. "Participants in the securitization industry realized that they needed to secure favorable credit ratings in order to sell structured products to investors. Investment banks therefore paid handsome fees to the rating agencies to obtain the desired ratings."
According to the CEO of a servicer of the securitization industry, Jim Callahan of PentAlpha, "The rating agencies were important tools to do that because you know the people that we were selling these bonds to had never really had any history in the mortgage business. ... They were looking for an independent party to develop an opinion,"
From 2000 to 2007, Moody's rated nearly 45,000 mortgage-related securities—more than half of those it rated—as triple-A. In contrast only six (private sector) companies in the United States were given that top rating.
By December 2008, there were over $11 trillion structured finance securities outstanding in the US bond market debt.
CDOs Rating agencies were even more important in disposing of the MBS tranches that could not be rated triple A. Although these made up a minority of the value of the MBS tranches, unless buyers were found for them, it would not be profitable to make the security in the first place. And because traditional mortgage investors were risk-averse (often because of SEC regulations or restrictions in their charters), these less-safe tranches were the most difficult to sell.Morgenson and Rosner Reckless Endangerment, 2010 p.278see also Financial Crisis Inquiry Report, p. 127
To sell these "mezzanine" tranches, investment bankers pooled them to form another security—known as a collateralized debt obligation (CDO). Though the raw material of these "obligations" was made up of BBB, A−, etc. tranches, the CRAs rated 70%70%. "Firms bought mortgage-backed bonds with the very highest yields they could find and reassembled them into new CDOs. The original bonds ... could be lower-rated securities that once reassembled into a new CDO would wind up with as much as 70% of the tranches rated triple-A. Ratings arbitrage, Wall Street called this practice. A more accurate term would have been ratings laundering." (source: McLean and Nocera, All the Devils Are Here, 2010 p. 122) to 80%80%. "In a CDO you gathered a 100 different mortgage bonds—usually the riskiest lower floors of the original tower ... They bear a lower credit rating triple B. ... if you could somehow get them rerated as triple A, thereby lowering their perceived risk, however dishonestly and artificially. This is what Goldman Sachs had cleverly done. it was absurd. The 100 buildings occupied the same floodplain; in the event of flood, the ground floors of all of them were equally exposed. But never mind: the rating agencies, who were paid fat fees by Goldman Sachs and other Wall Street firms for each deal they rated, pronounced 80% of the new tower of debt triple-A." (source: Michael Lewis, The Big Short: Inside the Doomsday Machine WW Norton and Co, 2010, p. 73) of the new CDO tranches triple A. The 20–30% remaining mezzanine tranches were usually bought up by other CDOs, to make so-called "CDO-Squared" securities which also produced tranches rated mostly triple A by rating agencies."According to data compiled by the FCIC, tranches from CDOs rose from an average of 7% of the collateral in mortgage-backed CDOs in 2003 to 14% by 2007. CDO-Squared deals—those engineered primarily from the tranches of other CDOs—grew from 36 marketwide in 2005 to 48 in 2006 and 41 2007." Financial Crisis Inquiry Report, p. 203 This process was disparaged as a way of transforming "dross into gold" or "ratings laundering"McLean, and Nocera. All the Devils Are Here, 2010 (p. 122) by at least some business journalists.
Trust in rating agencies was particularly important for CDOs for another reason—their contents were subject to change, so CDO managers "didn't always have to disclose what the securities contained". This lack of transparency did not affect demand for the securities. Investors "weren't so much buying a security" as they "were buying a triple-A rating", according to business journalists Bethany McLean and Joe Nocera.McLean and Nocera, All the Devils Are Here, 2010 p. 121
Still another structured product was the "synthetic CDO". Cheaper and easier to create than original "cash" CDOs, these securities did not provide funding for housing. Instead synthetic CDO-buying investors were in effect providing insurance (in the form of "credit default swaps") against mortgage default. Synthetics "referenced" cash CDOs, and rather than providing investors with interest and principal payments from MBS tranches, they paid insurance premium-like payments from credit default swap "insurance". If the referenced CDOs defaulted, investors lost their investment, which was paid out as insurance."Unlike the traditional cash CDO, synthetic CDOs contained no actual tranches of mortgage-backed securities ... in the place of real mortgage assets, these CDOs contained credit default swaps and did not finance a single home purchase." (source: The Financial Crisis Inquiry Report, 2011, p. 142) Because synthetics referenced another (cash) CDO, more than one—in fact numerous—synthetics could be made to reference the same original. This multiplied the effect if a referenced security defaulted.McLean, and Nocera. All the Devils Are Here, 2010 (p.263)
Here again the giving of triple-A ratings to "large chunks"McLean and Nocera. All the Devils Are Here, 2010 (p. 265) of synthetics by the rating agencies was crucial to the securities' success. The buyer of synthetic tranches (who often went on to lose his investment) was seldom an analyst "who had investigated the mortgage-backed security", was aware of deteriorating mortgage underwriting standards, or that the payments they would receive were often coming from investors betting against mortgage-backed security solvency. Rather, "it was someone who was buying a rating and thought he couldn't lose money."McLean and Nocera. All the Devils Are Here, 2010 (p. 266)
Downgrades and writedowns
By the end of 2009, over half of the collateralized debt obligations by valueworth $300 billion issued at the end of the housing bubble (from 2005–2007) that rating agencies gave their highest "triple-A" rating to, were "impaired"—that is either written-down to "junk" or suffered a "principal loss" (i.e. not only had they not paid interest but investors would not get back some of the principal they invested). The Financial Crisis Inquiry Commission estimates that by April 2010, of all mortgage-backed securities Moody's had rated triple-A in 2006, 73% were downgraded to junk.