Credit rating and examination of collateralized debt obligations and all structured finance products are integral to the smooth function of the secondary market for mortgage loans. A credit rating agency is a company that analyzes issuers of debt and debt-like securities and gives them an overall credit rating which measures the issuer’s ability to satisfy its debt obligations.
There are more than 100 major rating agencies around the world, and three of the largest and most important ones in the United States are Fitch Ratings, Moody’s and Standard & Poor’s. A debt issuer’s credit rating is very similar to the FICO score of an individual rated by the Fair Isaac Corporation widely used in the United States by institutional lenders. Of greater importance to the housing market, the credit rating agencies also analyze and rate the creditworthiness of the various tranches of collateralized debt obligations traded in the secondary mortgage market.
Credit ratings are widely used by investors because they provide a functional tool for comparing the credit risk among various investment alternatives. The examination of risk is crucial in calculating the interest rate a syndicator will need to offer to attract sufficient investment capital. From the other side of the transaction, it is important to the investor who is comparing the interest rates being offered by various investments. The ratings agencies provide this basic, third-party examination both sides of the transaction can rely upon for objective, accurate information. When the ratings agencies are doing their job well, there is greater efficiency in capital markets as syndicators of securities are obtaining maximum market values, and investors are minimizing their risks. This efficiency in the capital markets leads to better resource utilization and stronger economic growth.
Unfortunately for many investors in collateralized debt obligations during the Great Housing Bubble, the ratings agencies did not provide an accurate or credible rating of many CDO tranches. When the housing market pricing declined, many CDO tranches were afterward downgraded. In defense of the agencies, they were providing an examination of risk based on existing market conditions. Their reports contained caveats concerning downside risks in the event market conditions changed, but this list of risks is standard in any examination and widely ignored by investors who are counting on the rating to be a market forecasting tool instead of the market reporting tool it really is. Credit rating agencies are not in the business of market forecasting or evaluating systemic risks.
There is a deeper problem with the ratings agencies that began to surface in the Great Housing Bubble. Ratings agencies used to charge investors for their risk examination, but there was a change to charging the issuers instead. As one might imagine, there are reports that ratings agencies were concerned if they gave CDOs poor ratings, their dominant source of income would go in other places. This put pressure on the agencies to overlook certain problems or merely list them as footnotes to their reports instead of lower a rating due to a foreseeable contingency such as a decline in house prices.