Where Did the Risk Go? (2007)

Lifted from comments from reader Juan:

Where Did the Risk Go?

How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions

Joseph R. Mason. Louisiana State University – Ourso School of Business; University of Pennsylvania – Wharton Financial Institutions Center and Josh Rosner,  Graham Fisher & Co.    May 3, 2007

”We show that the big three ratings agencies are often confronted with an array of conflicting incentives, which can affect choices in subjective measurements of risk. Of even greater concern, however, is the fact that the process of creating RMBS and CDOs requires the ratings agencies to arguably become part of the underwriting team, leading to legal risks and even more conflicts.” Mason and Rosner were slightly ahead of the curve, made sense, well documented but, for most part, ignored.


”What is interesting about these trends is that while as early as January 2005, delinquency and foreclosure data pointed to substantial deterioration in the overall credit performance of even fixed-rate prime mortgage loans, actual losses on securitized pools were extremely low during that period. Hence, S&P reported 981 RMBS upgrades and only RMBS 17 downgrades in 2004, and Moody’s reported 414 RMBS upgrades to only 4 RMBS downgrades for the same period. That is the kind of news that led many to believe in decreased market risk. …. ”In an effort to meet market demands for investment grade assets with higher yields, the rating agencies created new models and approaches to rating these assets. Given the limited number of Nationally Recognized Statistical Rating Agencies (NRSROs) and requirements directing certain investors to purchase only “investment grade” rated assets, their move to rate newer asset classes strengthened their market power,9 or in the words of one rating industry executive, their “partner monopoly”.10 As highlighted by the table below, structured-financial products became a major growth opportunity for the ratings industry and has become an increasing proportion of their revenues….”

The rating agencies were obtaining most of their new business, revenues and profit from those firms creating structured products and very definitely wanted this increase to continue — but they were using incorrect models and overly short time frames [all the better to provide a higher than should be rating in cases at hand]. You can obtain copies from dif. sources, here are two – http://www.hudson.org/files/publications/Hudson_Mortgage_Paper5_3_07.pdf and http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1027475