The Credit Rating Crisis

Previous articleNext article FreeThe Credit Rating CrisisEfraim Benmelech and Jennifer DlugoszEfraim BenmelechHarvard University and NBER Search for more articles by this author and Jennifer DlugoszFederal Reserve System Search for more articles by this author Harvard University and NBERFederal Reserve SystemPDFPDF PLUSFull Text Add to favoritesDownload CitationTrack CitationsPermissionsReprints Share onFacebookTwitterLinked InRedditEmailQR Code SectionsMoreI. IntroductionBy December 2008, structured finance securities accounted for over 11 trillion worth of outstanding U. S. bond market debt (35%). 1 The lion’s share of these securities was highly rated by rating agencies. More than half of the structured finance securities rated by Moody’s carried a AAA rating—the highest possible credit rating. In 2007 and 2008, the creditworthiness of structured finance securities deteriorated dramatically; 36, 346 tranches rated by Moody’s were downgraded. Nearly one-third of downgraded tranches bore the AAA rating. Both academics and practitioners have blamed structured finance for being, in part, responsible for the current credit crisis. In September 2007, Princeton economist Alan Blinder wrote, “Part of the answer is that the securities, especially the now-notorious C. D. O. s, for collateralized debt obligations, were probably too complex for anyone’s good. Investors placed too much faith in the rating agencies which, to put it mildly, failed to get it right. It is tempting to take the rating agencies out for a public whipping. But it is more constructive to ask how the rating system might be improved” (Blinder 2007). The goal of our paper is to inform economists about the credit rating crisis of 2007–8. We begin by describing what happened to structured finance credit rating during the crisis. We then try to explain why the ratings collapsed. Using detailed information on rating decisions made by Moody’s for every structured finance tranche, we document the ratings performance of structured finance products since 1983. We augment the evidence on structured finance ratings performance with data on rating transitions of all corporate bonds rated by Moody’s over the same period. The data on corporate bonds are used as a benchmark for the true distribution of credit ratings that are based on economic fundamentals. The comparison is important since many of the new exotic structured finance products were engineered to obtain high ratings, but the credit ratings were determined through cash flow simulations that are prone to model errors. Decomposing structured finance downgrades by collateral type, we find that 64% of all downgrades in 2007 and 2008 were tied to securities that had home equity loans (HELs) or first mortgages as collateral. Collateralized debt obligations (CDOs) backed by asset-backed securities (ABS) accounted for a large share of the downgrades and some of the most severe downgrades. 2 ABS CDOs accounted for 42% of the total write-downs of financial institutions around the world. As of October 2008, Citigroup, AIG, and Merrill Lynch took write-downs totaling 34. 1 billion, 33. 2 billion, and 26. 1 billion, respectively, because of ABS CDO exposure (see Table 1). Table 1 ABS CDOs and Crisis-Related Write-Downs (Millions) Write-DownsLatest AnnouncementABS CDOsCorporate CreditRMBSOtherTotalSelect financial institutions: Insurers/Asset managers: ACA Capital11/8/20071, 700………1, 700 AIG11/10/200833, 190……33, 75366, 943 Ambac11/5/200811, 1363601, 04621912, 761 MBIA5/12/20083, 5001, 600 1, 8006, 900 Prudential7/30/2008……3, 410…3, 410 North American banks: Bank of America1/16/20099, 089932…2, 83412, 855 Bear Stearns1/29/20082, 300………2, 300 Citigroup10/16/200834, 1064, 0531, 31915, 90455, 382 Goldman Sachs9/16/2008…4, 1001, 7001, 4007, 200 JP Morgan Chase1/15/20091, 3005, 4675, 305…12, 072 Lehman Brothers6/16/20082001, 3004, 1003, 4009, 000 Merrill Lynch10/16/200826, 1002, 84512, 99813, 12555, 068 Morgan Stanley12/17/20087, 8003, 8103, 7811, 99217, 383 European banks: Credit Suisse10/23/20083, 4273, 0575302, 5239, 537 Deutsche Bank10/30/20082, 0925, 8203, 3863, 67714, 975 Fortis Bank8/4/20084, 3593, 660144…8, 163 ING11/12/2008565…8, 028258, 618 Royal Bank of Scotland11/4/20083, 6091, 8492, 5664, 12212, 146 UBS8/12/200821, 8703481, 71613, 87137, 805 Asian and emerging market banks: Aozora Bank5/15/2008510. 0………510. 0 Mitsubishi UFJ8/13/2008359. 52, 348921113, 640 Mizuho11/13/20083, 8986292, 5395847, 650 National Australia Bank10/21/2008669. 5………669. 5 Sumitomo Mitsui11/19/2007561. 7………561. 7Aggregate: Insurers/asset managers 61, 0746, 32010, 38638, 347116, 127 North American banks 84, 31923, 70242, 27259, 011209, 304 European banks 63, 46418, 57926, 42362, 634171, 100 Asian and emerging market banks 9, 3584, 7245, 7283, 74323, 553 Total 218, 21553, 32584, 809163, 735520, 084Note: ABS = asset-backed securities; CDO = collateralized debt obligation; RMBS = residential mortgage-backed securities. View Table ImageUsing microlevel data on their collateral composition, we document three features of ABS CDOs: (i) high concentration in residential housing (on average, 70% of the underlying securities were residential mortgage-backed securities RMBS or home equity loan securities, and 19% were CDO tranches backed by housing assets), (ii) high exposure to the most risky segment of residential housing (54. 7% of the assets of ABS CDOs were invested in home equity securities), and (iii) low intervintage diversification (about 75% of ABS CDOs were composed of mortgages that originated in 2005 and 2006). We discuss possible explanations for the collapse of ABS CDOs’ ratings. Our regression analysis shows that tranches with one rater only were more likely to be downgraded—a finding consistent with issuers shopping for the highest ratings available from the rating agencies. Consistent with claims made in the news media, we find evidence that Standard however, there is a negligible difference among the conditional default probabilities of AAA-, AA+-, and AA-rated bonds. Investors should perceive AAA, AA+, and AA as similarly low risk, on the basis of this data, yet AA+ and AA tranches are in short supply relative to AAA tranches. Similarly, financial regulation can explain the demand for highly rated securities but not AAA in particular. For example, the Investment Company Act of 1940 requires money market funds to hold highly rated securities, but they are not required to be AAA rated. It requires that “the security has received a long-term rating from the Requisite NRSROs in one of the three highest rating categories, ” which implies that AAA, AA+, and AA are all eligible assets for money market funds. 3The adoption of Basel II, which ties bank capital requirements to credit ratings, provides additional demand for highly rated securities. However, the role of Basel II in fueling the securitization boom may be overstated since, by mid-2008, U. S. banks were still not required to implement the proposed rules. Behavioral economics provides an additional insight as to why investors may demand AAA securities, even in the absence of ratings-based regulation. If investors use heuristics to classify assets, as in Barberis and Shleifer (2003), and only AAA-rated securities are perceived to be riskless, then issuers would cater to investor demand by carving out large portions of their deals as AAA. Benmelech and Dlugosz (2009) argue that the uniformity of CDO structures suggests that investor demand in general is an important determinant of deal structures. 3In addition, money market funds are not allowed to hold securities with a remaining maturity of 397 calendar days or more, while a typical maturity of a CDO at the time of the issuance is between 5 and 7 years. III. Structured Finance BackgroundThe market for structured finance has experienced remarkable growth since the inaugural issue of mortgage-backed securities (MBS) by Bank of America in 1977. Ranieri (1996) attributes the creation of structured finance products to concerns about the ability of thrifts—the major providers of mortgages in the 1980s—to fund the growing demand for housing in the late 1970s and 1980s. Wall Street attempted to address the impending demand by creating alternative, more efficient, and less expensive sources of funds. According to John Reed, a former chairman of Citicorp, “Securitization is the substitution of more efficient public capital markets for less efficient, higher cost, financial intermediaries in the funding of debt instruments” (quoted in Kendall 1996, 2). As of January 2008, there were 111, 988 individual rated tranches outstanding worldwide, with structured finance becoming the largest financial market in the world. While there are many different types of structured finance products, we provide a brief description of the main types of structured finance instruments that appear in our data. Asset-backed securities (ABS). The general term for bonds or notes backed by pools of assets rather than a single corporation or government. Common types of collateral for ABS are auto loan receivables, student loan receivables, and so on. ABS appear in our sample because they are sometimes used as collateral for CDOs. Mortgage-backed securities (MBS). ABS whose cash flows are backed by the principal and interest payments of a set of mortgage loans. MBS can be divided into RMBS and commercial-mortgage-backed securities (CMBS), depending on the type of property underlying the mortgages. Home equity loan securities (HELS). RMBS whose cash flows are backed by a pool of HELs. Collateralized debt obligations (CDOs). Structured finance securities that are pooled and tranched. CDOs are backed by a pool of assets, like other structured finance securities, but they issue classes of securities with some investors having priority over others. Collateralized bond obligations (CBOs). CDOs backed primarily by high-yield corporate bonds. Collateralized loan obligations (CLOs). CDOs backed primarily by leveraged high-yield bank loans. Collateralized mortgage obligations. CDOs backed by mortgage collateral (often RMBS or CMBS rather than individual mortgages). IV. Data and Summary StatisticsA. Sample ConstructionOur analysis uses three main data sets: (i) Moody’s Structured Finance Default Risk Services database, (ii) Moody’s Corporate Default Risk Services database, and (iii) Pershing Square’s Open Source Research data. The primary data source for this study is Moody’s Structured Finance Default Risk Services, which covers all structured finance products issued since 1982. The Moody’s data include a short description of the tranche; its Committee on Uniform Security Identification Procedures (CUSIP) number; the amount issued; the seniority, final maturity, and currency in which it was issued; and the initial credit rating, for every structured finance security rated by them. The data track rating changes through September 2008. Finally, the Moody’s Structured Finance Default Risk Services database also reports the date and amount of defaults for impaired tranches. As of September 2008, there are ratings’ data covering 179, 760 tranches and 33, 978 deals. Structured finance products are classified into seven broad deal types: ABS, CDOs, CMBS, MBS, public finance (PF), RMBS, and other. We augment the data with detailed information on 30, 499 structured finance tranches from the Open Source Research data set assembled by Pershing Square Capital Management. These data have been collected by Pershing in an attempt to improve the level of disclosure in the marketplace on potential losses in the bond insurance industry. The data include information on all CDOs of ABS that were insured by MBIA or Ambac—a total of 534 CDOs—issued during 2005–7. For each CDO in the data, all of the underlying collateral assets are identified by CUSIP, along with a description of the collateral type, amount outstanding, and initial and current (as of January 2008) rating by Fitch, Moody’s, and S the number of CDO tranches issued in 2006 (9, 278) was almost twice the number of tranches issued in 2005 (4, 706). Figure 1 illustrates the dramatic growth in the dollar value of global CDOs issued compared to all mortgage-related securities. Global CDO issuance went up from 157. 4 billion in 2004 to 551. 7 billion in 2006. While it was expected that CDO issuance in 2007 would top the 2006 record, total issuance declined to 502. 9 billion as a result of the financial turbulence that began in July 2007. As investors lost confidence in credit ratings, the market for structured finance products’ issuance dried up. CDO issuance fell to its lowest level since the mid-1990s, with a total of 53. 1 billion. Likewise, the number of all new structured finance tranches issued between January and September 2008 fell to 6, 644 from a peak of 47, 055 tranches in 2006. Table 2 Structured Finance Tranche Issuance by Year and Type (%) YearABSCDOCMBSMBSPFRMBSOtherNo. of total issuance by number for main deal types as well as total issuance by number are ABS = asset-backed securities; CDO = collateralized debt obligation; CMBS = mortgage-backed securities; MBS = mortgage-backed securities; PF = public RMBS = residential mortgage-backed Rating as of Table Collateralized debt obligations and mortgage-related securities (Credit Structured Finance Corporate Credit Rating of Structured Finance and 2 the of structured finance rating transitions over We of all tranches that were rated as of January 1 of each year from to 2008. for each we the number of and ratings over the of the For example, the first of Table rating changes from for the of securities that were rated as of As Table the total number of rated tranches as of was out of which tranches were of the tranches were and ratings were for tranches by the of It is important to that Table provides information for all outstanding tranches at the time of the of the while Table 2 displays information on new Table 2 illustrates the evolution of the structured finance market using data on the flow of new securities, while Table presents rating transitions for the of structured finance tranches. As Table the number of downgrades and the number of were before Table also reports the average of downgrades and a of 1 from to is as For example, a from to would be as from to to and then to In and the number of downgrades and the number of were downgraded during this time as corporate credit deteriorated in the economic of fell during the structured finance boom of 2005 and 2006. Table Structured Finance and Total and and A single downgraded in the year shows up that are downgraded and show up in the and the is in to Moody’s in which a that is downgraded and then in the same year shows up as of a single rating on a the difference in rating between and of Rating as of Table of downgrades of structured finance of structured finance products in 2007. the total number of tranches outstanding increased from to or by the number of downgrades from to There were downgrades of structured finance tranches in the first three of 2008, the total number of downgrades in 2005–7. were not only more common but also more severe in 2007 and 2008. The average was in 2007 and in 2008, compared to in 2005 and 2006. were less and in on There were in 2007 and in the first three of 2008. The average in each year was and A of Table and 2 the total number of and of structured finance tranches. the rating of a can more than within each we also the number of tranches by an or within a The that from Table is to the one by the in the credit of structured finance securities is most in 2007–8. this of tranches were by and only of tranches were on However, in relative the show that there was a in credit in that was only less severe than the current crisis. The overall market was much in than in 2008. The number of rated tranches outstanding in was of the number outstanding in 2008. In dollar the structured finance market in was of its in 2008 rating is the issuer to provide information to the rating or when the rating that there is not information to to a credit rating for the Credit Rating of Corporate that the of the credit rating crisis of was For we transitions in the credit ratings of corporate bonds. We use corporate bond rating transitions as a to what rating should like on the basis of the of the macroeconomic to the in Table we the total number of and on corporate bonds in A of Table and the number of securities by ratings in As we of all corporate bonds with available credit ratings as of January 1 of each year from to 2008 and and ratings the of the The number of rated bonds in the sample from as of to in and the growth in the structured finance market compared to the bond market. The number of rated structured finance tranches by a of from to in 2008, while in the bond market the number of rated bonds in 2008 was higher than its level in Corporate and Total and and