The Banking Crisis of 2007-2010

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Table of Contents

Credit Rating Agencies
Quality of ratings
Poor modeling
Lack of competition
Conflict of interest
Notching and tying
Conclusion
Reference List

The banking crisis was caused by a liquidity crisis that emanated from the housing market. In this scenario banks offered Adjustable Rate Mortgages (ARM) loans to people so as to enable them to buy houses; which were expensive and out of their price range. Quite predictably most of these ARM loans carried enormous default risk which was thence actualized in massive defaults. This subsequently led to the collapse of large financial institutions, some cases in which national governments responded by bailing them out. Stock markets were also affected with the housing market not being spared. This was characterized by evictions fore-closures and prolonged vacancies.

.Since this was the worst financial crisis ever, many businesses failed, coupled with declines in consumer wealth amounting to trillions of dollars. Governments had to intervene with financial commitments, the significant adverse effects on economies notwithstanding.

Ali et al found out that the Subprime Mortgage Crisis as a contributing factor. This describes the situation whereby there was widespread default on payments of loans secured against the value of houses by Americans with low credit ratings. This caused a fall in house prices coupled with loss of confidence in bonds linked to these loans. Mark Zeitoun notes that these resulted into expansive financial problems among banks and other mortgage providers.

Credit rating agencies had to review their ratings more so of securities linked on mortgages because of the rise in defaults on subprime mortgages. Banks that held such securities were thence unable to use them as collateral to service their borrowing needs. The resulting financial problems commencing with the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac); with major banks following suit. Because of this the government had to rescue Fannie Mae and Freddie Mac from bankruptcy due to the evident pervasive collapse. This led to reluctance from banks lending to each other brought about by uncertainty on the quality of banking assets. IMF adds that the very important inter-bank market was thus defunct. Northern Rock in the UK and other banks encountered problems in the process amplifying loss of confidence because of reliance on this financing avenue. Financial institutions and banks found themselves in a severe financial mess due to loss of short term borrowing and loss of investor confidence in assets. What resulted was the withdrawal of banks from their normal contribution to the economy which is providing credit for industry and commerce.

Credit Rating Agencies

The role of Credit Rating Agencies in the subprime mortgage-related securities market turmoil was scrutinized by the Securities and Exchange Commission. In the process, Fitch Ratings Ltd; Moody’s Investor Services and Standard and Poor’s Rating Services later on became subject of inquiry.

They are so few due to the stringent regulatory requirements and rules needed to be registered as nationally recognized statistical rating organizations such as the Credit Agency Reform Act of 2006. Their role in the downturn was the rating of mortgage-backed securities and collateralized debt obligations. They down graded the rating on these instruments raising questions on the accuracy and integrity of their rating process. Because of this there was subsequent critism and scrutiny.

Quality of ratings

A study of these rating agencies disclosed some process issues in the rating of bank’s securities in the subprime mortgage related market during the crisis. The first of these concerned the substantial increase in the number and complexity of Residential Mortgage Backed Securities (RMBS) and Collateralized Debt Obligations (CDO) deals from 2002 to 2006. In this period the volume of these deals that were rated by these agencies underwent a meteoric rise. USCHCOG found out that to match these increases the agencies were meant to match the staffing requirements of the new volumes. This they did to varying levels doing so sufficiently in the RBMS deals but falling short in the CDOs sector. There also arises the fact that the structured financial products that the agencies were asked to rate grew in complexity for instance the expanded use of credit default swaps to replicate the performance mortgage-backed securities and less conservative nature of loans being securitized into RBMS.

Robert Pozen realized that significant aspects of the ratings process were not always disclosed despite a claim that prior to their registration as nationally recognized statistical rating organizations (NRSROS), they disclosed their ratings process. The survey however indicates that the process methodologies and procedure were not usually disclosed at all or were not fully disclosed.

Better documentation of procedures and policies for RBMS and CBOS is needed for proper rating. Jeff et al are of the opinion that not only do the rating agencies profess their emphasis on the importance of providing accurate ratings with integrity; but they also became subject to a requirement to maintain internal documents relating to their methodologies and procedures in undertaking their credit ratings. This was prior to the registration as NRSROS in September 2007

To add on these it is evident that rating agencies were not in any obligation to review information contained in RBMS loan portfolios given to them for rating. They were also not required to insist on issuers perfuming due diligence and obtaining documents as to these diligence checks. There was thus a loophole in the due diligence procedures by the issues and the level of attention the credit agencies accorded the issue.

Lawrence White notes that credit rating agencies did not document significant steps in the ratings process which is important. Notably missing is the rationale for rating actions and committee decisions. Revealed is also the fact that there was failure to document significant participants in the ratings with the CRA rating process being faulty.

Poor modeling

It was noted that one rating agency reported the subprime mortgage having increased from $421 billion to $640 billion between 2002 and 2006. This erroneous postulate is contrary to the fact that as a percentage of all mortgages originated, subprime mortgages grew to represent from 14% to 22% of the pool in this period. This translates to $96.8 billion in 2002 to $600 billion in 2006.

The Office of Economic analysis staff discovered that all three agencies utilized a similar approach in rating RBMS bonds, employing three primary models: probability of default; loss severity; and the cash flow model. The first two estimate default probabilities and loss severity in the case of default on a loan-by-loan basis, respectively. Historical loan performance data is used to estimate the conditional relationships between loan and borrower characteristics and the two variables. These parameters are then applied to the loans in the RBMS portfolio and updated on loan performance data. Based on this data the agencies employed the following models: Use of hazard rates to forecast time to default, with simultaneous prediction of time to prepayment using Monte Carlo simulations of macroeconomic variables to create loss distribution by one agency; a second agency using logistic regression instead of a hazard rate model while using the same approach for loss distribution; the third agency used several different types of models to determine the effect of a factor on default probability. A comparison to the practice of one agency prior to 2007, it did not use any one specific subprime model instead using a combination of the output from the model to rate prime home RMBS and credit enhancement level benchmarks of previously issued deals by the same originator. It has been described that adjustments were made based on the perceived relative risk of the pool as compared to the previously issued pools. However no loan-by-loan basis analysis was done. RMBS pools comprise thousands of loans whose quality is prone to significant changes over time.

This mal-application of models is just part of a bigger problem including the incorporation of risk variables, use of historical data, surveillance of ratings and rating models for CDOs; that the process used to rate CDOs is fundamentally similar to that of RBMS, yet RBMS default probability and loss severity models require 50-60 inputs CDO models only require 5 inputs that were subsequently used to determine three assumptions going into the loss model.

Lack of competition

There are certainly reasons why we don’t have competition and this can be explained from the many barriers to entry. Because we people are so rigid and on past regulatory, institutional and natural barriers to entry we can explain why the markets have not been to our expectations. In the process there are agencies that have made a name and are recognizable as leaders like, Moody’s, Standard & Poor’s and Fitch thereby they have acquired market power over the last century in the credit rating business therefore protecting them from competition.

Normally others have not been able to enter these markets because of the there is massive use of regulatory mostly in credit rating. Since there have been many changes to the regulations in the long run it has made it easy for us to have Oligopolies. Banks cannot issue a bond where there is no CRA rating and that is why there is slow performance. In adverse addition, issuers, investors and authorities prefer to use the assessments of thus explaining the dominance of the certified CRAs.

As it was supposed to be, the expected competition that these industry is supposed to have has not been achieved the use of regulations is always shelved. A bad regime has always locked out people who might be interested in doing these businesses.

Undeniably forces that have mostly benefited from the now wider use of privileged CRAs have always translated to barriers to entry for new participants. There should be competition in the credit rating industry as its absence affects investors. As the ratings oriented regulation has been an impediment to competition, it has altered incentives that CRAs ought to have in giving investors non distorted information. The needs of the investors have been abused by little incentives from certified CRAs. On the contrary more interest is on assisting issuers to reap from a favored regulatory treatment than in ensuring investors get accurate information. SEC found out that there is a lot of inaccessibility as a consequence of stringent recognition criteria. Need for historical experience is a problem since CRAs, without approval cannot provide expected proper reputation. According of status of CRA is relied mostly on market reliance through regulatory recognition. As a result of these excessive barriers are seen and witnessed in the credit rating industry.

Conflict of interest

The ‘issuer pays’ model that exists in all asset classes that receive credit ratings creates conflict of interest. In the case of RMBS and CDOs the situation may be exacerbated owing to the fact that the arranger is the primary designer of the transaction. This allows for leverage that can enable it adjust the deal terms so as to receive the desired credit rating. Arrangers have been known to influence the particular rating agency for underwriting RMBS and CDO offerings. In addition the firms carrying out the underwriting function are highly concentrated, mostly seen in their underwriting function and source of revenue. The combination of the arrangers’ influence in the determination of rating agencies chosen has heightened the inherent conflicts of interest in the ‘issuer pay’ model. Arrangers are therefore able to benefit in the rating process whereby they prefer that the ratings process be quick and predictable. Influence could also take the form of pressuring agencies for more favorable ratings or reduced credit enhancement levels. This would reduce the cost of the debt for a given level of cash inflows from the asset pool. This is especially feasible in the case of arrangers of RMBS and CDOs in dissuading the rating agency in updating a model where it would lead to less favorable outcomes.

High profit margins from rating RMBS and CDOs seem to have provided an incentive for credit rating agencies to entice the arrangers to channel future business their way. Unsolicited ratings are however not available to independently gauge the rating agencies’ ratings. The structures of securities that disclose these findings are complex thus information regarding the composition of the assets especially prior to issuance is difficult to for judgment.

Notching and tying

May be described as case where rating agencies mostly borrow ratings from others. It is shown mainly as collateral within the investment vehicles rated. Notching and tying is an unfavorable discriminatory practice that targets both the issuers and competition in entirety. The issuers are threatened with receiving a lower credit rating, lowering of their existing credit rating, refusal of a credit rating or withdrawal of a credit rating. The reason is to claim more business whereby an agency handles the structured financial product and unless a portion of the assets underlying the structured product also are rated by the NRSRO (agency) then it takes the above action. This is a rogue tactic and amounts to nothing more than duress or coercion.

Majority of senior executives, mostly working in structured finance are not in support of notching as a practice, as they feel that it has led to undermining of competition.

Conclusion

Based on the above study, it is admissible that the criticism of credit rating agencies is justified. As disclosed in the research several malpractice issues were found to be rampant in the operations and processes of the rating agencies. Regarding the process, this survey has established that the agencies not only applied poor modeling in rating mortgage issuers, but they were also prone to nondisclosure and poor documentation of the rating processes. The rating industry’s inconsistencies as pertaining to competition, conflict of interest and unethical practices such as notching and tying greatly compromised the objectivity of their rating of sub prime mortgage providers. These issues led to wrongful judgment of financial institutions, a situation which in turn worsened the effects of the American and global financial crisis. Constructive criticism is therefore well deserved and justified. This feedback should drive the credit rating agencies to streamline their procedures and industry dynamics do as to avoid yet another financial catastrophe.

Reference List

A J Ali, R F Donald & W James, The Effects of Securitization on Mortgage Market Yields: A Co-integration Analysis, Real Estate Economics, 1998.

International Monetary Fund, International Capital Markets, Developments, Prospects and Key Policy Issues. International Monetary Fund, 1999.

J Jeff & L Miles, The Impact Of the Third Credit Rating On the Pricing of Bonds, Journal of Fixed Income, December 2000.

J W Lawrence, The Credit Rating Industry: An Industrial Organization Analysis, 2001.

M Z Mark, The Securitization of America, Regional Financial Review, February 1998.

R Pozen, Too Big To Save; How to Fix the U.S Financial System, John Wiley and Sons Inc. 2010.

Securities and Exchange Commission, Summary Report of Issues Identified in the Commission Staff’s Examinations of Select Credit Rating Agencies, SEC, 2008.

United States Congress House Committee on Oversight and Government, Reform Credit rating agencies and the financial crisis: hearing before the Committee on Oversight and Government Reform, House of Representatives, One Hundred Tenth Congress, second session, vol. 74-77, 2008.

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