From the Hudson Institute:
Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions
JOSEPH R. MASON
JOSHUA ROSNER
The residential mortgage-backed securities (RMBS) market has experienced significant changes over the past decade. Non-agency (“private label”) securities, which are not guaranteed by the government or the government-sponsored enterprises, now account for the majority of RMBS issued. Fundamental changes to origination and servicing create difficulty in secondary mortgage markets. The MBS created in mortgage markets already pose a variety of challenges to valuation over other financial instruments, but the fundamental changes in origination and servicing practices change the timing and predictability of the cash flows that make mortgages valuable.
When changes to origination and servicing occur unpredictably over time or across issuers, thereby affecting the cash flows of some unknown number of mortgages, RMBS become even more difficult to value. Hence, changes in origination and servicing practices, along with the existing complexity of RMBS, results in greater opacity in the RMBS market.
Those sentiments suggest that the RMBS market was transparent at some previous instant. In this paper, we explain that the general nature of bond ratings, as well as a fundamental misapplication of the corporate ratings process to RMBS, has never provided sufficient transparency for market efficiency. Rather, the benefits of securitization to date have rested primarily upon a chance combination of a lengthy economic expansion coupled with asset price increases of the sort that are fundamentally excluded from standard measures of inflation. We discuss ways in which conflicting incentives and the misapplication of corporate bond ratings methods have skewed the evaluation of risk in RMBS and CDOs.
The paper begins with a background discussion of beliefs about fundamental changes in risk in today’s markets. In Part II, we review many well-known shortcomings of the way the bond ratings industry presently approaches RMBS. Part III presents even more fundamental flaws, suggesting that a substantial overhaul is necessary to adequately characterize risk in not only RMBS, but the entire universe of ABS as well. In Part IV, we explain how the complexity of RMBS and ABS masks risk transfer, which can fool investors and regulators into believing that securitized funding arrangements are safer than they really are.
Parts V and VI show that similar problems affect the CDO markets, where risk is also ill-characterized and masked through complexity. Part VII links those risks to present economic conditions, suggesting that growth will be restored to equilibrium whether policymakers act or not. In Part VIII, we suggest policy conclusions based on our findings.