«MBS Ratings and the Mortgage Credit Boom Ashcraft, A.; Goldsmith-Pinkham, P.; Vickery, J. Publication date: 2010 Link to publication Citation for ...»
MBS Ratings and the Mortgage Credit Boom
Ashcraft, A.; Goldsmith-Pinkham, P.; Vickery, J.
Link to publication
Citation for published version (APA):
Ashcraft, A., Goldsmith-Pinkham, P., & Vickery, J. (2010). MBS Ratings and the Mortgage Credit Boom.
(CentER Discussion Paper; Vol. 2010-89S). Tilburg: Finance.
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MBS RATINGS AND THE MORTGAGE
MBS Ratings and the Mortgage Credit Boom
We study credit ratings on subprime and Alt-A mortgage-backed securities (MBS) deals issued between 2001 and 2007, the period leading up to the subprime crisis. The fraction of highly-rated securities in each deal is decreasing in mortgage credit risk (measured either ex-ante or ex-post), suggesting ratings contain useful information for investors.
However, we also find evidence of significant time-variation in risk-adjusted credit ratings, including a progressive decline in standards around the MBS market peak between the start of 2005 and mid-2007. Conditional on initial ratings, we observe underperformance (high mortgage defaults and losses, and large rating downgrades) amongst deals with observably higher-risk mortgages based on a simple ex-ante model, and deals with a high fraction of opaque low-documentation loans. These findings hold over the entire sample period, not just for deal cohorts most affected by the crisis.
Keywords: Credit Rating Agencies, Subprime Crisis, Mortgage-Backed Securities JEL Classifications: G01, G21, G24 Mistakes by credit rating agencies (CRAs) are often cited as one of the causes of the recent financial crisis, which began with a surge in subprime mortgage defaults in 2007 and 2008. Prior to the crisis, 80-95% of a typical subprime or Alt-A mortgage-backed-securities (MBS) deal was assigned the highest possible triple-A rating, making these securities attractive to a wide range of domestic and foreign investors. Reflecting high mortgage defaults, however, many MBS originally rated investment-grade now trade significantly below par, and have experienced large rating downgrades and even losses. Figure 1 plots net rating revisions on subprime and Alt-A MBS issued since 2001.
While net rating revisions are small for earlier vintages, MBS issued since 2005 have experienced historically large downgrades, by 3-10 rating notches on average, depending on the vintage.
Critics interpret these facts as evidence of important flaws in the credit rating process, either due to incentive problems associated with the “issuer-pays” rating model, or simply insufficient diligence or competence (e.g. US Senate, 2010; White, 2009; Fons, 2008).1 In their defense however, rating agencies argue that recent MBS performance primarily reflects a set of large, unexpected shocks, including an unprecedented decline in home prices, and a financial crisis, events which surprised most market participants. CRAs also point to warnings made by them before the crisis about increasing risk amongst subprime MBS, and argue that ratings became accordingly more conservative to reflect this greater risk.2 1 For example, Jerry Fons, a former Moody’s executive, argues in Congressional testimony that “My view is that a large part of the blame can be placed on the inherent conflicts of interest found in the issuer-pays business model and rating shopping by issuers of structured securities. A drive to maintain or expand market share made the rating agencies willing participants in this shopping spree. It was also relatively easy for the major banks to play the agencies off one another because of the opacity of the structured transactions and the high potential fees earned by the winning agency.” (Fons, 2008). The New York Attorney General is reportedly currently investigating eight large MBS issuers regarding claims these firms manipulated ratings through rating shopping, by reverse engineering rating models, sometimes with the help of former CRA employees, by misreporting information on MBS collateral, and other means (New York Times, 2010).
2 In Senate testimony, Michael Kanef, Structured Finance Group Managing Director of Moody’s, states: “In response to the increase in the riskiness of loans made during the last few years and the changing economic environment, Moody’s steadily increased its loss expectations and subsequent levels of credit protection on pools of subprime loans. Our loss expectations and enhancement levels rose by about 30% over the 2003 to 2006 time period.” and also that “We provided early warnings to the market, commenting frequently and pointedly over an extended period on the deterioration in origination standards and inflated housing prices.” (Kanef, 2007). Kanef cites aggressive underwriting standards, a decline in national home prices, and a
MBS deals issued from 2001-07, the period leading up to the crisis. Our analysis is based on a novel dataset of 3,144 MBS deals matched by us with security- and loan-level data. These deals represent around 60,000 securities and 12.1m loans, covering nearly 90% of deals issued during this period.
Our basic research question: How well did initial credit ratings summarize the variation in MBS default risk across this sample of deals? CRAs state that one of their key goals is for each letter rating to have a consistent interpretation regardless of the type of security or the time the rating opinion is issued. (See Section 1 for a detailed discussion). Motivated by these statements, we study the consistency of MBS ratings in two dimensions: (i) through time, and (ii) across deals from a given vintage backed by different types of loans.
Our main unit of analysis is an MBS deal, which is a set of structured bonds linked to a common pool (or pools) of mortgages. Ratings for an MBS deal are typically described in terms of the “subordination level” or “attachment point” of each rating, which is the fraction of the deal junior to the bonds of that letter rating. For example, if a deal consists of $1bn of mortgages, and only the most senior $850m of bonds are rated triple-A, subordination below triple-A is 15%. Holding the quality of the underlying loans fixed, higher subordination implies the deal is rated more conservatively, because the fraction of highly-rated bonds is smaller.
The first part of our analysis studies the determinants of subordination, and time-series trends in rating standards. We first document that average unconditional subprime subordination levels increase between 2001 and the end of 2004, and then are relatively flat until mid-2007. A similar pattern, albeit less pronounced, is evident for Alt-A deals.
worsening of mortgage credit conditions as the main causes for the poor performance of recent subprime vintages (p.14), and states that “Along with most other market participants, however, we did not anticipate the magnitude and speed of the deterioration in mortgage quality (particularly for certain originators) or the rapid transition to restrictive lending.” (p.17). In similar vein, Devan Sharma, President of S&P, writes: “Why did these ratings on mortgage-backed securities perform poorly? Put simply, our assumptions about the housing and mortgage markets in the second half of this decade did not account for the extraordinarily steep declines we have now seen. Although we did assume, based on historical data stretching back to the Great Depression, that these markets would decline to some degree, we and virtually every other market participant and observer did not expect the unprecedented events that occurred.” (Sharma, 2009).
the expected directions to fundamentals like the level of mortgage credit risk (based on a simple “exante” default model), and the strength of credit enhancement features in the deal. Controlling for these factors, we find a hump-shaped pattern in initial subordination between 2001-07. Namely, riskadjusted subordination increases between 2001 and 2004, but then declines significantly between the start of 2005 and mid-2007. During this latter period, the average riskiness of new MBS deals increases significantly, based either on our default model, or on other metrics such as early-payment defaults, house price appreciation, and mortgage underwriting characteristics. However, the fraction of highly-rated MBS in each deal remains flat, rather than increasing in response to this greater risk.
Consistent with this ex-ante evidence, these later vintages, particularly 2006 and 2007, also perform worst ex-post, and are downgraded most heavily, as shown in Figure 1.
The second part of our analysis examines how well credit ratings order relative risks across MBS deals from within a given cohort. Here we focus on studying variation in realized performance.
If credit ratings are informative, mortgages underlying deals rated more optimistically (i.e. lower subordination, or equivalently a larger fraction of highly-rated securities), should perform better expost, in terms of lower mortgage default and loss rates. Furthermore, prior information available when the deal was initially rated should not be expected to systematically predict deal performance, after controlling for credit ratings. This is because this prior information should already be reflected in the ratings themselves, to the extent it is informative about default risk.
We find higher subordination is generally correlated with worse ex-post mortgage performance, as expected. However, conditional on subordination, time dummies and credit enhancement features, we also find significant variation in performance across different types of deals. First, MBS deals backed by loans with observably risky characteristics such as low FICO scores and high leverage (summarized by the projected default rate from our simple ex-ante model) perform poorly relative to initial subordination levels. Moreover, deals with a high share of low- and
of observably risky deals. This suggests such deals were not rated conservatively enough ex-ante.
These findings hold robustly across several different measures of deal performance: (i) early-payment defaults; (ii) rating downgrades; (iii) cumulative losses; (iv) cumulative defaults. In some cases, our results are magnified for deals issued during the period of peak MBS issuance from the start of 2005 to mid-2007. However, perhaps most notably, we repeat our analysis separately for each annual deal cohort between 2001 and 2007. We find that the underperformance of low-doc and observably high risk deals holds surprisingly robustly over the entire sample period, including earlier deal vintages not significantly affected by the crisis. Indeed, these differences in performance can be observed even only based on performance data publicly available before the crisis starts.
While our results are not conclusive about the role of explicit incentive problems, two findings appear consistent with recent theoretical literature that models these frictions. First, Mathis, McAndrews and Rochet (2009) and Bolton, Freixas and Shapiro (2009) predict rating standards will decline when security issuance volume and revenues are high relative to reputational costs of errors.
This appears consistent with our finding that risk-adjusted subordination declines between early 2005 and mid-2007, which we show coincides with the peak of MBS deal volume.
Second, Skreta and Veldkamp (2009) and Sangiorgi, Sokobin and Spatt (2009) predict rating inflation should generally be increasing in security “opacity” or “complexity” (defined as residual uncertainty about security value). We argue the share of low-doc loans underlying the deal is a reasonable proxy for opacity for our sample, since evaluating the quality of such loans relies on “soft” self-reported information from the borrower about their income, rather than verifiable data like tax returns. Our finding that “low-doc” deals underperform relative to their ratings, even by comparison to other types of risky deals, thus appears consistent with this “opacity” prediction.