European Commission to Investigate Credit Rating Agencies

The European Commission has decided to investigate the actions of the major credit rating agencies and their behavior in the sub-prime mortgage markets. The instability in the sub-prime market for mortgage-backed securities has been the driver of much of the financial market turmoil in recent weeks. The Financial Times quotes one Commission official as saying, “The securitised subprime mortgage market would not have grown to the extent that it did without the favourable ratings given by some agencies.” While that is true, it doesn’t follow that the rating agencies have done anything wrong.

To understand the problem, one must understand what a mortgage-backed security is in the first place and what function the rating on the MBS serves. An MBS is essentially a financial instrument that provides a revenue stream to the purchaser from mortgages held by the seller of the security. This allows banks to get mortgage liabilities off their books (and allows them to make new loans as a result), and it lets new investors into the mortgage market. A rating agency puts a Aaa (or A3 or B2 or whatever) rating on the MBS based on the risk that the payments won’t be made on time and in full. All sorts of features are built into the average MBS to ensure that they almost always carry the highest Aaa rating.

The FT reported, “Banks first warned about a potential crisis in subprime last year. But it was only this spring that S&P and Moody’s started downgrading the ratings of mortgage-backed securities on a significant scale.” That sentence bears close scrutiny. Banks warned of a “potential” crisis last year. It is at that point that the credit rating agencies mentioned, along with Fitch, would have started to review matters. Downgrades to the rating (which basically means the credit risk has risen) happened in the spring, after several weeks of reassessment.

The markets last spring paid virtually no attention to the downgrades. There was some chatter, and a few conferences held panel discussions on it, but prices took no notice. Equities and bonds performed as if there were no problems. Now, in August, the market is pricing this substantially bigger risk into MBS and other securities. It would seem that the rating agencies were ahead of the market, which is their function.

Much the same happened during the 1997 Asian currency crisis. Moody’s even issued a white paper that demonstrated that downgrades to credit ratings preceded the market collapse by several weeks, even months. The rating agencies have a great many challenges, and they undoubtedly need reform and possibly regulation. They are not the parties responsible for the current mess. That honor goes to the lenders, the borrowers and the regulators for making, accepting and permitting so much bad mortgage debt to be issued in the first place.

© Copyright 2007 by The Kensington Review, Jeff Myhre, PhD, Editor. No part of this publication may be reproduced without written consent. Produced using Fedora Linux.

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