Mortgage Credit Ratings and the Financial Crisis: The Need for a State-Run Mortgage Security Credit Rating Agency

Abstract

With the exception of the investment banks, there probably has been no other financial actor with as great a hand in causing the current financial crisis as the major credit rating agencies (CRAs). CRAs gave residential mortgage backed securities (RMBSs) and RMBS-collateralized debt obligations (R-CDOs) inflated credit ratings, enabling financial institutions and other investors to buy trillions of dollars worth of these securities. Eventually, it became apparent that these securities were overvalued, which—because of mark-to-market accounting rules—forced huge write-downs for those who owned them. Consequently, the balance sheets of many financial institutions were decimated, some became insolvent, and the whole financial system was pushed to the brink of collapse.

Today the private mortgage securitization market is virtually non-existent, and only mortgage securities guaranteed by the Government Sponsored Enterprises (GSEs), Fannie Mae, Freddie Mac, and Ginnie Mae, are bought by investors. Responsibility for the frozen private mortgage securitization market has been widely assigned to the CRAs. Because mortgage securitization is so important to reviving the economy, the federal government, through its acquisition and subsidization of the GSEs, has become an underwriter and purchaser of RMBSs and R-CDOs. It is not a desirable solution, however, for the government to act as a long-term mortgage security investor. This Note’s proposal hopes to revive private mortgage securitization with significantly less expansive government intervention.

To restart the non-GSE RMBS and R-CDO market and to ensure its continued functioning, this Note argues that a federal government entity (“the Agency”) needs to take the place of the CRAs in rating RMBSs and R-CDOs. Inaccurate RMBS and R-CDO ratings are caused in large part by the “issuer pays” system of financing, whereby issuers of securities pay the CRAs for credit ratings, thus creating an obvious conflict of interests. However, some academics and the CRAs claim that the CRAs’ incentive to maintain a strong reputation (“reputational capital”) outweighs their desire in any individual case to profit from inflated ratings. The current financial crisis, however, disproves this claim and instead indicates that the conflict of interests inherent in issuer financing have overcome the reputational capital constraint and resulted in inflated RMBS and R-CDO ratings. Since the issuer pays model is unlikely to change, the CRAs will continue to be incentivized to inflate RMBS and R-CDO ratings, and investors and regulators will probably distrust CRA ratings of R-CDOs and RMBSs for the foreseeable future. On the other hand, this Note will show that a government entity can effectively rate R-CDOs and RMBSs.