While regulators have incorporated the ratings of the Big Three into their regula- tions, the Big Three largely escaped effective regulation. Thus, to the extent that they made systemic mistakes or demonstrated systemic biases, they were not held accountable to anyone. The business model of the Big Three has been found to be rife with problems: conflicts of interest, lack of transparency, and lack of leadership being some of the most serious.
Their business model was based on serious conflicts of interest, conflicts that should and did undermine the trust that others had in them. The Big Three were paid by the issuers who needed their ratings. As a result, the profit motive drove the agencies to recklessly expand the market for their services.
The Big Three were also deficient when it came to transparency. They helped investment banks structure the transactions to be rated to an extent not known to the rest of the world. They were integrally involved, for instance, in legitimizing subprime debt instruments like the collateralized debt obligation (CDO) securities that make up many of the toxic assets that have dragged down the balance sheets of so many financial firms. The rating agencies also claimed that their very sophis- ticated rating models were reliable enough to predict with great accuracy the risk of default and delayed payment. It turns out however, that “sophisticated” was just a way of saying complex and confusing. Like many other financial players, it appears that their complex risk management models had some very simplistic assumptions undergirding them—national housing prices will never go down on a year-to-year basis, for one.
Finally, the leadership at the rating agencies set an ethos that clearly distorted the mission of these firms. The rating agencies did not properly monitor their employees to ensure that they avoided even the most obvious conflicts of interest.
Clearly, the Big Three’s worst excesses went unchecked by regulators, and the public paid the price.
196 Borrowers
CONCLUSION
The bust of the subprime market in the mid-2000s led to the global financial crisis of the late 2000s. This crisis has virtually ended subprime lending for the current credit cycle. Most subprime lenders have gone out of business or merged with other financial institutions. The remaining financial institutions have tightened their underwriting so that they no longer lend to those with subprime credit profiles. It is likely, however, that subprime lending will return in some form once the credit cycle turns.
Rating agencies were historically considered to be mere commentators on the comings and goings of the players in our free market economy while ensuring that objective information is widely disseminated to all. This view, however, fails to take into account the privileged regulatory status that the SEC and other government regulators have granted to the Big Three. It also fails to take into account the role that the Big Three have in structuring RMBS transactions. Moving forward, effec- tive regulation of the NRSROs must take into account their gatekeeper function, and ensure that their systemic biases are not permitted to trump state consumer protection initiatives.
NOTES
1. See Robert Van Order, “The U.S. Mortgage Market: A Model of Dueling Charters,”Journal of Housing Research233 (2000): 233–34.
2. U.S. General Accounting Office, Consumer Protection, “Federal and State Agencies Face Challenges in Combating Predatory Lending” 18 (2004).
3. Steven L. Schwarcz,Private Ordering of Public Markets: The Rating Agency Paradox, 2002 U.
Ill. L. Rev. 1, 15.
ABOUT THE AUTHOR
David J. Reissis a professor of law at Brooklyn Law School and has also taught at Seton Hall Law School. His research focuses on the secondary mortgage market.
He was previously an associate at Paul, Weiss, Rifkind, Wharton & Garrison in its real estate department and an associate at Morrison & Foerster in its land use and environmental law group. He was also a law clerk to Judge Timothy Lewis of the United States Court of Appeals for the Third Circuit. He received his B.A. from Williams College and his J.D. from the New York University School of Law. His ar- ticle, “Subprime Standardization: How Rating Agencies Allow Predatory Lending to Flourish in the Secondary Mortgage Market,” in theFlorida State University Law Review,was granted an award as the best article of 2006 by the American College of Consumer Financial Services Lawyers.
PART IV
The Process of Securitization
Copyright © 2010 John Wiley & Sons, Inc.
CHAPTER 26
A Primer on the Role of
Securitization in the Credit Market Crisis of 2007
JOHN D. MARTIN
Carr P. Collins Chair in Finance in the Hankamer School of Business at Baylor University∗
Once upon a time credit markets were dominated by lenders who both originated loans and held them to maturity. Today, the majority of credit is created using an originate-to-distribute model in which the originator of the loan sells it to someone who combines it in a portfolio of similar loans and then issues new securities that hold a claim against the income provided by the loan portfolio. This process is calledsecuritization.The growing importance of securitization gave rise to three issues that form the basis for this paper:
1. First, whereas loans were once held by the lender until repaid, with secu- ritization, these loans are pooled, and claims on their cash flows are sold to investors around the world. As a consequence, the impact of credit orig- ination problems is no longer limited to the originating institution but is diffused throughout the credit markets.
2. Second, since the loan originator does not actually hold the credit it origi- nates, but distributes the loans to others through securitization, the origina- tor has a reduced incentive to monitor the credit-granting process. This is a classic principal-agent problem that arises whereby the incentives of the originator of credit are not aligned with those of the entity that ultimately holds the loan.
3. Third, the credits are securitized in pools with new securities that have claims on the pooled cash flows. This means that these new securities do not have a direct claim on any specific loan or credit. This complexity makes it difficult to sort out the claims in the event of a specific credit default.
∗I want to thank Mark McNabb for his comments on earlier drafts of this paper; responsibility for any remaining errors is mine, however.
199 Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future
by Robert W. Kolb Copyright © 2010 John Wiley & Sons, Inc.