The Mortgage-Backed Securities Meltdown: Full Employment for Lawyers
TASA ID: 135
Whatever the impact on the rest of America, the financial meltdown of 2008 will guarantee full employment for the legal profession for a long, long time. Thomas Friedman says it all[1]:
This financial meltdown involved a broad national breakdown in personal responsibility, government regulation and financial ethics. So many people were in on it: ... people who had no business bundling [bad] loans into securities and selling them to third parties, as if they were AAA bonds, but made fortunes doing so; people who had no business rating those loans as AAA, but made fortunes doing so; and people who had no business buying those bonds and putting them on their balance sheets so they could earn a little better yield, but made fortunes doing so....
So many potential lawsuits, so little time! And each more meritorious than the last. So this article considers only the market for mortgage-backed securities (MBS), one of the many places enterprising tort lawyers can look for a well-earned payday.
But before we start pointing fingers, let's review the basics of the market. In the early 1980's, Solomon Brothers came up with the idea of buying large numbers of mortgages, placing them in a trust, and selling participations in that trust. These mortgage-backed securities appeared to be a true win-win. Commercial banks were no longer constrained to hold mortgages to maturity, thus allowing them to do what (they thought) they did best, i.e. loan origination. Furthermore, the sale of mortgages into mortgage-backed securities allowed banks to diversify beyond the local economy. Investors had access to a new asset class that promised relatively high yields with relatively little risk to investment capital, and, of course, the investment banks made hefty fees by being the middlemen in these deals. It was thought that even the homeowner benefited - by 1992, an industry publication claimed that the average mortgage rate was a full percentage point lower than otherwise because of the linkage between the retail mortgage market and the wholesale capital markets created by MBS.
The key to investor acceptance of MBS was a variety of assurances of timely payments of interest and principal. At first, these assurances came in the form of explicit government guarantees, but, with the huge success of the first generation of mortgage-backed securities, "private label" MBS, with no explicit guarantees, entered the market. Here, investors only had the assurances of the rating agencies that these securities were indeed investment grade, but the thousands of mortgages within each mortgage poolappeared to offer considerable diversification. Further safety could be ensured by such tricks as guaranteeing that some classes of security owners would receive first rights to the homeowners' monthly payments. Nevertheless, it must be emphasized that private label MBS could not possibly sold without rating agency"blessing."
Then things got really complicated. By the beginning of the 21st century, the two trillion dollar MBS market was bigger than that of U.S. treasury obligations. Mortgage- backed securities were so readily available that investment banks began to use them as collateral in "second generation" trusts, in effect, treating the MBS as the "first generation trusts" had treated the underlying mortgages. Again, there were clear diversification benefits, but, with the added complexity of the instruments came added complexities of pricing.
A fundamental principle of the fixed income securities markets is that the risk of owning a security is (usually) reflected in its price. In the case of mortgage -backed securities, there is relatively little risk in assembling an MBS from constituent mortgages, but there is significantly more risk in holding the MBS to maturity. How should this risk be priced? Again, the rating agencies played a crucial role: by giving a particular MBS a particular rating, they are, in effect, advising the public that this MBS is worth the same as any other security with that particular rating and maturity.
In fact, pricing even the simplest MBS was sufficiently tricky that overpayment for such securities contributed to the collapse of savings and loan institutions in the early 1990's[1]. So accurate pricing of these new, second generation securities, whose cashflows, while originating from these simpler MBS, were subject to additional payment rules, was well beyond the state of the art. Compounding the valuation problem was the nature of the underlying mortgages, many of which were issued to less creditworthy ("sub-prime") borrowers, relatively recent, and therefore poorly understood entrants into the mortgage market.
However, this lack of understanding did not trouble the industry in the least. Remember, the Wall Street investment banks were selling these deals to "buy side" investors, such as pension funds, university endowments, etc., so the investment banks were not exposed to the deals' long term viability. Meanwhile, the buy side fund managers were assured by the rating agencies that these MBS were of the same AAA credit quality as the best corporate bonds, even though the MBS offered significantly higher interest rates. This put the fund managers in a bind: if the fund managers didn't buy such securities, despite any misgivings, weren't they violating their fiduciary responsibilities?
Culpability of the Rating Agencies, especially Moody's
As Thomas Friedman makes clear, many enablers were required to keep this charade on-track, but perhaps the most culpable were the rating agencies. The flagrant conflict of interest inherent in the rating agencies' business model was well known in the industry[2] since at least 1992, and it has been described elsewhere[3]. Nevertheless, this somewhat more process-oriented slant should be useful to tort lawyers: Since MBS issuers paid the agencies a few hundred thousand dollars for the one or two man-weeks of work required to issue a rating, and many of these securities were created in quarterly issuance programs, the agencies had enormous financial incentives to keep the issuers happy. They needed models that, on one hand, had a veneer of plausibility, and, on the other, were simple enough for the PhD model builders to explain to the rest of us. And, of course, they also had to be relatively easy to implement, in terms of both the calculations required and the necessary input data. Never mind that these models had little to do with reality; what mattered was merely the appearance of due diligence, since few people could tell the difference!
For much of 2003, I built a spreadsheet to be used for structuring sub-prime securities. As a result, I became acquainted in detail with the existing Moody's, Standard and Poor's, and Fitch's model for rating such securities. My previous studies of credit risk had alerted me to a central mathematical difficulty in modeling the default risk of such securities, namely, that defaults in the underlying mortgages are not independent, but correlated: If I default, it is more likely that you will, if only because we are both subject to the same overall economic conditions. This invalidates the hypotheses of the theorems underlying much of probability theory, so accurate estimates of default risk require elaborate Monte Carlo simulations, based on the details of each individual loan. Instead, each of the rating agencies opted for a rather simplistic model. I focus only on the Moody's model in the following, simply because my evidence against it is most damning;[4] a similar case could be made against each of the other agency models.
A credit risk textbook[5] published in 2002 noted that the Moody's model being used at the time was flawed because it systematically underestimated the effect of correlations in defaults. Moody's recognized the deficiency in their model and published a refinement in the fall of 2004 that seems to have more accurately included the effect of default correlations. However, if they knew that there were problems with the previous model, why did they continue to use it to rate deals while they were developing a better one? Could it be related to the fact that they were making a few hundred thousand dollars every time that they rated a deal? Could it be that they couldn't afford to admit that their existing models were inadequate?
My personal experience with Moody's quants was that they were remarkably un-interested in feedback that was being supplied to them by issuers, or at least by me. I explained to them that the detailed statement of their rating methodology was incomplete in that an interpolation was required and that it was equally reasonable to do linear or logarithmic interpolation. Nevertheless, nothing in their methodology statement mandated one interpolation methodology over another, even though it made a non-negligible difference in the answer. The quants just said, "Use whichever methodology you want"(!)
Remember, these were people with degrees at least as fancy as mine. They knew perfectly well what I was asking; they just didn't want to be bothered.
That Moody's published a revised methodology in 2004 raises the "what did they know, and when did they know it" question. The date of the document on which I based my spreadsheet was some time in 2000[6]; however, because my spreadsheet was written in 2003, it necessarily implemented the earlier methodology, the one that fails to properly consider the correlations that are so important in this setting.
Now comes the question of legal liability. Moody's standard defense is that investors should perform their own "due diligence" before concurring with a Moody's rating. On one hand, Moody's cries of "caveat emptor" here seem pretty thin. Per Investopedia.com, "giving continuous, comprehensive [investment] advice is considered [to be] acting in a fiduciary role". It is hard to argue that Moody's wasn't doing that, especially since many investment managers are constrained to buy only securities that Moody's rates "investment grade," or sometimes even higher. And the above certainly suggests negligence, as defined by most state courts, and a breach of fiduciary duty, as defined by the federal courts.
On the other hand, Moody's does have a point: an investment manager who slavishly acts on the advice of an organization with such a well known conflict of interest is not exactly an exemplary fiduciary, either. Doesn't that make both the Moody's and the investment managers liable?
This article discusses issues of general interest and does not give any specific legal, medical, or business advice pertaining to any specific circumstances. Before acting upon any of its information, you should obtain appropriate advice from a lawyer or other qualified professional.
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[1] Lewis, Michael, Liar's Poker.
[2] private conversation with head of interest rate derivatives trading, major money center bank, New York branch, 1992.
[3] Lowenstein, Roger, "Triple A Failure," Article, The New York Times Magazine, April 27, 2008.
[4] Ironically enough, according to the deal structurer that was the chief user of my spreadsheet, the Moody's model was generally held to be the most sophisticated of the rating agency models!
[5] Bluhm, et. al. (2002). An Introduction to Credit Risk Modeling.
[6] Both the 2000 and 2004 methodology documents are available from the author.