The system for rating mortgage bonds and similar securities is still flawed a decade after loose grades helped trigger a financial crisis, and fixing it may be as simple as making a single rule, a former analyst for S&P said.
Howard Esaki, who retired from S&P Global Ratings in 2015, said he believes that for securities like mortgage bonds, issuers should be required to ignore the most lenient grade it receives. If a bank selling a bond seeks ratings from three firms, for example, it should have to use the two that are based on stricter standards, Esaki wrote in a forthcoming paper to be published by the Milken Institute.
“Efforts to address conflicts of interest haven’t gone far enough,” Esaki said in a recent phone call. Spokesmen for the three biggest ratings firms, S&P, Moody’s Investors Service and Fitch, declined to comment.
Esaki and his co-author, Larry White, a professor at NYU Stern School of Business, are trying to fix a long-standing problem in the ratings business: issuers pay for ratings, so graders have an incentive to go easy on their customers to win more business. The 2008 financial crisis came about in part because competition among ratings companies inflated grades on mortgage bonds, a Senate subcommittee report found in 2011. The failure of those securities contributed to more than $1.9 trillion of losses at financial firms worldwide during the global meltdown.
Moody’s last month settled with the U.S. Justice Department and 21 states for $864 million over its ratings on subprime mortgage securities in the run-up to the crisis. S&P settled similar claims with the U.S. in 2015 for $1.5 billion.
Key Business
Even after the crisis, the U.S. Securities and Exchange Commission accused S&P of lowering its standards to win more revenue in commercial mortgage bonds, and forced it to sit out from part of the market for most of 2015. The ratings unit of S&P Global Inc has since been allowed to return. Securities like mortgage bonds contribute about a fifth of the annual revenue at Moody’s Investors Service, making it second only to corporate debt in importance to the firms, said Peter Appert, an equity analyst at Piper Jaffray.
Esaki has seen some of these conflicts first-hand. He spent 15 years as a top commercial mortgage-bond researcher for Morgan Stanley, during which time he witnessed the effect of weak ratings on the subprime mortgage market. In 2010, he joined S&P as head of research for global structured finance, a position he left in 2015.
Preliminary Grades
For asset-backed securities, mortgage bonds, and other types of repackaged debt known as “structured finance” securities, changing the rules for winning new business would give bond raters less to gain by lowering their standards, Esaki and White write in their forthcoming paper.