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New Mortgage-Backed Security Ratings Make Case for Reform

A few weeks ago, Citigroup and the real-estate investment firm Redwood Trust announced they had organized the sale of new mortgage-backed securities. They reported that they had picked 255 high-quality jumbo mortgages — mortgages too big to be backstopped by Fannie Mae and Freddie Mac — issued by Citigroup in California to back the financial instruments. Every borrower put down more than 20 percent in cash, and the average remaining balance on each loan was $933,000 — these borrowers, Redwood said, were rich and cash-rich. Redwood pegged the value of the Sequoia Mortgage Trust at $222.4 million and prepared to bring it to market.

But this is the first private issuance of mortgage-backed securities in more than two years — and it has sparked a market frenzy. Redwood Trust’s Brett Nicholas proclaimed, “This transaction has broken the ice in the private mortgage securitization market, which has been essentially frozen since 2008.” Investor demand was high enough that Redwood Trust cut its yield. And citing a turnaround in the private mortgage securities market, Wells Fargo said it is rebuilding its housing finance team.

Gearing up for the market reawakening, Redwood hired Moody’s to rate the securities — expecting a AAA rating, meaning no more of a likelihood of default than the U.S. government. Moody’s delivered. But then, its chief rival in the credit ratings business, Standard & Poors, without having been hired to assess the Redwood mortgage-backed deal, decided it had something to say. On Wednesday, it released a note saying that it did not believe the Redwood residential mortgage-backed securities met its AAA standards. These “jumbo” loans were riskier, it said. Some of the loans have periods where the mortgage-holder only pays the interest rate, and some become adjustable-rate after five years. “If mortgage rates rise, property values remain flat, and the extension of credit is limited, we believe borrowers may face difficulties refinancing,” S&P said.

But the point of this post is not to question whether the Redwood deal is good or not, or whether the unfreezing of the private mortgage-backed securities market is good or not, or whether anyone should care about this deal or not. It is to point out the inanity of the credit ratings business. These Redwood securities have received more scrutiny than any other mortgage deal in recent memory. Investors and the press have poured over them with a fine-tooth comb. They have ginned up hundreds of inches of newspaper space, and hundreds of blog posts and a number of research reports. Presumably, the financial sophisticates buying up the Redwood securities pool have done extensive homework on everything from the risks of these precise Californian jumbo mortgages to the possibility of housing finance bills changing the marketplace down the line.

Nobody really needed the credit ratings agencies to analyze this deal, per se. But the credit ratings agencies did analyze it and… came up with different conclusions. It is as good an argument as any for ignoring the ratings and doing one’s own due diligence. And I wonder, since the financial regulatory reform bill does little to reform the way credit ratings work, whether that might become more common — for sophisticated investors to not care about (and therefore not demand) ratings on smaller and highly transparent financial instruments.

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