« How Does One Get the Market Off Crack Cocaine?? | Main | Auction IPOs Sag »
August 27, 2007
Securitization and the Rating Agencies
The bubble in the subprime residential mortgage market has caused many to take a hard look at securitization. Securitization is the pooling of large asset pools, such as subprime mortgages, and the sale of securities backed by the pools. The seller is often the securities division of a major investment or commercial bank. The weak link seems to be the rating agencies that appraise and rate the securities. The rating agencies are hired and paid by the pooling agent, the seller. Moreover, many of those working with the rating agencies are hoping to work eventually for the banks that hire them. The conflicts are obvious and have led to the rating agencies being overly generous with their ratings. The generous ratings led to a demand for assets, subprime mortgages, that could be securitized. With the low interest rates adding another incentive, the makings of a financial bubble became inevitable.
August 27, 2007 in Securities Markets | Permalink
TrackBack
TrackBack URL for this entry:
http://www.typepad.com/services/trackback/6a00d8341bfae553ef00e54ee714688834
Listed below are links to weblogs that reference Securitization and the Rating Agencies:
Comments
Hasn't Professor Frank Partnoy been complaining about the required use of credit agencies for years now?
Is anyone paying attention, I wonder.
Posted by: Michael Webster | Aug 28, 2007 5:41:10 AM
Maybe, but I suspect that conclusion is premature. As far as I can tell, no AAA-rated bonds (and perhaps even no investment-grade bonds) have yet had their monthly payments reduced due to defaults on the underlying loans. That may change in upcoming months--lower-rated bonds have in some cases been hard hit, and that makes the higher-rated bonds more vulnerable. Still, it seems premature to point the finger at ratings agencies when so far the investment grade bonds have not yet seen their payments reduced.
Posted by: Brett McDonnell | Aug 28, 2007 8:09:31 AM
Your indictment of rating agencies may be a bit harsh. I really doubt that lax review in hopes of future employment was involved, any more than it would have been for any industry or financial group. The internal review procedures leading to an approved rating involve a number of pretty sharp analysts and senior managers, and I think they would pick up on questionable analysis, especially after the black eye they got for losses on credit instruments in the post-Enron period.
The more likely explanation is the prior excellent track record of these instruments and the fact that there is diversification protection in the number and variety of underlying securities involved. It would have been necessary to visualize what did in fact happen: a broad cascading effect as teaser rates morphed into unsustainable mortgage payments and a nationwide pattern of defaults. And if anyone had predicted that convincingly, these securitizations would not have been marketable.
Posted by: Jerry Maloney | Aug 28, 2007 4:59:34 PM
The hazardous effects of securitization have been apparent for some time now. In 2002, in an article about securitization and predatory lending, I argued that securitization reduces careful underwriting, because lenders can outsource much of the risk of default. Also, it encourages the boom, bust and bankruptcy cycle of subprime lenders. Subprime lenders can grow rapidly, fueled by fresh money selling their loans to be securitized, and then bust when they've made too many problematic loans. Borrowers are then left to deal with the current holder of the note who can claim holder in due course status to fight off many of the defenses to the loan. To some extent, the current subprime crisis is just this cycle writ large. You can see that article at:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=904661
Securitization rewards too many market participants for producing loan quantity rather than quality, as lenders, rating agencies and investment houses benefit more from volume of loans rather than by making carefully underwritten loans. Investors should have been paying closer attention, but to some extent relied excessively on the ratings to price the securities, rather than independently evaluating the risks.
Posted by: Kurt Eggert | Aug 30, 2007 1:19:16 PM
Can’t you imagine what would happen to a lending institution if you as a lending officer lend moneys to purchase home or refinance an existing mortgage with no documentation to verify the borrower’s income or occupation or merely on the stated income accompanying no documents? In cases where or in days when the loan is lent to be retained on-book of the lender who has no knowledge of financial technology to transfer the credit risks inherent with the loan to any third party investors, the lender may not undertake such risks associated with liar’s loans. Intuitive experienced gut feelings of the lender certainly signal deceptive or fraud smells so as to avert such risks.
Credit risk transfer, if abused, would enable to lend unaffordable borrowers without due diligence or in any corrupted and abusive lending practice. You can lend without verification and without reviewing the payment ability of the borrower in unreasonable belief that the home price continue to rise because and on conditions that you are sure to be left immune from the estimated credit risks stemming from the abusive practice. Most indispensable condition precedent for closing the mortgage is to assure you to fund by securitization.
If the loan officer or staff takes no responsibility for any abundant losses suffering from loans originated in such manner, and their performance of their duties is evaluated only on the basis of volume of drawn down loans without consideration of any penalty for actual damages later on incurred to your institution, there will appear a pile of corruptions you face. You can further guess how the originator behaves in lending if it is known that investors intending to expose themselves to the credit risks have no direct access to loan by loan information, and make a blind purchase of RMBS without reading documentation for each loan but in reliance of rating and due diligence conducted by the deal intermediary and the trustee. Once origination is functionally separated from holding of loans on true sale basis, the lender may not be much concerned about loan losses and you find the material deficiency in mechanism to deter from abusive lending.
Can’t you imagine why such liar’s loans or fraudulently or abusively originated loans deserves rating or investment-grade eligibility, needless to say AAA, the mark of complete assurance of safety as financial product. Where no one knows the technological development of credit risk management of liar’s loans, it wonders if such loans may be worth rating as underlying assets. I am maybe wrong since and when some of non verified loans can be originated for the purposes to retain on book and the lender developed the risk management system therefore on the aggregate basis in lieu of loan by loan analysis with setting the risk tolerance threshold. For such loan management, I believe the higher compensation suffices the risk.
Rating agencies argue immune from due diligence care under section 11 of 33 Securities Law, if publicly offered, for they are not a party of transacting the securitization though they are always part of (or request the intermediary securities underwriter to be among) the transaction e-mail distribution list for the transaction documents. Investment bankers may not argue immunity from due diligence responsibility. However, investors are clearly disclosed the loan underwriting policy taken in the origination process and procedure for loans likely to smell of unfair deceptive or fraudulent and abusive practice in the pooling and servicing agreement and prospectus or offering circular whatever else referred to. The origination policy as described in those offering and filed document is not detailed to full length of operation manual of each credit criteria, but it is sufficient to have insight of the stated income loan or no verification loan, the risk associated with which are undertaken by investors. Though the rating is part of required items contained in the filing or offering document under SEC’s securities rules and regulations, without which securities are prohibited from offering, investors can neither buy assurance of isolation from such risks nor rely to much extent on AAA which does not assure the quality of background due diligence work of investment bankers to separate loans smelling of fraud or abusiveness.
If securitization technique is abused completely in subprime structured finance, transaction parties (loan underwriter, securities underwriter, loan pool and securities trustee, transaction lawyer addressing the true sale for risk transfer, originator auditor (not immune if internal control over financial statement) and non transaction party such as rating agency can enjoy liability remoteness so referred to as by LoPucki by selling and delivering risk to you with reasonable premium you agree to. Tragedy appears where the loan underwriter and holders of loan is separate.
No financial product liability arise against the defective products offered to investors. When investors eat it, it will be at your risk.
Posted by: kazosawa | Sep 6, 2007 12:54:32 AM
AAA rating liability for subprime loan RMBS
Liability remoteness, not bankruptcy immune SPE, assured by securitization technique
Who is liable for subprime loan securitization?
How responsible are Invesors?
Can’t you imagine what would happen to a lending institution if you as a lending officer lend moneys to purchase home or refinance an existing mortgage with no documentation to verify the borrower’s income or occupation or merely on the stated income accompanying no documents? In cases where or in days when the loan is lent to be retained on-book of the lender who has no knowledge of financial technology to transfer the credit risks inherent with the loan to any third party investors, the lender may not undertake such risks associated with liar’s loans. Intuitive experienced gut feelings of the lender certainly signal deceptive or fraud smells so as to avert such risks.
Credit risk transfer, if abused, would enable to lend unaffordable borrowers without due diligence or in any corrupted and abusive lending practice. You can lend without verification and without reviewing the payment ability of the borrower in unreasonable belief that the home price continue to rise because and on conditions that you are sure to be left immune from the estimated credit risks stemming from the abusive practice. Most indispensable condition precedent for closing the mortgage is to assure you to fund by securitization.
If the loan officer or staff takes no responsibility for any abundant losses suffering from loans originated in such manner, and their performance of their duties is evaluated only on the basis of volume of drawn down loans without consideration of any penalty for actual damages later on incurred to your institution, there will appear a pile of corruptions you face. You can further guess how the originator behaves in lending if it is known that investors intending to expose themselves to the credit risks have no direct access to loan by loan information, and make a blind purchase of RMBS without reading documentation for each loan but in reliance of rating and due diligence conducted by the deal intermediary and the trustee. Once origination is functionally separated from holding of loans on true sale basis, the lender may not be much concerned about loan losses and you find the material deficiency in mechanism to deter from abusive lending.
Can’t you imagine why such liar’s loans or fraudulently or abusively originated loans deserves rating or investment-grade eligibility, needless to say AAA, the mark of complete assurance of safety as financial product. Where no one knows the technological development of credit risk management of liar’s loans, it wonders if such loans may be worth rating as underlying assets. I am maybe wrong since and when some of non verified loans can be originated for the purposes to retain on book and the lender developed the risk management system therefore on the aggregate basis in lieu of loan by loan analysis with setting the risk tolerance threshold. For such loan management, I believe the higher compensation suffices the risk.
Rating agencies argue immune from due diligence care under section 11 of 33 Securities Law, if publicly offered, for they are not a party of transacting the securitization though they are always part of (or request the intermediary securities underwriter to be among) the transaction e-mail distribution list for the transaction documents. Investment bankers may not argue immunity from due diligence responsibility. However, investors are clearly disclosed the loan underwriting policy taken in the origination process and procedure for loans likely to smell of unfair deceptive or fraudulent and abusive practice in the pooling and servicing agreement and prospectus or offering circular whatever else referred to. The origination policy as described in those offering and filed document is not detailed to full length of operation manual of each credit criteria, but it is sufficient to have insight of the stated income loan or no verification loan, the risk associated with which are undertaken by investors. Though the rating is part of required items contained in the filing or offering document under SEC’s securities rules and regulations, without which securities are prohibited from offering, investors can neither buy assurance of isolation from such risks nor rely to much extent on AAA which does not assure the quality of background due diligence work of investment bankers to separate loans smelling of fraud or abusiveness.
If securitization technique is abused completely in subprime structured finance, transaction parties (loan underwriter, securities underwriter, loan pool and securities trustee, transaction lawyer addressing the true sale for risk transfer, originator auditor (not immune if internal control over financial statement) and non transaction party such as rating agency can enjoy liability remoteness so referred to as by LoPucki by selling and delivering risk to you with reasonable premium you agree to. Tragedy appears where the loan underwriter and holders of loan is separate.
No financial product liability arise against the defective products offered to investors. When investors eat it, it will be at your risk.
Posted by: Kazundo Osawa | Sep 6, 2007 1:33:27 AM
