SUBPRIME CRISIS ACCELERATED BY FALLING RATINGS:
Collateralized Debt Obligations, or CDOs, have blown up in terms of sales in the past few years. According to Richard Tomlinson and David Evans of Bloomberg, “Sales of CDOs worldwide have soured since 2004, reaching $503 billion last year, a fivefold increase in three years.” For the first few years, CDOs were an investors dream, offering high yields, sometimes around 9% annually, while being backed by high ratings by Moody’s or S&P. As the Bloomberg authors asked: “Why buy a corporate bond yielding 5 percent when you can invest in a CDO with the same credit rating and the promise of a return twice as high?” Good question.
The answer, as most of us now know, is that the credit ratings were not the same, and many funds were overexposed to subprime mortgages with no warnings to their investors. For example, Evans and Tomlinson noted that “Corporate bonds rated Baa, the lowest Moody’s investment rating, had an average 2.2 percent default rate over five-year periods from 1983 to 2005… From 1993 to 2005, CDOs with the same Baa grade suffered five-year default rates of 24 percent.” Were these CDO ratings a mistake? Did the rating services really not know of the subprime risk? Or was something else at stake?
Evans and Tomlinson looked into the rating companies themselves and found that “[i]n the past three years, S&P, Moody’s and Fitch have made more money from evaluating structured finance—which includes CDOs and asset-backed securities—than from rating anything else, including corporate and municipal bonds, according to their financial reports. The companies charge as much as three times more to rate CDOs than to analyze bonds.” Also, the ratings companies are typically paid by the issuers of debt.
The ratings companies are quick to point to their disclaimers, noting that investors should not rely on said ratings. In the end, many investors and brokers did. However, many fund managers who gathered up subprime securities should have known better.
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=ajD1HS5Dj_Ro
http://www.bloomberg.com/news/marketsmag/ratings.html
