This begins Act II of the tragedy in Professor Coffee's presentation. The investment banks bought loans because they knew that they could securitize them on a global basis if they could get "investment grade" ratings from two of the critical gatekeepers, names the rating agencies SandP and Moody's. Two ratings were needed for investor acceptance. So why did the gatekeepers fail to do their jobs?Standard and Poors' argument that its ratings were not motivated by "commercial considerations" seems to a weak one, although the issue of proving that the ratings were made in "bad faith" will be difficult for the government, unless there are a load of "smoking e-mails."
When Moody's and SandP were focused on corporate bond issuance, no one client accounted for more than 1% of their business. When structured finance overtook corporate bond issuance, their business mix changed dramatically. In 2006, for example, 56% of Moody's revenues came from the top investment banks for structured finance product ratings. In addition, now the rating agencies generated consulting revenues from the same investment banks, counseling them on how to design a marketable structure. This concentrated their business and reduced their independence.
An additional wrinkle came with the acquisition of Fitch, and the new French owner's decision to grow its market share. Now, instead of a duopoly, you had three firms competing for the two ratings that had to accompany every "investment grade" deal. Professor Coffee had a dramatic slide that showed significant grade inflation for both investment-grade and below-investment grade securities
In 2012, we wrote about the Australian judge who wrote that investors could sue Standard and Poors for assigning AAA ratings to a CPDO structured finance vehicle.
Like judging the performance of the audit firms, the argument has to stay on technical and process grounds.
- What models did Standard and Poors use to evaluate the performance of the mortgage pool underlying the structured finance vehicle?
- Did SandP rigorously analyze a sample of underlying types of mortgage loans in the pool, especially the higher risk loans?
- Did their modeling, analytical process, and historical experience with these products provide a reasonable basis for their AAA rating?
- Was the high percentage of AAA deals and the absence of split ratings among the three competitors a reasonable statistical outcome?