There are more than 100 major rating agencies around the world, and three of the largest and most important ones in the United States are Fitch Ratings, Moody’s and Standard & Poor’s. A debt issuer’s credit rating is very similar to the FICO score of an individual rated by the Fair Isaac Corporation widely used in the United States by institutional lenders. Of greater importance to the housing market, the credit rating agencies also analyze and rate the creditworthiness of the various tranches of collateralized debt obligations traded in the secondary mortgage market.
Credit ratings are widely used by investors because they provide a convenient tool for comparing the credit risk among various investment alternatives. The analysis of risk is crucial in determining the interest rate a syndicator will need to offer to attract sufficient investment capital. From the other side of the transaction, it is important to the investor who is comparing the interest rates being offered by various investments. The ratings agencies provide this critical, third-party analysis both sides of the transaction can rely upon for unbiased, accurate information. When the ratings agencies are doing their job well, there is greater efficiency in capital markets as syndicators of securities are obtaining maximum market values, and investors are minimizing their risks. This efficiency in the capital markets leads to better resource utilization and stronger economic growth.
Unfortunately for many investors in collateralized debt obligations during the Great Housing Bubble, the ratings agencies did not provide an accurate or credible rating of many CDO tranches. When the housing market pricing declined, many CDO tranches were subsequently downgraded. In defense of the agencies, they were providing an analysis of risk based on existing market conditions. Their reports contained caveats concerning downside risks in the event market conditions changed, but this list of risks is standard in any analysis and widely ignored by investors who are counting on the rating to be a market forecasting tool rather than the market reporting tool it really is. Credit rating agencies are not in the business of market forecasting or evaluating systemic risks.
There is a deeper problem with the ratings agencies that began to surface in the Great Housing Bubble. Ratings agencies used to charge investors for their risk analysis, but there was a transition to charging the issuers instead. As one might imagine, there are reports that ratings agencies were concerned if they gave CDOs poor ratings, their primary source of income would go elsewhere. This put pressure on the agencies to overlook certain problems or merely list them as footnotes to their reports rather than lower a rating due to a foreseeable contingency such as a decline in house prices.
Tags: Mortgages Processing, Residential Lenders, Secondary Markets