The Ratings Game: All AAA Ratings Are Not The Same

The Washington Post featured an interesting article by Steve Perlstein called “It’s Not 1929, but It’s the Biggest Mess Since.” It’s another well written review of the Subprime/credit crises, which contained some nuggets of knowledge I was not aware of. It’s classic Wall Street and shows you how to squeeze more value out of an investment.

It starts with mortgage-backed Collateralized Debt Obligations (CDOs). Here’s how Steve describes it:

By now, almost everyone knows that most mortgages are no longer held by banks until they are paid off: They are packaged with other mortgages and sold to investors much like a bond.

In the simple version, each investor owned a small percentage of the entire package and got the same yield as all the other investors. Then someone figured out that you could do a bigger business by selling them off in tranches corresponding to different levels of credit risk. Under this arrangement, if any of the mortgages in the pool defaulted, the riskiest tranche would absorb all the losses until its entire investment was wiped out, followed by the next riskiest and the next.

With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches — those with the lowest credit ratings — were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the “mezzanine” tranches, which offered middling yields for supposedly moderate risks.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same “tranching” process, they could use these mezzanine-rated assets to create a new set of securities — some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired.

You may have to read that last paragraph twice to get it. The middle or “mezzanine” tranches, which were originally not rated AAA, were sliced up again into 3 sections, which now suddenly included again AAA-rated securities. In other words, AAA quality was created out of thin air.

Ingenious, but I have no clue how ratings agencies can go along with this kind of scheme. It simply tells me that ratings on any security nowadays may not have the true value you think it does. While you and I may not be buying tranches in CDOs, it still makes me wonder if ratings agencies have any integrity left.