Next week, the Federal Housing Finance Agency (FHFA), the regulator for Fannie Mae and Freddie Mac, hosts its Supervision Summit. Attendees comprise 300 "stakeholders," whom I'll address the morning of Wednesday, December 8, 2010 with a presentation titled: Repairing the Damage of "Fraud as a Business Model."
Among other things I'll remind them that widespread foreclosure problems have festered for years. In January 2008, I submitted the manuscript for my book, Structured Finance, to my publisher. I explained that the rating agencies should be stripped of their NRSRO designation for structured products. Among a host of other problems, the rating agencies were clueless as to how to account for failures in the way the assets were handled in the creation of the deals they rated:
Executives at Standard & Poor's, Moody's and Fitch said they were waiting until foreclosure sales before recognizing losses, but they did not comment on the rising number of vacant homes on which foreclosures had not occurred, the complaints of trustees who could not foreclose because they could not "find" the required documentation to prove they had the right to foreclose or on the possibility of non-economic mortgage restructuring which would simply delay foreclosure. They also did not comment on the rising delinquencies which most often led to inevitable foreclosure.
NRSRO stands for "Nationally Recognized Statistical Rating Organization." Moody's, Standard and Poor's, and Fitch were the key rating agencies participating in rating collateralized debt obligations, yet they failed to follow basic statistical principles. When the SEC solicited comments for its proposed rules for the Credit Rating Agencies, mine was the first letter it posted on its web site in February 2007. I recommended the SEC revoke the NRSRO designation for the rating agencies with respect to rating structured finance transactions.
By the end of 2007 and through 2008, rating agencies scrambled to keep up. Moody's kept changing its models and "correlation" assumptions. At one point it announced that "new correlation" would equal three times "old correlation." In December 2007, Standard and Poor's announced an increase in capital requirements in order for certain financial guarantors to maintain "triple-A" ratings only to materially increase its loss assumptions in January of 2008. Fitch announced it might issue one notch downgrades for Ambac and MBIA [the two largest municipal bond insurers] in December 2007, only to downgrade Ambac two notches in January 2008 when Ambac announced larger than expected losses in its credit derivatives portfolio. The rating agencies were inconsistent, ill-informed, and floundering.
Structured Finance & Collateralized Debt Obligations, (excerpt from Chapter 17) Wiley, 2008.
MBIA eventually slid from "AAA" to a junk rating. Ambac filed for Chapter 11 bankruptcy protection November 8, 2010.
Of course, I will also give my recommendations on how to fix the rating agencies. The least controversial part of my presentation will be on the rating agencies, but it is worth mentioning this small preview in advance. None of the issues I'll talk about next week is new, and "financial reform" is late to the party and dead on arrival.