Advisory Center for Affordable Settlements & Housing

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Misapplied Bond Ratings Cause Mortgage Backed Securities

Many of the current difficulties in residential mortgage-backed securities (RMBS) and collateralized debt obligations (CDOs) can be attributed to a misapplication of agency ratings. Changes in mortgage origination and servicing make it difficult to evaluate the risk of RMBS and CDOs. 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. We analyze the fundamental differences between rating structured finance products like RMBS and CDOs and traditional products like corporate debt. We show that the inefficiencies of rating RMBS and CDOs are leading investors to discount U.S. markets. The residential mortgage-backed securities (RMBS) market has experienced significant changes over the past decade.

Non-agency (“private label”) securities, which are not guaranteed by the government or the government-sponsored enterprises, now account for the majority of RMBS issued. When changes to origination and servicing occur unpredictably over time or across issuers, thereby affecting the cash flows of some unknown number of mortgages, RMBS become more difficult to value. Hence, changes in origination and servicing practices, along with the existing complexity of RMBS, results in greater opacity in the RMBS market. Those sentiments suggest that the RMBS market was transparent at some previous instant. In this paper, we explain that the general nature of bond ratings, as well as a fundamental misapplication of the corporate ratings process to RMBS, has never provided sufficient transparency for market efficiency. Rather, the benefits of securitization to date have rested primarily upon a chance combination of a lengthy economic expansion coupled with asset price increases of the sort that are fundamentally excluded from standard measures of inflation. We discuss ways in which conflicting incentives and the misapplication of corporate bond ratings methods have skewed the evaluation of risk in RMBS and CDOs.

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