Tag Archives: Moody’s

S&P Must Face The Orchestra on Rating Failure

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After many state Attorneys General brought suit against S&P over the objectivity of their ratings, S&P sought to consolidate the cases in federal court. Judge Furman (SDNY) has issued an Opinion and Order in In Re:  Standard & Poor’s Rating Agency Litigation, 1:13-md-02446 (June 3, 2014) that remanded the cases back to state courts because “they arise solely under state law, not federal law.” (3) Explaining the issue in a bit greater depth, the Court stated,

there is no dispute that the States’ Complaints exclusively assert state-law causes of action — for fraud, deceptive business practices, violations of state consumer-protection statutes, and the like.The crux of those claims is that S&P made false representations, in its Code of  Conduct and otherwise, and that those representations harmed the citizens of the relevant State. (20, citation omitted)

The Court notes that in “the final analysis, the States assert in these cases that S&P failed to adhere to its own promises, not that S&P violated” federal law. (28) The Court concludes that it does not reach this result “lightly:”

Putting aside the natural “tempt[ation] to find federal jurisdiction every time a multi-billion dollar case with national  implications arrives at the doorstep of a federal court,” the federal courts undoubtedly have advantages over their state counterparts when it comes to managing a set of substantial cases filed in jurisdictions throughout the country. Through the MDL process, federal cases can be consolidated for pretrial purposes or more, promoting efficiency and minimizing the risks of inconsistent rulings and unnecessary duplication of efforts. (51, citation omitted)

S&P knew that it would have to face the music regarding the allegations that its ratings were flawed. But it hoped that it could face a soloist, one federal judge. That way, it could keep its litigation costs down, engage in one set of settlement talks and get an up or down result on its liability. The remand means that S&P will face many, many judges, a veritable judicial orchestra. In addition to all of the other problems this entails, it is also almost certain that S&P will face inconsistent verdicts if these cases were to go to trial. This is a significant tactical setback for S&P. From a policy perspective though, the remand means that we should get a better understanding of the issuer-pays model of rating agencies.

The (R)evolution of Single-Family Rental Securitization

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Kroll Bond Rating Agency distributed its Single-Family Rental Securitization Methodology. Because this is a new asset class, it is interesting to watch how rating agency’s assess the risks inherent in it. And it will be interesting, of course, to evaluate down the road whether they got it right or not. The Methodology states that

Single-family Rental (SFR) securitizations are a new class of asset-backed securities with characteristics of both commercial mortgage-backed securities (CMBS) and residential mortgage-backed securities (RMBS). Like CMBS, the primary source of certificateholder distributions during the term of an SFR transaction are loan debt service payments that are generated by income producing real estate collateral. Also like CMBS, there is an element of balloon risk, as SFR loans do not fully amortize over their terms, and the repayment of ultimate principal on the certificates is dependent upon a successful refinance of the loan or loans that serve as trust collateral. However, there is a broader source of demand for the single-family homes underlying an SFR securitization, which can be sold into the vast market for owner-occupied homes, totaling approximately 79 million units. In the event that the pool of single-family homes backing an SFR securitization needs to be partially or entirely liquidated due to an event of default either during the loan’s term or at the loan’s maturity, the expected recovery from such a distressed sale of homes would be largely determined by the conditions in the larger market for single-family homes, which is a primary focus of RMBS analysis.

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the SFR securitization market is currently characterized by large institutional sponsors that have engaged in purchasing and refurbishing large numbers of single-family homes in distressed markets over relatively short periods of time.

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As this is an evolving asset class, we will modify or adjust our methodology to address new transaction features as they emerge. SFR securitizations to date have been collateralized by a single large loan that is in turn secured by mortgages on several thousand income producing single-family homes. While this methodology is designed for this structure, it is also applicable to securitizations secured by a few large loans. Structures featuring a larger number of loans to distinct borrowers, many of whom may be non-institutional in nature, pose additional credit considerations that are not addressed herein. (3)

This summary demonstrates that there are a lot of new characteristics for this asset-class that Kroll is trying to capture in its rating methodology. These include the hybrid nature of the security itself; the hybrid nature of the underlying collateral for the security; the innovative business model of institutional investors entering the single-family market in a big way; and the possible entry of new players in that market, such as non-institutional ones; and changes in the type of collateral underlying the securities.

The takeaway for readers: don’t mistake the apparent simplicity of a rating (AAA, Aaa) as a signal of the solidity of the reasoning that went into it. Ratings, particularly those for new types of securities, are constantly evolving. To think otherwise is to risk being left holding a bag filled with all of lemons that the market has to offer to unsuspecting investors.

New and Improved Rating Agencies!

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The SEC issued its 2013 Summary Report of Commission Staff’s Examinations of Each Nationally Recognized Statistical Rating Organization. I had noted that the 2012 report was not an impressive document. Much the same can be said for the 2013 version of this statutorily required document (it is required to be produced pursuant the 1934 Securities Exchange Act). It seems, to my mind, to focus on the trees at the expense of the forest.

The report is overall positive, with the staff noting “five general areas of improvement among the NRSROs [rating agencies]” from the previous reporting period:

(i) Enhanced documentation, disclosure, and Board oversight of criteria and methodologies. The Staff has observed that many NRSROs have developed and publicly disclosed ratings criteria and methodologies that better describe ratings inputs and processes. Some NRSROs have also increased Board oversight of rating processes and methodologies.

(ii) Investment in software or computer systems. The Staff found that some NRSROs have made investments in software and information technology infrastructure by, for example, implementing systems for electronic recordkeeping and for monitoring employee securities trading. One NRSRO has implemented systems that enable it to operate in a nearly paperless environment, so as to minimize the inadvertent dissemination of confidential information and to ensure preservation of all records required by Rule 17g-2.

(iii) Increased prominence of the role of the DCO within NRSROs. The Staff has found that the role of the DCO [designated compliance officer] has taken on more prominence within many NRSROs. The Staff has noticed that certain DCOs have increased reporting obligations to, and more interaction with, the NRSRO’s Board. At these NRSROs, the DCO meets with the Board to discuss compliance matters, quarterly or more frequently.

(iv) Implementation or enhancement of internal controls. The Staff has recognized that all NRSROs have added or improved internal controls over the rating process. More NRSROs are using audits and other testing to verify compliance with federal securities law, and NRSROs have generally improved employee training on compliance matters.

(v) Adherence to internal policies and procedures. The Staff has noticed a general improvement in NRSROs’ adherence to internal rating policies and procedures, which improvement appears to be attributable, in part, to improvements in the internal control structure at NRSROs. (8)

Hard to complain about any of these findings, but I have a sinking feeling that improvements such as these won’t add up to enough of a change to the culture that put profits ahead of objective ratings. Hopefully I am wrong about that

S&P’s Fightin’ Words

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S&P filed a memorandum in support of its motion to compel discovery in the FIRREA case that the United States brought against S&P last year. S&P comes out fighting in this memorandum, arguing that the “lawsuit is retaliation for S&P’s decision to downgrade the credit rating of the United states in August 2011.” (1)

S&P argues that the “most obvious explanation” for the United States’ “decision to pursue a FIRREA action against S&P alone” among the major rating agencies “is apparent:”   “S&P alone among the major rating agencies downgraded the securities issued by the United States.” (17) This is not obvious to me, particularly given the various explanations for this disparate treatment that have appeared in outlets like the WSJ over the last couple of years. But it may be true nonetheless.

In any case, I do not find the “chronology of events relating to the downgrade and the commencement of this lawsuit” to provide “powerful evidence linking the two.” (17) The chronology ends with the following entries:

  • S&P’s downgrade of the United States occurred on Friday, August 5, 2011. That Sunday, August 7, Harold McGraw III, the Chairman, Chief Executive Officer and President of McGraw Hill (of which S&P was a unit), received a telephone message from a high-ranking official of the New York Federal Reserve Bank; when the call was returned, the official conveyed the personal displeasure of the Secretary of the Treasury with S&P’s rating action.
  • This was followed on Monday by a call to Mr. McGraw from the Secretary of the Treasury, Timothy Geithner, in which Secretary Geithner stated that S&P had made a “huge error” for which it was “accountable.” He said that S&P had done “an enormous disservice to yourselves and your country,” that S&P’s conduct would be “looked at very carefully,” and that such behavior could not occur without a response.
  • The McClatchy Newspapers subsequently reported in a piece authored by Kevin G. Hall and Greg Gordon that while the United States’ original investigation included S&P and Moody’s, “[i]nvestigator interest in Moody’s apparently dropped off around the summer of 2011, about the same time S&P issued the historic downgrade of the United States’ creditworthiness because of mounting debt and deficits.” A source familiar with the investigations was quoted as stating: “After the U.S. downgrade, Moody’s is no longer part of this.”
  • In the year preceding S&P’s downgrade of the United States, two states, Mississippi and Connecticut, had initiated proceedings alleging deceptive practices based specifically on an alleged lack of independence. Each of those states named both Moody’s and S&P as defendants. After the downgrade, additional state lawsuits were commenced, with allegations nearly identical to those of the Connecticut and Mississippi complaints. Drafted after coordination and consultation with the U.S. Department of Justice, none of those lawsuits named Moody’s. (19, footnotes omitted)

This is surely no smoking gun and lots of dots remain to be connected.  How did DoJ get involved? Are the state Attorneys General in on the conspiracy? Why would DoJ stop an investigation of Moody’s to punish S&P? Sounds a bit like cutting off your nose to spite your face?

That being said, S&P might be right about the motivation for this suit and their allegations may be enough to win this motion to compel discovery. But whoever wins this round, this should be a fight worth watching.

Non-QM Mortgages Risks and Best Practices

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Moody’s issued a report, Non-QM US RMBS Face Higher Risk of Losses Than QM, but Impact on Transactions Will Vary, that discusses the risk that

US RMBS backed by non-qualified mortgages (those that do not meet a variety of underwriting criteria under new guidelines) will incur higher loss severities on defaulted loans than those backed by qualified mortgages. The key driver of the loss severities will be the higher legal costs and penalties for non-QM securitizations. In non-QM transactions, a defaulted borrower can more easily sue a securitization trust on the grounds that the loan violated the Ability-to-Repay (ATR) rule under the Dodd-Frank Act. . . . The extent of the risks for RMBS will vary, however, depending on the mortgage originators’ practices and documentation, the strength of the transactions’ representations and warranties, and whether the transactions include indemnifications that shield them from borrower lawsuits. (1)

The higher costs for non-QM investors may include longer foreclosure timelines and the resulting wear on the collateral.

If Moody’s analysis is right, however, the Dodd-Frank regime will be working as intended. It should incentivize mortgage originators to strengthen their compliance practices such as those relating to documentation, recordkeeping and third party due diligence. It should also incentivize securitizers to demand strong reps and warranties, put back and indemnification provisions. Sounds like a reasonable trade off to  me.

Pandora’s Credit Box

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Jim Parrott and Mark Zandi posted Opening the Credit Box, a call for “[e[asing mortgage lending standards.” (2) Parrott has had high level positions in the Obama Administration and Zandi, Moody’s Analytics’ chief economist, was mentioned as a possible Director for the FHFA. Given the importance of these two authors to debates about the housing market, I think it is worth evaluating their views carefully. I have to say, they are somewhat worrisome.

They favor easing “mortgage lending standards so that more creditworthy borrowers can obtain the loans needed to purchase homes” in order to support “the current recovery,” but also to support “the economy’s long-term health.” (2) This is wrongheaded, as far as I am concerned.  Mortgage underwriting standards should not be set to support the economy. They should be set to balance the availability of credit with the likelihood of default. If we want to support the economy through the housing sector, we can do so through various tax credits or direct subsidies. But starting down the path of employing underwriting standards to do anything other than evaluate credit risk will quickly lay the foundation for the next housing bubble.

The paper contained a number of similarly disturbing cart-leading-the-horse statements. For instance, they write that for “the housing recovery to maintain its momentum, first-time and trade-up homebuyers must fill the void left by investors.” (2) Again, the goal of of encouraging new entrants in the market should not be to drive demand in the short-term. Rather, it should be done in order to allow creditworthy potential homeowners to have the opportunity to purchase a home on sustainable terms.

The authors take pains to step back from the extreme version of their position.  For instance, they write, “To be clear, the objective is not, and should not be,a return to the recklessly loose standards of the bubble years, but to strike a sensible balance between risk management and access to credit. Today’s market has overcorrected and it is hurting the nation’s recovery.” (2) But given the arguments that they have made, I find this coda to be too little too late.

I also found disturbing their analysis of put-back risk (whereby Fannie and Freddie can make loan originators buy back loans that violate various representations and warranties). Their analysis portrays originators as victims of unfairly tightened standards. The fact is, however, that originators had a long run of pushing off junk mortgages onto Fannie and Freddie. The industry will certainly need to figure out a new normal for put-backs and reps and warranties. It seems a bit premature, however, to say that Fannie and Freddie should just loosen up just as it is settling suits with these same originators for billions of dollars.

We should work toward housing market that balances access to homeownership with mortgages that households are likely to be able to afford in the long term. Once that relatively undistorted market finds its baseline, we can talk about tweaks to it. But jumping in today with policies intended to fill a void left by speculative investors seems like a recipe for disaster. In the Greek myth, Pandora opens up the box and lets loose all of the evils of humanity. I worry that rashly opening up the credit box will do the same for the housing market, once again.

Rating Agency 1st Amendment Defense Weakened, Again

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Federal District Judge O’Toole (D. Mass.) issued an Opinion and Order in Federal Home Loan Bank of Boston v. Ally Financial Inc. et al., No. 11-10952 (Sept. 30, 2013)  relating to the potential liability of S&P and Moody’s (the Rating Agency Defendants) for their ratings. The case “arises from the purchase of private label mortgage-backed securities” (PLMBS) by the plaintiff, FHLB Boston. (1)  FHLB Boston alleges that the rating agency defendants knew that their ratings “were inaccurate and based on flawed models, and that their conduct gives rise to” a claim for fraud as well as other causes of action. (1) The Rating Agency Defendants sought to have the claims dismissed for failure to state a claim. The Court rejected this as to the fraud claim:

The Rating Agency Defendants’ argument that their ratings are non-actionable opinions is unconvincing. As discussed in Abu Dhabi I, “[a]n opinion may still be actionable if the speaker does not genuinely and reasonably believe it or if it is without basis in fact.” 651 F. Supp. 2d at 176 (internal citations omitted). Here the Bank has pled with sufficient particularity that the Rating Agency Defendants issued ratings that they did not genuinely or reasonably believe. For example, the Amended Complaint alleges that the Rating Agency Defendants diluted their own standards and carried out their ratings procedures in an intentionally lax manner as to PLMBS while maintaining higher standards in other contexts. The Bank has also sufficiently pled scienter, alleging that the Rating Agency Defendants competed for business by artificially inflating ratings, as they were only paid if they provided high ratings. (4)

Rating agencies were able to avoid liability for decades, claiming that their ratings were like min-editorials that were protected by the First Amendment. A number of recent cases reject that defense in a variety of contexts (See here, here and here for instance). It is unclear what will happen when these cases are appealed, but for now it appears that a number of courts have identified situations where an opinion can be more than an opinion — it can amount to actionable fraud.