Is it possible for rating agencies to rate a security higher than what it should be rates without maleficence?

Question

In the run up to the 2008 financial crisis, many securities that were risky were rated much higher, at say, AAA. Raghuram Rajan in his book "Fault Lines" argues that this could does not necessarily have to arise from maleficence on the part of rating agences:

Roughly 60 percent of all asset-backed securities were rated AAA during the lending boom, whereas typically less than 1 percent of all corporate bonds are rated AAA. How could this be, especially when the underlying assets against which the securities were issed were subprime mortgage-backed securities. Was this a sham perpetrated by the rating agencies?

Theory suggests it did not have to be a sham. In certain circumstances, a significant percentage of the securities issued against a package of low-quality loans can be highly rated. An example and some simple probability analysis can make the point. Suppose two mortgages, each with a face value of \$1 and a 10 percent chance of total default, are packaged together. Suppose further that the investment bank structuring the deal issues two securities against the package—a junior security with face value of \$1 that bears the brunt of losses until they exceed $1, and a senior security that bears losses after that. The senior security suffers losses only if both mortgages default. If mortgage defaults occur independently (that is, they are uncorrelated), then the senior security defaults only 1 percent of the time. This is the magic of combining diversification with tranching the liabilities—that is, creating securities of different seniority. Put a sufficient number of subprime mortgages together from different parts of the country and from different originators, issue different tranches of securities against them, and it is indeed possible to convert a substantial quantity of the subprime frogs into AAA-rated princes, provided the correlation between mortgage defaults is low.

How does this "convert" a substantial quantity of the subprime securities into AAA-rated securities -- the individual tranches are still rated according to their risk levels, right?

Answer 1

This is (to a degree) how fixed income is still rated, particularly in CLOs and MBS/CMO. The risk of default on the ABS is mitigated by overcollateralizing the senior tranches and the joint probability of default of each underlying asset. The risk premium in ABS pricing is due to the possibility of systematic risk, as opposed to idiosyncratic risk (which has been diversified out, therefore improving the credit quality of the structure). In the case of subprime CMO, the AAA tranches were rated with the assumption that subprime default rates would be effectively steady compared to historical values (a bad assumption as it turned out!).

This raises a follow-on point about the need to use ratings cautiously in investment analysis. If you read the criteria, you will see that AAA means something different in each asset class. That is, a AAA in corporate bonds is different than a AAA in sovereigns, and are all uniquely different than AAA in municipals or ABS (as a handful of examples). The big mistake of 2008 (and maybe still even now) is that investing decisions were not driven by credit analysis, but by cursory looks at ratings and whether they fit the mandate.

A great example of this caution is just thoughtfully walking through it in real life. Based on S&P, Microsoft is rated AAA, yet the United States government is rated AA+, which, at face, would appear that MSFT is a better investment than Treasuries (believed to be risk-free). How could this be? If the United states defaulted on its debt (i.e. sovereign debt crisis), would MSFT, a USA domiciled company, really be safe? You can see that context is extremely important to using ratings and that it also is just one piece of the overall investment decision.