Senate Hearings : The Empire Strikes Back

See? Accrued Interest isn’t the only blog in the world that can use Star Wars titles.

Following the last testimony reported here, that of Dr. Lawrence J. White, Moody’s stepped up to the plate. The testimony has been published by the Senate committee.

They first reviewed the process, including one very critical element:

It is important to note that, in the course of rating a transaction, we do not see individual loan files or information identifying borrowers or specific properties. Rather, we receive only the aforementioned credit characteristics provided by the originator or the investment bank. The originators of the loans and underwriters of the securities also make representations and warranties to the trust for the benefit of investors in every transaction. While these representations and warranties will vary somewhat from transaction to transaction, they typically stipulate that, prior to the closing date, all requirements of federal, state or local laws regarding the origination of the loans have been satisfied, including those requirements relating to: usury, truth in lending, real estate settlement procedures, predatory and abusive lending, consumer credit protection, equal credit opportunity, and fair housing or disclosure. It should be noted that the accuracy of information disclosed by originators and underwriters in connection with each transaction is subject to federal securities laws and regulations requiring accurate disclosure. Underwriters, as well as legal advisers and accountants who participate in that disclosure, may be subject to civil and criminal penalties in the event of misrepresentations. Consequently, Moody’s has historically relied on these representations and warranties and we would not rate a security unless the originator or the investment bank had made representations and warranties such as those discussed above.

They also make the point that the 2002-2005 vintages of Residential Mortgage Backed Securities (RMBS; “vintage” refers to the date the mortgage was given) are performing at or above expectations; it’s the 2006 vintage that is creating headaches. The following data is extracted from their figure 2:

Downgrade / Upgrade Percentage By Vintage (By Rated Original Balance)
Vintage Downgrade Upgrade
2002 2.3% 2.0%
2003 1.1% 2.7%
2004 0.3% 0.2%
2005 0.5% 0.3%
2006 5.4% 0%
2002-2006 2.2% 0.6%

Moody’s categorized their response to an observed deterioration in sub-prime portfolios as follows:

  • We began warning the market starting in 2003
  • We tightened our ratings criteria
  • We took rating actions as soon as the data warranted it:As illustrated by Figure 3, the earliest loan delinquency data for the 2006 mortgage loan vintage was largely in line with the performance observed during 2000 and 2001, at the time of the last U.S. real estate recession. Thus, the loan delinquency data we had in January 2007 was generally consistent with the higher loss expectations that we had already anticipated. As soon as the more significant collateral deterioration in the 2006 vintage became evident in May and June 2007, we took prompt and deliberate action on those transactions with significantly heightened risk.

Note that the first two points are also elucidated; I’m just highlighting their third point.

Their Figure 5 provides some detail that I’ve been trying to find for a while. Readers will remember the decomposition of the Bear Stearns ABS 2005-1 in this blog, and know that the highest rated tranche is the biggest, while the smaller tranches are relatively small. The tranches On Review or Downgraded (First & Second Lien Transactions combined) comprise 15.9% of the total by number, but only 5.4% by dollar value.

And, finally, they get to their actions to address the problems and their recommendations for others. Moody’s initiatives are:

  • Enhancements to analytical methodologies
  • Continued investments in analytical capabilities
  • Changes to credit policy function (this means increased separation of the reporting channels between the sales and ratings departments)
  • Additional market education
  • Development of new tools beyond credit ratings

I am sure they mean well by their last two points, but they won’t work. The market does not want to be educated and the market does not want any more detail – the reaction to their change in bank rating methodology proves that.

What does the market want? The market wants a very simple methodology so it can claim to have done a due-diligence without wasting more than five minutes on investment crap and someone to blame when something goes wrong, that’s what the market wants.

Moody’s recommendations for policies outside its control are:

  • Licensing or other oversight of mortgage brokers
  • Greater disclosure of additional information by borrowers and lenders
  • Tightening due diligence standards for underwriters
  • Stronger representations and warranties
  • Increased disclosure from issuers and servicers on the individual loans in a pool
  • Increasing transparency (in structured products)

Not very much, perhaps, but not very much change is needed.

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