Credit Rating Firms Failed to See Rising Risk in Mortgage Products

Subprime mortgagesThe dominant credit rating agencies used risk models that turned out to be inaccurate, derived from faulty data on subprime, interest-only and other high risk mortgages that came to dominate the housing market, according to a Senate subcommittee’s report.
Throughout the buildup of the housing bubble, Moody’s and S&P boosted revenues substantially by rating securities backed by residential mortgages, and increasingly those mortgages were of the subprime variety, originated from borrowers with poor credit on homes that were overvalued.
“Although the credit rating agencies were aware of increased levels of mortgage fraud and lax underwriting, they did not factor that credit risk into their models,” found a report by the Senate Permanent Subcommittee on Investigations.
The Senate panel today focused on credit rating agencies in its ongoing hearings on the financial crisis and the contributing factors to the housing market collapse.
Its report on Moody’s and S&P, the panel found that the agencies raked in record revenues on ratings of mortgage-backed investment products using failed risk assessment models and ignoring signs of fraud and mounting carelessness in loan originations.
According to the Congressional Research Service, the models used by the agencies “failed to understand the likelihood of falling house prices, attached the wrong weights to the effect of falling house prices on loan default rates; and miscalculated the interdependence among loan defaults,” cites the Senate panel’s report.
At the height of good times, credit rating agencies charged issuers from $50,000 to more than $1 million to obtain a rating on a mortgage-backed security or collateralized debt obligations, known as CDOs.
The practice became more lucrative with the addition of CDOs, a multi-layered product containing securities from multiple mortgage pools. It is the investment product at the center of the fraud case against Goldman Sachs made public a week ago.
“Investors who relied on the credit agencies’ ratings of mortgage based securities suffered heavy losses when many residential mortgage-backed securities and CDO securities that were initially rated investment grade were sharply downgraded,” the Senate panel’s report said.
From 2004 to 2007, Moody’s and S&P produced a record number of ratings and record revenue, primarily because of mortgage-backed securities and CDO ratings.
Analysts within the firm typically rely on their company’s rating models to evaluate risk, and “do very little additional credit risk analysis, instead they focus on reviewing the legal structure of the financial instrument to see how it works,” the report said.

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