It’s Not the Bond Rating Agencies’ Fault

I received a thoughtful email recently from someone making a strong case in favor of the beleaguered bond ratings agencies. While many have beat up on the ratings firms for attaching investment-grade ratings to synthetics RMBS that contain a significant amount of subprime debt, thus pointing the finger at agencies as partial culprits in the inability to price these things to market, my corespondent disagrees.

The essence of his argument:

  • 1-year to 10-year default probabilities are on-model for 90% of the issued ratings
  • CDOs are illiquid, and troubled hedge funds are caught in a mark-to-market cascade, unwinding hastily and marking-to-market, not to model, and thus forcing others to do the same thing, even if it is at a low price
  • The lower value of the credit portfolio forces funds to cut equity holdings, etc.

I’ll save my response for later, but happy to hear what others think.


  1. I just left a very large hedge fund and I know that they had the models to figure out the probabilities on the defualts accurately. The CDO guys there are dancing in the streets so they bet right.

  2. -If he/she is referring to 2006 & 2007 vintage subprime, Alt-A, or prime HELOC RMBS, they are dead wrong about being on the default curve.
    -CDO’s are getting marked down because the underlying collateral has been marked down. The CDO’s amplify the ratings and credit leverage that is implicit in the RMBS structure.
    -Fundamentally, this is a solvency problem and not a liquidity problem. Roubini has a post that summarizes that issue nicely.
    -The rating agency claim that none of this was foreseeable is total BS. I have two words for them: Casey Serin. If they had spent 10 minutes on his web site, they would have known that there were fatal problems with the way these mortgages were being underwritten. Undoubtedly there were people in the ratings agencies who recognized this, but were also undoubtedly shouted down because the revenue opportunity was so great and because the default history of 02-04 was so good. None one that spent any time in early 2006 studying time series of housing valuation metrics or who got any information from the field on how mortgages were being underwritten could have come away unconcerned about the risk embedded in subprime and Alt-a loans. If the mortgage raters, of all people, didn’t see it, it is because they didn’t want to.
    -For sure, there are many other enablers in this process, but the claim that the rating agencies couldn’t have seen this coming is BS.