A lead article in several media outlets on Feb. 5 reported that the U.S. Justice Department is gearing up to sue Standard and Poor’s rating agency for civil fraud. The alleged infractions are the bond ratings this company (and two others) assigned to some of the complex structured debt securities produced by Wall Street that collapsed and led to the Financial Crisis of 2008.
The underlying assets of these securities were sub-prime mortgage loans on which borrowers defaulted in large numbers from 2006 through the depths of the recession.
The justice department is said to be bringing this suit because S&P “knowingly and with the intent to defraud, devised, participated in and executed a scheme to defraud investors.”
I don’t mind offering an opinion right now. This is bunk and will in the end embarrass the Obama administration.
How could a package of junky loans — and no one disputes they were risky — be turned into AAA-rated securities? The answer lies in two parts: existing means-tested risk model parameters that likely presumed there would be defaults on some of the loans — but not a majority — and that the amount of underlying mortgages pledged to support the structure would be more than sufficient to provide the necessary cash flow to justify that high rating.
Your mortgage loan and hundreds of similarly structured mortgages, with similar terms, interest rates and maturity dates — they don’t have to be exact — generate mortgage payments each month consisting of principle and interest. Those mortgages, aggregated into “pools” are bought and sold in the bond markets, and when pledged against a synthetic structured debt instrument, become the underlying collateral for the creation of collateralized debt obligations, CDOs.
That monthly payment we all make is the cash flow that is dedicated to each of the separate securities within the larger CDO. Each of the separate synthetic securities, called tranches, has more or less cash flow assigned to them to retire that part of the obligation in accordance with the expected average life of the instrument.
If there is more than sufficient cash flow, because the underwriting dealer added additional collateral to the structure, then regardless of how junky the mortgages might be, it is entirely possible those cash flows, based on risk models determined by each rating agency, may be entitled to a AAA rating.
If the structure is deemed to be short of collateral, the agency might call the dealer and ask it to pony up more collateral to warrant the highest ratings on one or more of the tranches. That is not “knowingly with intent” executing “a scheme to defraud investors.”
In these articles, I find it useful to repeat that large institutional investors in collateralized debt obligations understood what they were buying. They, too, were presuming more than enough mortgage collateral would protect them.
As S&P, the banks and Alan Greenspan among many, many others have already stated, no one was able to predict the complete collapse of this market, and there had existed no precedent to expect it.
The most significant warning was a set of data showing a widening gap between home prices and equivalent rents, but who was to say where the bubble was actually to burst — if at all?
My good friend John, in Winston-Salem, was aghast that I would implicate Congress in this mess, but facts are facts. A starting point is Charles Duhigg’s piece in the New York Times, Oct. 5, 2008, titled “Pressured to Take More Risk, Fannie Mae Hit a Tipping Point.”
Duhigg reports Congress, investors and a major mortgage banker twisted the housing giant’s arm, and it agreed to buy $2 trillion in sub-prime mortgages, opening the door to a free-for-all among predatory lenders. Add to that rising interest rates through mid-2006 to stem inflationary pressures building since 9/11, soaring crude oil prices in 2007-08, and a collapsing stock market and you have a mess still affecting the American economy in 2013.
This is not rating agency fraud.
Despite the Republicans pratfalls, screw-ups and internecine bickering of the last two years, they have a chance to regain some stature on this one if they just shut up and stay out of the way.
Russ Wigh is a professor of business. Email him at rdwigh@bellsouth.net.