Commentary: Credit Rating Failures in the Aftermath of the Mortgage Meltdown

Abstract

Credit ratings from the major rating agencies failed to signal the true risk content of residential mortgage-backed securities (RMBS), collateralized debt obligations (CDOs), and commercial mortgage-backed securities (CMBS) issued from 2005 through 2007. This article compares the failures across rating agencies and asset classes, using data filed by the rating agencies with the Securities and Exchange Commission (SEC). The data confirm the terrible performance of RMBS ratings. The likely causes include a combination of the breakdown of mortgage industry lending practices and the concurrent deterioration of rating agency practices. The data show that CDO ratings perform somewhat better than RMBS ratings. That result is perhaps surprising and likely reflects the confounding effects of the SEC’s definitions of its reporting categories. The data also show bad performance for CMBS ratings although the underlying causes differ from those driving the results for RMBS and CDOs. Moreover, the data show high levels of rating withdrawals across all asset classes, raising the question of possible underreporting of defaults.

Key Findings

• ▪ Rating agency data reported to the SEC confirm the terrible performance of RMBS ratings, with triple-A-rated RMBS displaying 10-year default rates of 30% to 35% as of year-end 2017. The likely causes include a combination of the breakdown of mortgage industry lending and securitization practices and the concurrent deterioration of rating agency practices.

• ▪ The data show that CDO ratings performed better than RMBS ratings, likely because the data include ratings for many synthetic corporate CDOs. Other studies indicate that performance is significantly worse for CDOs backed by structured finance assets.

• ▪ CMBS ratings also performed poorly. Although CMBS rated triple-A displayed 10-year default rates of only 2% to 3%, those rated double-A had default rates of 12% to 19% while single-A-rated CMBS default rates were 23% to 32%.

• ▪ The data document high levels of unexplained rating withdrawals on structured finance securities. The effect of such withdrawals may be to artificially depress the reported default rates.