The current joke on the street goes something like this: Do you know what a cov-lite rating is? Well, just the kind of rating the rating agencies were giving - no verification, no due diligence.
While rating agencies have taken the heat from disillusioned investors, they are now fighting back. The agencies are speaking out not only in the Senate - which listened to the testimony of executives from Moody's Investors Service and Standard & Poor's last week - but also, specifically for Moody's, by enhancing its RMBS rating methods.
The enhanced ratings send a hopeful message to the market. However, they also add to the concern that previously originated loans may have values far lower than what their ratings indicate since extended due diligence was started late, a CDO analyst said.
Indeed, just last week, Moody's released an update on its assumptions for rating new structured finance CDOs. The rating agency noted that for all first-lien subprime RMBS transactions originated in the second half of 2006 through the first half of 2007 and rated Aa1' though Aa3,' the market should apply a two-notch downgrade.
Moody's said the market should apply a three-notch downgrade to first-lien transactions rated A1' though A3' and a six-notch downgrade to all those rated Baa1' through Baa3.'
"It is really a shameful admission that all their ratings were wrong," a market participant said. "They do not even trust their own ratings - for example, the fact that you need to assume that a Baa' given in 2007 now, for analysis purposes, needs to be treated as being six notches below, it means this is really a disaster."
Rating agencies have countered the criticism - these firms were also accused of letting revenue influence their ratings - by defending the quality and adequacy of their ratings.
"If S&P put revenue ahead of analytical rigor, we would not refuse to rate, as we have, transactions that do not meet our criteria," Vickie Tillman, executive vice president for credit market services at S&P, said at the U.S. Senate Committee meeting on Banking, Housing, and Urban Affairs last Wednesday. Tillman cited the firm's previous decision not to rate significant amounts of Canadian ABCP when it failed to meet S&P's minimum rating criteria. The paper has recently become illiquid.
Rating agencies have also maintained that their ratings are not investment recommendations. "Moody's has always been clear and consistent in telling the market that our ratings should not be used for any purpose other than as a gauge of default probability and expected credit loss," Michael Kanef, group managing director in Moody's asset finance group, said at the Senate hearing.
Yet, despite their protests, Moody's is taking steps to enhance its credit rating method for nonprime RMBS securitizations in an effort to bring confidence back to the market.
The rating agency issued a report last week detailing steps that both the market and Moody's could jointly take to increase the transparency of individual loan characteristics and performance. The rating agency proposed that it will now ask servicers to provide monthly loan level performance information for all newly originated RMBS transactions. The firm also recommended that performance reports on RMBS deals should be standardized by securitization sponsors and expanded in scope, as well as distributed to all transaction participants in the case of public transactions.
At the same time, "qualified third parties" could be appointed by either the market or issuers to review the accuracy of the loan information. Moody's will be making the credit distinctions based on the presence of a third-party review and on subsequent findings from a review of the appraised home value, the borrower's credit history and the reasonableness of the borrower's stated income, among other things.
The review should also include contacting a sample of borrowers to confirm the terms of their loan, the income stated and whether the house is their primary residence, the rating agency said. While it would not be in charge of appointing the third party, Moody's said, the third party's competence would certainly be a factor in the deal's ratings.
Further, the number of loans reviewed in a given transaction would depend not only on the transactions but also be based on initial findings. For instance, if 10% of the loans in a transaction were randomly sampled and demonstrated a significant number of problems, the remaining portion of the pool would warrant further investigation.
At the same time, the rating agency will make distinctions based on the level of oversight regarding representations and warranties. Moody's said it believes the appointment of a third party - such as the trustee, the master servicer or a credit risk manager - to ensure that loans that breach representations and warranties are identified and "put back" to the sellers, will add value to these reps and warranties.
However, not all investors were convinced that a check on loans that breach these representations and warranties would be successful. From a practical point of view, such a check would be difficult to implement because it would generate all sort of market disputes, said the market participant, who also argued that such a check would undermine the concept of true sale.
Currently, there is no exact timing yet on the implementation of the proposals, but the rating agency said it would like to make the adjustments as soon as possible. The source of funding for these plans has yet to be determined.
Moody's was not the only one to make rating suggestions in hopes of restoring market confidence. Mark Adelson, of Adelson & Jacob Consulting argued for unsolicited ratings at a subcommittee hearing on capital markets, insurance and government-sponsored enterprises, noting that rating agencies need checks and balances.
"The best way to combat the threat of competitive laxity is to encourage rating agencies to openly challenge their competitors' ratings when they have differing opinions. In this way, the rating agencies keep each other honest by engaging in a public debate." Adelson recommended that Congress encourage or require each rating agency that holds the NRSRO designation to issue unsolicited ratings on at least 3% to 5% of the securities or deals that are shopped away from it. "Under such a framework, it would be impossible for any single rating agency to curry favor with issuers and bankers by refraining from the hostile' practice of assigning unsolicited ratings," he said.
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