Inaccurate rating models came straight from the federal government

FALSE NARRATIVE: Credit rating agencies (S.& P. and Moody's) allowed competitive pressures to affect their ratings, adopting inaccurate rating models.

The New York Times reports about S.& P. and Moody's use of inaccurate rating models.

Documents Show Internal Qualms at Rating Agencies
By SEWELL CHAN
Published: April 22, 2010

… A Senate panel will release 550 pages of exhibits on Friday — including these and other internal messages — at a hearing scrutinizing the role S.& P. and the ratings agency Moody' s Investors Service played in the 2008 financial crisis. …

The investigation, which began in November 2008, found that S.& P. and Moody' s used inaccurate rating models in 2004-7 that failed to predict how high-risk residential mortgages would perform; allowed competitive pressures to affect their ratings; and failed to reassess past ratings after improving their models in 2006.

The companies failed to assign adequate staff to examine new and exotic investments, and
neglected to take mortgage fraud, lax underwriting and “unsustainable home price appreciation” into account in their models, the inquiry found.

By 2007,
when the companies, under pressure, admitted their failures and downgraded the ratings to reflect the true risks, it was too late.

NPR reports about blaming the credit ratings agencies.

Economy Got You Down? Many Blame Rating Firms
Alex Blumberg and David Kestenbaum
June 5, 2009

If you're looking for someone to blame in the collapse of the global economy, one popular punching bag is the credit ratings agencies. Firms like Moody's, Fitch and Standard and Poor's are supposed to let investors know whether bonds are particularly risky or relatively safe.

Ratings agencies gave their triple-A rating, the highest ranking, to many bonds backed by home mortgages — the same bonds we now call toxic assets. Grouping those bonds among the safest investments allowed trillions of dollars to flow into the housing market, which in turn created the housing bubble.

It's hard to overstate the ratings agencies' role in the worldwide financial system. They've been around for a century, assigning a letter grade to everything from railroads to school districts, even entire countries. …

Those Marvelous Ratings


Jim Finkel also wondered about those computer models and the ratings they helped produce. He works for a company called Dynamic Credit and helped put together complex bonds called collateralized debt obligations, which were made up of mortgages. Finkel profited from the AAA ratings, but he says the ratings agencies' blessings seemed too good to be true.

"They should have just said, 'You know what? We just don't have enough information about this stuff to ascribe a rating to it,' " he says.
"There were ratings that we saw that made no sense to us.. We marveled at the ratings that all of these CDO products got."

THE REALITY: Up until 1994, Rating agencies were extremely conservative in their estimates. However, RTC and FDIC, in an effort to sell billions in toxic mortgage-backed securities, devised their own overly optimistic method estimating defaults. Inaccurate rating models came straight from the federal government, and rating agencies adopted them because they didn' t have a choice.

The proof of this reality comes directly from the FDIC' s website

After the savings and loan crisis, the FDIC conducted a study on the challenges faced by the FDIC and the RTC in resolving troubled banks and thrifts during the financial crisis of the 1980s and early 1990s. The result was a two book publication, Managing the Crisis.


Managing the Crisis: The FDIC and RTC Experience

www.FDIC.gov/bank/historical/managing/history1-16.pdf

(If link goes dead, I will replace it)

Given the importance of careful auction planning, coupled with the need to accurately determine risk exposure, the RTC devised a method to project each transaction termination date and to estimate realized losses. A model was developed to project cash flows for each transaction using available information on prepayments, delinquencies, defaults, and losses. It provides an estimate of credit reserve losses, termination dates, year-by-year cash flows, reserve funds, and residual values for each securitization. …

At the time of the closing, loss estimates for each securitization were provided by the RTC-FDIC financial adviser and by the rating agencies. In 1994, the RTC began to generate loss estimates using the model. In May 1996, the FDIC compared actual and expected loss estimates from the various sources. The comparison showed that the rating agencies were extremely conservative in their estimates, when compared to estimates by the model and the financial adviser. For example, rating agency-expected losses on the Multi-Family Securitization Program as a percentage of unpaid principal balances averaged approximately 29 percent, the FDIC model loss estimates averaged 12 percent; the financial adviser estimated losses to be 7 percent, and the actual realized losses were approximately 7 percent. Overall, the losses and recovery rates that were initially estimated by the rating agencies were severely overstated for the RTC-FDIC securitization program,

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One Response to Inaccurate rating models came straight from the federal government

  1. Gail says:

    Eric you might be interested in this if you haven't heard it:

    http://www.earthpolicy.org/index.php?/press_room/C69/aug1010/

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