WORD ON THE STREET: There is a fatal flaw in the rating product and process: It created a market that was too good to be true, because the valuation and credit analysis that was done at closing was only related to the collateral conditions at closing.
What happens with asset-backed securities (ABS) and residential mortgage-backed securities (RMBS), in particular – but all securitizations, in theory – is they may actually improve over time, like good wine. But the rating agency is not around to take a second look, much less a periodic look. There is never an apples-to-apples comparison between the analysis done initially and the one completed after the fact.
That was a great situation for investors for 20 or 25 years, because it meant that they were holding securities that, on average, were better than the ratings suggested. While it was a good situation for investors, the sellers were happy as well, because securitization is much more flexible and offers a sort of corporate rating arbitrage. But unfortunately, the sellers could have done even better.
After 1998, we had an opportunity to repackage securities in collateralized debt obligations (CDOs) – in particular, RMBS CDOs. But the rating process is not a valid credit risk measure after origination: It either understates or overstates credit quality.
So by using invalid credit measures, we have created a perverse incentive to put securities into the market that are not well structured and will not improve, but actually will deteriorate. And we can repackage them into CDOs without the ultimate investors realizing what is happening until it is too late. This will happen just because the rating system does not reflect current credit quality.
What is the source of the flaw? The credit quality of ABS and RMBS is measured based upon empirical data. But for CDOs, asset-backed commercial paper (ABCP) and structured investment vehicles, the credit measure is a rating. It is not empirical data. And if the rating is stale, then the assessment is wrong.
So my recommendation for reigniting the securitization markets as the engine of capital formation is the same today as it was years ago. If it was not understood then, well, as Benjamin Franklin said, ‘Tell me and I forget. Teach me and I learn. Involve me and I understand.’ We are all involved in this now, so I hope that the recommendations will have some resonance.
To motivate better behavior, the most important thing is not to regulate it, but to create clear standards and enforce them. The standards that need to be set, in particular, are with respect to disclosure on the securities and the standards by which they are rated.
What is the rating scale that allows a AAA security to go out as a AAA or allows a CCC security to go out as a AAA? We all need to know this. The rating-scale issue has not aired publicly. I know from working at Moody's Investors Service that we all benchmarked our ratings according to a fixed-point scale – and at Moody's, the analysts actually showed the investor public how the scale worked.
The scale needs to be taken out of the hands of rating agencies, because with it, they have effectively created a discount window for corporations to go to the market with their collateral and get cash. That is a great idea, but it is something that affects the economy as a whole.
The rating scale needs to be determined by the regulators – and probably the administration and Congress. The consensus scale that comes out of this needs to be published so that the whole market can actually monitor the credit quality of ABS and RMBS and CDOs and ABCP so that the determination of current credit quality is not left in the hands of a few people.
The whole reason for the securitization market – which, by the way, came out of the savings and loan crisis – was a recognition that receivable asset quality can be better than the firm's own credit quality. And the firm can finance itself more cheaply off-balance-sheet, given how our bankruptcy system works. The whole idea is an economy of capital utilization: capital efficiency. When Congress decides to mandate risk retention or any other structural feature, Congress is, in fact, structuring these deals.
A simpler way to address systemic risk is to go back to the original definition of credit quality. What are we doing when we securitize? We are finding the boundary between debt and equity, using a judicious amount of leverage that gives buyers and sellers the best possible deal. Judiciousness is determined primarily with reference to the rating scale, and that is why I advocate transparency around the rating scale.
The securitization problem cannot be resolved with structural solutions, per se. There has to be an ability to monitor how the losses are performing and how the securities are performing. And if you have that kind of transparency, you will motivate proper behavior. That is a much simpler model.
Ann Rutledge is founding principal of R&R Consulting, based in New York. This article is edited and adapted from oral testimony delivered May 18 before the Senate Committee on Banking, Housing and Urban Affairs' Subcommittee on Securities, Insurance and Investment.
