MBS Ratings and the Mortgage Credit Boom

TLDR: In this paper, credit ratings on subprime and Alt-A mortgage-backed-securities (MBS) deals issued between 2001 and 2007, the period leading up to the subprime crisis were studied.

Abstract: We study credit ratings on subprime and Alt-A mortgage-backed-securities (MBS) deals issued between 2001 and 2007, the period leading up to the subprime crisis. The fraction of highly rated securities in each deal is decreasing in mortgage credit risk (measured either ex ante or ex post), suggesting that ratings contain useful information for investors. However, we also find evidence of significant time variation in risk-adjusted credit ratings, including a progressive decline in standards around the MBS market peak between the start of 2005 and mid-2007. Conditional on initial ratings, we observe underperformance (high mortgage defaults and losses and large rating downgrades) among deals with observably higher risk mortgages based on a simple ex ante model and deals with a high fraction of opaque low-documentation loans. These findings hold over the entire sample period, not just for deal cohorts most affected by the crisis.

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Tilburg University
MBS Ratings and the Mortgage Credit Boom
Ashcraft, A.; Goldsmith-Pinkham, P.; Vickery, J.
Publication date:
2010
Link to publication in Tilburg University Research Portal
Citation for published version (APA):
Ashcraft, A., Goldsmith-Pinkham, P., & Vickery, J. (2010).
MBS Ratings and the Mortgage Credit Boom
.
(CentER Discussion Paper; Vol. 2010-89S). Finance.
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Download date: 10. aug.. 2022

MBS RATINGS AND THE MORTGAGE
CREDIT BOOM
By
Adam Ashcraft, Paul Goldsmith-Pinkham,
James Vickery
May 2010
European Banking Center Discussion
Paper No. 2010–24S
This is also a
CentER Discussion Paper No. 2010-89S
ISSN 0924-7815

MBS Ratings and the Mortgage Credit Boom
Adam Ashcraft
*
Federal Reserve Bank of New York
Paul Goldsmith-Pinkham
Harvard University
James Vickery
Federal Reserve Bank of New York
*
First version: January 25, 2009
This version: May 14, 2010
*
Email: adam.ashcraft@ny.frb.org; pgoldsm@fas.harvard.edu; james.vickery@ny.frb.org. For valuable
comments and feedback, we thank Effi Benmelech, Richard Cantor, Joshua Coval, Jerry Fons, Dwight
Jaffee, Amit Seru, Joel Shapiro, Charles Trzcinka, Paolo Volpin and Nancy Wallace, as well as seminar
participants at the RBA, 6th Finance Downunder conference, UC Berkeley, UNC, 2010 AEA meetings,
NYU Stern / New York Fed Financial Intermediation conference, FDIC Annual Research Conference,
SEC, Gerzensee EESFM Corporate Finance meetings, AsRES-AREUEA Joint International Real Estate
Conference, NBER Summer Institute, 5
th MTS Conference on Financial Markets, WFA Day-Ahead Real
Estate Symposium, Universidad Carlos III, Chicago Fed Bank Structure Conference, Notre Dame
Conference on Securities Market Regulation, Rutgers, DePaul and the New York Fed. We also thank Scott
Nelson for outstanding research assistance. Views expressed in this paper are those of the authors, and do
not reflect the opinions of the Federal Reserve Bank of New York or the Federal Reserve System.

MBS Ratings and the Mortgage Credit Boom
Abstract
We study credit ratings on subprime and Alt-A mortgage-backed securities (MBS) deals
issued between 2001 and 2007, the period leading up to the subprime crisis. The fraction
of highly-rated securities in each deal is decreasing in mortgage credit risk (measured
either ex-ante or ex-post), suggesting ratings contain useful information for investors.
However, we also find evidence of significant time-variation in risk-adjusted credit
ratings, including a progressive decline in standards around the MBS market peak
between the start of 2005 and mid-2007. Conditional on initial ratings, we observe
underperformance (high mortgage defaults and losses, and large rating downgrades)
amongst deals with observably higher-risk mortgages based on a simple ex-ante model,
and deals with a high fraction of opaque low-documentation loans. These findings hold
over the entire sample period, not just for deal cohorts most affected by the crisis.
Keywords: Credit Rating Agencies, Subprime Crisis, Mortgage-Backed Securities
JEL Classifications: G01, G21, G24

1
Mistakes by credit rating agencies (CRAs) are often cited as one of the causes of the recent financial
crisis, which began with a surge in subprime mortgage defaults in 2007 and 2008. Prior to the crisis,
80-95% of a typical subprime or Alt-A mortgage-backed-securities (MBS) deal was assigned the
highest possible triple-A rating, making these securities attractive to a wide range of domestic and
foreign investors. Reflecting high mortgage defaults, however, many MBS originally rated
investment-grade now trade significantly below par, and have experienced large rating downgrades
and even losses. Figure 1 plots net rating revisions on subprime and Alt-A MBS issued since 2001.
While net rating revisions are small for earlier vintages, MBS issued since 2005 have experienced
historically large downgrades, by 3-10 rating notches on average, depending on the vintage.
Critics interpret these facts as evidence of important flaws in the credit rating process, either
due to incentive problems associated with the “issuer-pays” rating model, or simply insufficient
diligence or competence (e.g. US Senate, 2010; White, 2009; Fons, 2008).
1
In their defense however,
rating agencies argue that recent MBS performance primarily reflects a set of large, unexpected
shocks, including an unprecedented decline in home prices, and a financial crisis, events which
surprised most market participants. CRAs also point to warnings made by them before the crisis
about increasing risk amongst subprime MBS, and argue that ratings became accordingly more
conservative to reflect this greater risk.
2
1
For example, Jerry Fons, a former Moody’s executive, argues in Congressional testimony that “My view is
that a large part of the blame can be placed on the inherent conflicts of interest found in the issuer-pays
business model and rating shopping by issuers of structured securities. A drive to maintain or expand market
share made the rating agencies willing participants in this shopping spree. It was also relatively easy for the
major banks to play the agencies off one another because of the opacity of the structured transactions and the
high potential fees earned by the winning agency.” (Fons, 2008). The New York Attorney General is
reportedly currently investigating eight large MBS issuers regarding claims these firms manipulated ratings
through rating shopping, by reverse engineering rating models, sometimes with the help of former CRA
employees, by misreporting information on MBS collateral, and other means (New York Times, 2010).
2
In Senate testimony, Michael Kanef, Structured Finance Group Managing Director of Moody’s, states: “In
response to the increase in the riskiness of loans made during the last few years and the changing economic
environment, Moody’s steadily increased its loss expectations and subsequent levels of credit protection on
pools of subprime loans. Our loss expectations and enhancement levels rose by about 30% over the 2003 to
2006 time period.” and also that “We provided early warnings to the market, commenting frequently and
pointedly over an extended period on the deterioration in origination standards and inflated housing prices.”
(Kanef, 2007). Kanef cites aggressive underwriting standards, a decline in national home prices, and a

Frequently asked questions

Q1. What are the main factors that affect credit enhancement for each bond?

Credit enhancement for each bond is also affected by performance triggers (whichgovern how cashflows are split amongst different security types depending on mortgage pool7performance), the structure of interest swaps used, and other features of the pooling and servicing agreement. 

Q2. How many notches would mean that the securities in the deal had been upgraded?

A value of +3 would mean securities in the deal had been downgraded by a weighted average of three notches from issuance until August 2009, while -3 would indicate they had been upgraded by three notches. 

Q3. What is the contribution of other mortgage characteristics to the rising default rate after 2004?

The contribution of “other mortgage characteristics” accounts for other determinants of the rising model-projected default rate after 2004, namely changes in average loan covariates (e.g. LTV, FICO scores), and changes in the estimated model coefficients. 

Q4. What is the way to measure the quality of a low-doc loan?

The authors argue the share of low-doc loans underlying the deal is a reasonable proxy for opacity for their sample, since evaluating the quality of such loans relies on “soft” self-reported information from the borrower about their income, rather than verifiable data like tax returns. 

Q5. What is the main determinant of credit rating downgrades?

While rating downgrades are used as the primary performance metric in several relatedpapers on structured finance ratings (e.g. Adelino, 2009; Benmelech and Dlugosz, 2009; Griffin and Tang, 2009), a potential shortcoming of this measure is that the revised ratings may also be subject to systematic biases or errors. 

Q6. Why are low-doc loans more difficult to evaluate than other types of loans?

As argued above, low-doc loans are likely to be more opaque and difficult to evaluate thanother mortgage types, because of uncertainty about whether the borrower’s income is self-reported truthfully or not. 

Q7. What does the analysis say about the ratings of seasoned securities?

Since the authors focus on the quality of initial MBS ratings, their analysis does not speak to whetherratings on seasoned securities are revised slowly in response to shocks. 

Q8. How much of the price of ABX.HE was linked to original AAA securities?

HE 2006-01 (linked to originally-AAA securities from deals issued in the second half of 2005) was 80.05% of par, but the 2007-01 and 2007-02 AAA prices (linked to MBS issued in the second half of 2006 and first half of 2007) were much lower, only 34% of par.