More Games Played by Ratings Agencies With Securitizations

I found this paper this morning: "Ratings, Mortgage Securitizations and the Apparent Creation of Value."

Some excerpts below (my bold):

Structured products are designed to produce desired ratings. The company issuing a bond has no easy way of restructuring itself to change the rating assigned to a bond if it does not like the rating.

Yup.

The apparent creation of value happens when any portfolio of debt-like assets is securitized. It is therefore a potential explanation for popularity of re-securitization and re-re-securitization.

Double yup.

On to the summary:

The creation of tranches with AAA ratings was the key to the success of the securitization of subprime mortgages during the 2000 to 2006 period. Indeed, the profitability of a securitization to the structurer depended critically [on] the volume of AAA-rated tranches that were created ...

Pension funds, endowments and other large investors often establish rules governing how their assets can be invested. These rules often specify that the credit rating of instruments must be above a certain level, and sometimes that the credit rating must be AAA. There is a limited supply of AAA-rated corporate and sovereign bonds in the world ...

Was a AAA-rated tranche equivalent to a AAA-rated bond? The answer ... should be clear from our analysis ... If the rating agencies applied their criteria appropriately, one dimension of the loss distribution of a AAA-rated tranche was the same as that of a AAA-rated corporate bond, but other aspects of the loss distribution were liable to be quite different ...

Consider a bond and a thin tranche, both rated BBB by S&P or Fitch. They will have approximately the same probability of default. However, in the case of the bond, the expected loss in the event of default is about 60% whereas, in the case of the tranche, it is almost 100%.

There are other reasons why investors should have been wary ... regarding a AAA bond as equivalent to a AAA tranche. As pointed out by Coval et al. (2009), AAA-rated tranches have high systematic [sic, should be "systemic"] or market risk. They tend to lose money when the market as a whole performs very poorly and there are many defaults. AAA-rated bonds do not have as much systematic risk.

Another difference concerns the probability of downgrade. As explained earlier, structurers knew the models used by rating agencies and were able to show proposed structures to rating agencies before creating them. As a result, it is likely that AAA-rated tranches had just made it to the AAA category.

I won't even comment on the unmentioned here, regarding systemic risk -- that these instruments that are likely to perform more poorly during periods of systemic risk are themselves, with their shiny AAA veneers, contributors to the eventual appearance of that systemic risk.

So those are some of the games. Investors, note well.