Tag Archives: 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.

The Road to Securitization

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Miguel Segoviano et al. of the IMF released a helpful Working Paper, Securitization:  Lessons Learned and the Road Ahead (also on SSRN). It opens,

Like most forms of financial innovation, there are cost and benefits associated with the securitization of cash flows. From a conceptual perspective, a sound and efficient market for securitization can be supportive of the financial system and broader economy in various ways such as lowering funding costs and improving the capital utilization of financial institutions—benefits which may be passed onto borrowers; helping issuers and investors diversify risk; and transforming pools of illiquid assets into tradable securities, thus stimulating the flow of credit—an issue of particular relevance for some European countries. However, these features need to be weighed against the potential costs, including the risk that securitization contributes to excessive credit growth in and outside of the formal banking system; principal-agent problems that amplify perverse incentives; the complexity and opaqueness of certain products which make efficient pricing problematic; and the heavy reliance of the industry on credit ratings. (3)

The authors identify lessons learned from the financial crisis as well as impediments to a renewed securitization market. They conclude with a set of policy recommendations.

I recommend this paper as a good overview. I particularly like that it looks beyond the United States market, although it does spend plenty of time looking at the history and structure of the U.S. market. The recommendations tend to be pretty reasonable, but not particularly innovative — implement Dodd-Frank-like requirements in non-U.S. jurisdictions; de-emphasize the role of NRSRO credit ratings; increase transparency and decrease needless complexity throughout the industry; modernize land record regimes, etc.

It is surely hard to get your hands around the global securitization industry, but it is important that we try to. Securitization is here to stay. We should manage its risks the best that we can.

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.

Moody Misrepresentation

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Judge Daniels (SDNY) granted Moody’s motion for summary judgment in In re Moody’s Corporation Securities Litigation, No. 07 Civ. 8375 (Aug. 23, 2013). This is a big win for Moody’s, but I did find the following passage striking in its tone:

Moody’s own emphasis on the importance of its independence weakens its case for summary judgment on the issue of materiality. Moody’s 2005 and 2006 Annual Reports, as well as their Forms 10-K from the same timeframe, are replete with pronouncements of Moody’s independence and integrity.  For example, Moody’s stated in its 2005 Annual Report that it “is committed to reinforcing among all relevant stakeholders a sense of trust in the accuracy, independence and reliability of Moody’s products and services . . ..’ Likewise, in its Code of Professional Conduct dated June 2005, Moody’s stated that it “will use care and professional judgment to maintain both the substance and appearance of independence and integrity”, and that the ratings it issues “will not be affected by the existence of, or potential for, a business relationship between Moody’s (or its affiliates) and the Issuer (or its affiliates) or any other party . . ..” In light of the great lengths to which Moody’s has gone to tout its independence and integrity, it is inconsistent for Moody’s to simultaneously argue that a reasonable investor would not find such statements to be material. Moody’s thus fails to demonstrate that no reasonable jury could find the alleged misrepresentation at issue to be material. (13, citations omitted)

We are starting to see judges hold rating agencies to the standards they set for themselves (here, for example), although we have not yet seen a court hold one of them liable for violating them.  That may yet come as more of these cases wend their way through the courts.

Round One to California in Suit Against S&P

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California Superior Court Judge Karnow issued a Memorandum Order Overruling Defendants’ Demurrers in California v. The McGraw-Hill Cos. et al., CGC-13-528491 (Aug. 14, 2013 San Francisco County).   California Attorney General Harris alleged “that S&P intentionally inflated its ratings for the investments and that these knowingly false ratings were material to the investment decisions of [California Public Employees’ Retirement System (PERS) and the California State Teachers’ Retirement System (STRS)], in violation of the False Claims Act and other statutes.” (2)

S&P demurred to the False Claims Act causes of action [asked for the causes of action to be dismissed], because, among other reasons,

(l) the complaint does not plead that any ‘claims’ were ever “presented” to the state;

(2) if claims were presented, they did not involve ‘state funds’ . . .. (4)

S&P asserts, among other things, that because it “was not the seller, it did not “present” any claims for payment.” (4) The Court stated, however, that the False Claims Act “imposes liability on any person who ’causes’ a false or fraudulent claim to be presented or ’causes to be made or used a false . . . statement material to a false or fraudulent claim.’ C. 12651(a)(1)-(a}(2).” (4, citation omitted) The Court inferred “from the complaint that S&P ’caused’ PERS and STRS to purchase the securities. This is good enough for present purposes.” (4, citation omitted)

I am a longstanding critic of the rating agencies, but I have to say that I am struck by how broadly courts have interpreted statutes relied upon by the federal government and the states as they pursue alleged wrongdoing by financial institutions involved in financial crisis. In the courts’ defense, they typically rely on the plain language of the statutes, but, boy, do they interpret them broadly.

In this case, giving a rating can “cause” someone to purchase a security — is there any limit on what is a sufficient “cause” to trigger the statute? In DoJ’s case against Bank of America, a financial institution may be liable under FIRREA for a fraud it perpetrates even if the only entity affected by the fraud is — Bank of America! Similar broad interpretations of NY’s Martin Act make it relatively easy for NY government to bring a securities fraud case against a financial institution because our normal intuitions about intent are not relevant under that act.

Pursuing alleged wrongdoers: good.

Pursuing alleged wrongdoers with broad, ambiguous and powerful tools:  worrisome.

Borden and Reiss on High-Stakes MBS Litigation

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Brad and I posted Goliath Versus Goliath in High-Stakes MBS Litigation on SSRN (and BePress).  The abstract reads,

The loan-origination and mortgage-securitization practices between 2000 and 2007 created the housing and mortgage-backed securities bubble that precipitated the 2008 economic crisis and ensuing recession. The mess that the loan-origination and mortgage-securitization practices caused is now playing out in courts around the world. MBS investors are suing banks, MBS sponsors and underwriters for misrepresenting the quality of loans purportedly held in MBS pools and failing to properly transfer loan documents and mortgages to the pools, as required by the MBS pooling and servicing agreements. State and federal prosecutors have also filed claims against banks, underwriters and sponsors for the roles they played in creating defective MBS and for misrepresenting the quality of the assets purportedly held in MBS pools. This commentary focuses on the state of this upstream litigation. It reviews claims of several complaints and discusses some decisions on motions for summary judgment in several of the cases. The commentary is not a comprehensive review of all the activity in this area, but it does provide an overview of the issues at stake in this litigation. The litigation in this area is still relatively new, but with hundreds of billions of dollars at stake, it will likely last for years to come and should reshape the MBS landscape.

Replacing Rating Agencies

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Although rating agencies have been the subject of much criticism, including much from yours truly, (here for instance) there is no clearly superior replacement for the existing business model.  Even worse, there is not even much theoretical work on alternatives. Thus, it is exciting to see that Becker and Opp have posted a new paper, Replacing Ratings, that at least considers a plausible alternative.

Their paper examines “a unique change in how capital requirements are assigned to insurance holdings of mortgage-backed securities. The change replaced credit ratings with regulator-paid risk assessments by Pimco and BlackRock.” (1) But their analysis did not “find evidence for more accurate inputs to regulation.” (3, emphasis removed) Indeed, their “empirical analysis reveals that the old system was better able to discriminate between risks. As a result, the old system based on ratings not only provided higher levels of capital, but also ensured that capital was more appropriately related to risks.” (3-4)

By the end of their analysis, they believe that “the new system only recognizes current (expected) losses, but does not provide any buffer against possible future losses. Our results are consistent with regulatory changes being largely driven by industry interests.” (21)

They find the new system is worse than the old system and that the new system benefits the industry.  So why should we care about this research at all?  For at least three reasons:

  1. it identified a change in the insurance industry that has implications way beyond that industry;
  2. it compared how two different MBS evaluation systems performed; and
  3. it identified the drawbacks of the new system.

This is how we begin to build a body of knowledge about “viable alternatives to ratings.” (2) But, of course, there is much more work to be done.