Ratings Agencies One Link In Housing Boom

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CHARACTER, J. PIERPONT MORGAN FAMOUSLY ASSERTED, was the only basis on which he would extend a loan, not money or collateral. "Before money or anything else. Money cannot buy it...Because a man I do not trust could not get money from me on all the bonds in Christendom."

How far we have strayed from that archaic-sounding principle now is evident everywhere. Lenders made loans they never meant to collect, only sell. So, it should be no wonder that a growing number of borrowers have no intention of repaying those loans.

None of that would have been possible but for the ability to take deficient and even fraudulent mortgages and package them into top-quality, triple-A-grade securities, which banks and other investors thought they could purchase without worry or limit.

The process of turning junk mortgages into gilt-edged securities surpasses medieval alchemists' wildest dreams of transforming lead into gold. And the magic wand that performed this feat was held by the credit-rating agencies, whose practices were scrutinized by the Congressional panel Wednesday.

Moody's (ticker: MCO) Raymond McDaniel called his service's performance "deeply disappointing" in testimony prepared for the Financial Crisis Inquiry Commission. Moody's, along with competitors Standard & Poor's and Fitch Ratings, accorded triple-A ratings to billions of dollars' worth of structured investments, which collapsed when the mortgages underlying them went into default.

The star witness before the panel, Berkshire Hathaway's chief executive Warren Buffett, claimed the ratings agencies "made a mistake that virtually everybody in the country made." That is, that home prices only went up. Berkshire (BRKA) is a major holder of Moody's shares, though it has been paring its position in recent months.

Why the course of house prices was crucial to the ratings of the mortgage-backed securities that were packaged into collateralized debt obligations is highly revealing. It shows how the nature of borrowing and lending changed in the century since J.P. Morgan described his principles of credit.

Borrowers' creditworthiness used to depend on their ability to service the debt, along with a margin of safety in the value of the collateral that exceeds the size of the loan. I know I had to document my income, assets and other liabilities to show I could pay the mortgage, which equaled no more than 80% of the value of the house after I scrimped and saved the 20% downpayment.

Those quaint standards were supplanted by loans with wild, new terms: "no doc," "stated income," "piggyback loans" and "option ARMs." The late Daniel Patrick Moynihan referred to "defining down deviancy" in the collapse of social standards. Mortgage originators defined down deadbeats to the point that they often said the main criterion to get a loan was to have a pulse.

So, it should be no surprise that an ever-expanding number of borrowers are just saying no to paying their mortgages. The New York Times became the latest to describe the trend over the holiday weekend ("Owners Stop Paying Their Mortgages, and Stop Fretting," May 31.) Knowing the huge backlog of foreclosures facing lenders, they stopping sending their mortgage payments, which frees up a hefty chunk of change each month. They realize if they stopped making their auto payments, the repo man would be towing their car away in short order. But they can expect to live in their house expense-free for a year or more until they'll be foreclosed upon.

During the housing bubble, homeowners who couldn't pay their mortgages almost always could sell the house at a profit. Or they could refinance and take out a bigger mortgage and use the money to pay off their debts. That is, as long as the value of the house went up; then, owners could tap it like an automated teller machine.

That presumption also lay behind the triple-A rating of securities backed by the most dubious loans. Based on the recent history of the housing market (which is basically all anybody had to go on), the ratings agencies conjured models that predicted the number of defaults. When the mortgages were sliced and diced into tranches of the MBS, the model would assume a certain number of the riskiest tranches would suffer defaults. But the highest tranches always would be insulated by the lower classes' losses, much as pawns protect the king on a chess board.

Tweak an assumption about losses here and there, and the top tranches would be accorded the coveted triple-A rating. For banks, a triple-A security required them to hold little or no capital against it. Thus unconstrained, banks could pile on triple-A MBS virtually without limit.

All it took was the imprimatur of Moody's, S&P or Fitch. Since the ratings agencies were paid by Wall Street, money evidently talked. Said one former Moody's officer, "we became a triple-A factory."

Given this sorry story, it's hard to say who was worse: mortgage originators who made loans just to collect a commission and to sell to investors; Wall Street underwriters with finance MBAs who might really believe that they could transform sows' ears subprime into triple-A silk purses; or the investors who believed they were getting a free lunch in triple-A securities that provided higher yields.

And given the corruption all down the line in the lending process, it's no wonder that homeowners in tight straits might well wonder why they should be the only ones to do the right thing.

The late Hyman Minsky described the final stage of financial cycles as "Ponzi finance." At that point, borrowers can't repay debts from income but need to borrow more or sell assets to service those debts. That works only as long as asset prices rise.

Minsky became a forgotten figure in finance after his death in 1996, just as the era of irrational exuberance took off. How different things might have turned out if what he described as Ponzi finance was seen to underlie the entire bubble, including the putatively sober process of granting triple-A ratings, an integral component of the boom that went bust.

Comments: randall.forsyth@barrons.com

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