Redirecting My Rating Agency Rage

This week, I attended the American Securitization Forum Conference. There were lots of wonderful, informative sessions about the state of the mortgage- and asset-backed securities market. But perhaps the session I was most excited for was the very last I expected to attend on Tuesday: Credit Rating Agency Business and Regulatory Reforms. I have relentlessly railed against the rating agencies since the financial crisis, as I believe their actions in characterizing bad bonds as good ones went a long way in overheating the mortgage market and causing the credit crunch. I haven't changed my mind, but seeing a lot of these guys on the panel, I actually feel kind of bad for them. My anger might be better directed elsewhere.

The rating agencies have clearly taken a beating over the past few years. They really do recognize that they made big mistakes. Of course, they still maintain that they shouldn't be sued for their "opinions." But they do concede that most reforms that have been mentioned aren't bad ideas.

In fact, they've begun adopting many of these reforms voluntarily. Some such steps include better educating their analysts, ensuring that analysts rotate among clients so to better avoid getting too comfortable with a given bank or issuer, and better asset performance surveillance after the rating has been assigned. It's good that they're taking the initiative, because Congress' proposed reform was very thin on changes for the agencies.

The rating agencies are so important because they have traditionally had a major effect on prices in the bond market. Sure, market supply and demand matter more, but there are various bands within price ranges that have depended on the agency ratings for similar bonds. Under current law, the agencies also have a major effect on capital adequacy requirements.

But as I sat through the session, it was obvious that the defensive tone I heard in the voices of the rating analysts a few years ago was gone. They sounded like their souls had been broken. The panel discussion turned out to be anticlimactic. And it made me think: even though the rating agencies definitely messed up, it was investors who enabled their foolishness. And some investors aren't as contrite about their mistakes.

Think about so called "no doc" mortgages. Those were the ones that didn't require borrowers to supply any documentation in order to verify what they told the mortgage brokers was true. "You say you make $100,000 per year? Great -- you qualify! Nope, we don't need a pay stub." The rating agencies were then glad to stamp AAA ratings on some of the bonds backed by those mortgages. That is clearly irresponsible. If you can't be sure that the underwriting was based on anything real, then it's impossible to say how the loans will perform. It's like saying x + y = 4, without verifying the values of x and y.

But investors knew this going in, or should have. It wasn't a secret that these deals lacked documentation. The agencies' also never hid the fact that their ratings assumed that housing prices would generally rise. Investors became entirely too reliant and trusting on the ratings.

So, in a sense, the investors got exactly what they deserved. Sure, the rating agencies made mistakes, and the investors did expect them to be experts who knew a thing or two about the bonds they rated. But that's no excuse for those investors not fully understanding the bonds and failing to demand adequate due diligence on the underlying assets. Even though, in practice, the agencies' rating is considered to be a very important characteristic of a bond, in reality they're merely opinions. Good investors don't put too much confidence in the opinions of others, but develop strong, informed opinions of their own.

And going forward, I hope that's what we begin to see. And, in fact, talking to people at the conference, I think that's what we're already beginning to see (I hope to expand more on this next week). Rating agencies can continue to merely provide opinions, and that's fine -- so long as investors take what they say as mere opinions, and not market gospel.