The Rating Agencies

The rating agencies play an important role in the financial marketplace. Their job is to evaluate publicly traded securities and estimate the risk an investor exposes himself to when purchasing the securities. The agencies review past performance of the type of security they are evaluating, the history of the particular security, current overall market conditions and future trends of the market.

Reviewing the historical performance of the market or a particular security is straightforward. The data is readily available and it is simply a mathematical analysis. The tough part is developing future market trends. This is where the rating agencies earn their money. By studying historical market trends and evaluating current market conditions they then attempt to predict the future. In the case of rating Mortgage Backed Securities (MBS) it is now obvious that the predictions were wrong. Not a day goes by that we don’t see a rating agency lowering the credit grade on some MBS.

How could they be so wrong? Until I see some solid evidence, I’m not buying the conspiracy theory. On the surface it seems to me that the agencies have far too much to lose in jeopardizing their creditability by misclassifying the bond ratings. I feel the problem lies within the combination of two issues. To begin with, there is not a long history of subprime mortgages and whatever history that is available only covers a timeframe of rapidly appreciating home values in a strong economy. In addition, the volume of subprime mortgages originated was increasing on a monthly basis. Without a dependable history to work with, the reliability of future projections becomes questionable.

Should this short history have impacted the rating? After all, they certainly must have seen this? I believe they did recognize the limitations of the data they were working with and concluded that it wasn’t a big enough issue to negatively affect their rating. In hindsight this proved to be a bad decision and became a major component in the mortgage meltdown.

Investors make money by finding abnormalities in a market. They search for opportunities where they feel the yield on a particular investment is not in line with its level of risk. If the investor is right, he makes money. If he’s wrong, he loses money. Investors were seeing high rated MBSs carrying a higher yield than other investments with the same rating. Many investors focused on this imbalance and bought. They were betting on the credit rating being a better barometer of risk that the actual yield on the security. The bet proved to be wrong, the market yield proved to be a better representation of the risk of the mortgages.

Under normal market conditions, securities are bought and sold on an ongoing basis. This provides investors the opportunity to sell when they feel the investment is becoming riskier, or buy when they feel the timing is right. This results in small market fluctuations day-to-day as investors adjust their portfolios.

The problem the market faced in August is that, almost overnight, there were no buyers for MBSs. With no buyers there is no market and therefore a market price couldn’t be determined. This started a cascading effect throughout the mortgage market, the domestic security markets as well as the foreign security markets. The end result has been massive writedowns of the values of the securities held by investors, mortgage companies going out of business, consumers finding mortgage money harder to find with a resulting increase in foreclosures and real estate depreciation.

Just as the value of MBSs got too high before investors responded, we are currently seeing the value being too low. Buried in all the bad news we’ve been reading, there are some positives things happening. As investors begin to look closely at the financial institutions and MBSs, they are finding buying opportunities. It started with the $7.5 billion investment in Citicorp by Abu Dhabia. They saw a buying opportunity and took advantage. Goldman Sachs is on the verge of buying Litton Loan Servicing, another example of an experienced investor taking advantage of an undervalued asset. Investors from Singapore and the Middle East purchased a 10% ownership of UBS. We are going to see more and more of this as the weeks go on.

The market is slowly re-establishing. Many investors, both large and small, have taken huge loses in the meltdown of the mortgage industry. This has created a buying opportunity for other investors and they will be taking advantage of this.

Will investors lose faith in the ratings given by the agencies? Will investors look to other avenues for risk evaluation? Only time will give us answers. There is one thing we all can re-learn from this situation. There are no sure things in life; every investment is a gamble. In any market there will be winners and there will be losers. Winners are quick to take credit for their wise decisions and losers are just as quick to try to find someone to blame for their losses.