Anatomy of a Subprime Mortgage Bond Rating
In this week’s New York Times Sunday Magazine, Roger Lowenstein attempts to untangle the process of rating mortgage-backed securities and collateralized debt obligations. Lowenstein got Moody’s to walk him through its process for rating a typical subprime MBS from the 2006 vintage (though the performance of that year’s bonds have proved to be anything but typical by historical standards.)
Apart from a couple of debatable analogies by sources he quotes, the article provides a helpful explanation of the process, and with the benefit of hindsight makes it easy to see where things went wrong. It’s well worth reading.
Moody’s was fair-minded in choosing an example; the case they showed me, which they masked with the name “Subprime XYZ,” was a pool of 2,393 mortgages with a total face value of $430 million.
“Subprime XYZ typified the exuberance of the age. All the mortgages in the pool were subprime — that is, they had been extended to borrowers with checkered credit histories. In an earlier era, such people would have been restricted from borrowing more than 75 percent or so of the value of their homes, but during the great bubble, no such limits applied.”
Lowenstein concludes by addressing the conflict of interest inherent in the rating agencies making their money from the firms whose bonds they rate, suggesting that the government should stop certifying the agencies altogether.
“Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves — not farm the job out to Moody’s. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less. Moody’s itself favors doing away with the official designation, and it, like S.&P., embraces the idea that investors should not “rely” on ratings for buy-and-sell decisions.”
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