As the most severe financial and economic crisis since the Great Depression unfolds, scholars, practitioners, and regulators have been studying its causes and possible cures to prevent similar crises in the future. At the center of the crisis is the explosive growth of the mortgage-backed securities (MBS) market, which is both fueled by and fueling the housing market boom. In this paper, we study an important piece of the evolution of the MBS market the rating agencies (Moody’s and S&P in particular) and their role in the expansion of the MBS market.
Specifically, we examine whether conflicts of interest lie behind the growth of MBS, and whether and when the market began to realize this incentive in practice. We ask, in particular, did the rating agencies grant large mortgage originators, who brought substantial business, unduly favorable ratings?
Playing an important role in all fixed income securities markets, rating agencies have been sharply criticized for their practice that is behind the rise and fall of the MBS market. Many criticisms are based on the fact that the ratings industry faces a potential conflict in their fees/income structure. Instead of being compensated and rewarded by the ‘consumers’ (e.g., institutional investors) for high-quality ratings, the agencies are paid by issuers of fixed income securities.
The conflict of interest hypothesis thus stipulates that rating agencies give more favorable ratings to large issuers who have greater bargaining power because they bring, and could potentially take away, more business. This incentive was perhaps stronger for the new MBS market for much of the 2000s, as compared to the mature corporate bond market, as a booming new market generates a significant new revenue source. As recent theoretical work by Bolton, Freixas, and Shapiro (2009) suggests, this incentive is the strongest during market booms because the reputational costs for getting caught understating risk is lower while the benefits in terms of additional rating business generated are the highest. Moreover, unlike the corporate bond market, a small number of large issuers of MBS brought many deals to the ratings agencies. These facts and arguments provide the basis of our empirical tests.
We match a large sample of MBS tranches sold between 2000 and 2006 with information on the price and ratings history (from Moody’s and S&P) to their issuers. We compare tranches sold by large issuers vs. smaller issuers, where issuer size is based on the issuing institutions’ current annual market shares. We also classify the subsample period of 2004-2006 as the market boom period. In our first set of tests, we examine the ex post performance of these two groups of securities by looking at price changes between origination and April, 2009. We find that tranches sold by larger issuers performed significantly worse than similar tranches sold by smaller issuers.
The pattern holds for both AAA and non-AAA tranches, and for MBS rated by either Moody’s or S&P, the two largest rating agencies, controlling for the characteristics of the securities and issuer fixed effects. Moreover, we find that these differences are concentrated during the market boom years of 2004 through 2006. By contrast, AAA-rated tranches issued by large issuers in 2000 actually outperform their counterparts issued by small issuers. The results are consistent with the hypothesis that the conflict of interests affects rating agencies’ practice, especially during periods when the benefits of granting favorable ratings to large issuers are the highest.
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