OKAY, WHAT ABOUT THE RATINGS FIRMS?

Are they going to be held accountable?

How ratings firms' calls fueled subprime mortgage meltdown
By Aaron Lucchettiand Serena Ng
THE WALL STREET JOURNAL
08/19/2007

In 2000, Standard & Poor's made a decision about an arcane corner of the mortgage market. It said a type of mortgage that involves a "piggyback," where borrowers simultaneously take out a second loan for the down payment, was no more likely to default than a standard mortgage.

While its pronouncement went unnoticed outside the mortgage world, piggybacks soon were part of a movement that transformed the home-loan industry: a boom in "subprime" mortgages taken out by buyers with weak credit.

Six years later, S&P reversed its view of loans with piggybacks. It said they actually were far more likely to default. By then, however, they and other newfangled loans were key parts of a $1.1 trillion subprime-mortgage market.

Today that market is a mess. As defaults have increased, investors who bought bonds and other securities based on the mortgages have found their securities losing value, or in some cases difficult to value at all.

S&P, Moody's Investors Service and Fitch Ratings gave top ratings to many securities built on the questionable loans, making the securities seem as safe as a Treasury bond.

Also helping spur the boom was a less-recognized role of the rating companies: their collaboration, behind the scenes, with the underwriters that were putting those securities together. Underwriters don't just assemble a security out of house loans and ship it off to the credit raters to see what grade it gets. Instead, they work with rating companies while designing a mortgage bond or other security, making sure it gets high enough ratings to be marketable.

The subprime market has been lucrative for the credit-rating firms. Compared with their traditional business of rating corporate bonds, the firms get fees about twice as high when they rate a security backed by a pool of house loans. The task is more complicated. Moreover, through their collaboration with underwriters, the rating companies can actually influence how many such securities get created.

Moody's Investors Service took in around $3 billion from 2002 through 2006 for rating securities built from loans and other debt pools. This "structured finance" — which can involve student loans, credit card debt and other types of loans in addition to mortgages — provided 44 percent of revenue last year for parent Moody's Corp., up from 37 percent in 2002.

Underwriters, these people say, would sometimes take their business to another rating company if they couldn't get the rating they needed.

Had the securities initially received the risky ratings that some of them now carry, many pension and mutual funds would have been barred by their own rules from buying them. Hedge funds and other sophisticated investors might have treated them more cautiously. And some mortgage lenders might have pulled back from making the loans, without such a ready secondary market for them.

By 2006, S&P was making its own study of such loans' performance. It singled out 639,981 loans made in 2002 to see if its benign assumptions had held up. They hadn't. Loans with piggybacks were 43 percent more likely to default than other loans, S&P found.

Still, S&P didn't lower its ratings on existing securities, saying it had to further monitor the performance of loans backing them. It thus helped the market for these loans hold up through the end of 2006.

The downgrading, begun late last year, became an avalanche this summer. On July 10, Moody's cut ratings on more than 400 securities based on subprime loans. S&P put 612 on review, and downgraded most two days later. The moves jolted financial markets and prompted some investors to criticize the ratings firms for misjudging the market.

Money mangers unloaded on a July 12 conference call with Moody's analysts. "You had reams upon reams of data," said Steve Eisman, a managing director of hedge fund Frontpoint Partners, which had made bets against the subprime market. "Despite all that data, your original predictions of the performance of 2006 loan pools have proven to be completely and utterly wrong." He asked why the rating firms waited to take major steps.