Assessing Risk on Subprime Mortgage Backed Securities: Did Credit Rating Agencies Misrepresent Risk to Investors?

The Securities and Exchange Commission (SEC) has asked whether credit rating agencies (CRA) committed fraud by misleading investors with respect to the default risk on mortgage backed securities (MBS). This paper argues that, to the detriment of investors, the CRA did not incorporate information available to securitizers in their ratings of subprime mortgage backed securities. A test of this proposition utilizes data on CRA ratings of 32 Goldman Sachs MBS issued in 2005-2007 and Moody’s Investor Services projections of loss for these mortgage pools. The percent of principal balances rated triple-A is relatively constant over this period. In contrast, projected losses increase substantially for 2006-2007 MBS issues. A Goldman Sachs presentation to its Board highlights factors that enhanced the risk of default in 2006-2007. Review of a select sample of 2006-2007 MBS prospectuses contain disclosures of market, originator and mortgage characteristics that the securitizer associates with an increased risk of default. These disclosures suggest that the risk of default increased step wise beginning in 2006. While the same information was available to the CRA, their credit risk ratings did not incorporate this information and remained flat. Should the SEC obtain data on the near term performance of these MBS they would be able to establish if this divergence in risk assessment was substantial and if the CRA chose to support their clients to the detriment of MBS investors.