As many are aware, the ratings agencies play an outsize role in financial markets. Their analysis of a debt issuance has much to do with whether the sponsor can sell it--if it is rated very high (triple A, for example), investors assume it is extraordinarily unlikely that there will be a default loss. On the contrary, if it is rated with junk bond status, investors understand they are taking a significant risk of default and will look for high payouts early in the game in order to make the risk palatable.
In the booming securitization business that was a central factor in the 2007-8 financial crisis and the Great Recession that is its aftermath, rating agency determinations on mortgage-backed securities and collateralized debt obligations--especially on the ones that were resecuritizations of prior securitization tranches like "re-REMICs" and "CDOs-squared" such as the Delphinus 2007-1 CDO (see pitchbook link at bottom)--had a great deal to do with the ability of sponsors to cram low-quality debt into securitization vehicles and sell it off to buyers unaware of the significant risk they were taking on.
Rating agency determinations play a huge role, as well, in the tax treatment of financial instruments. IN the past, tax practitioners considered that rating agencies had done "deep" due diligence and were well aware of the quality of the collateral backing a debt issuance, the reasonably expected future cash flows of the entity issuing the debt, and the equity structure underlying and supporting the debt. Accordingly, if you asked a tax practitioner in one of the firms doing a good bit of capital market work what they generally looked at to determine whether a financial instrument labeled debt was indeed to be treated as "debt in substance" for tax purposes, that practitioner would likely point to the credit rating as one of the primary factors, along with the amount of capital in the entity and the terms of the debt--in particular the interest rate. (The latter is significant for several reasons. For example, if it is a rate that varies based on enterprise success or a rate that is extraordinarily high compared to market rate for similar debt, then the return looks more like the kind of return one expects on equity.)
So one of the questions frequently asked by those outside Wall Street is--why are rating agencies still flying high, without suffering any obvious repercussions from their so-wrong ratings determinations on so many securitization interests filled with "toxic" debt like subprime mortgage loans?
Rating agencies claim as a defense that their ratings are 'mere' opinions that qualify for First Amendment protection--i.e., somewhat like car salesmen who are allowed to engage in ads filled with obvious sales puffery without redress from the buyer/victim that falls for the puffery. There hasn't been a good test of that First Amendment defense in the context of the financial crisis and the securitization juggernaut fueled by high ratings of questionable debt pools filled with subprime loans. But it may yet be coming.
Yves Smith explores the meaning of the SEC's Wells notice to Standard & Poors regarding their rating of a 2007 Magnetar CDO called Delphinius, in Is the SEC Finally Taking Serious Aim at the Ratings Agencies?, Naked Capitalism, Sept. 27, 2011. The Delphinus CDO at issue here has a pitchbook showing asset makeup (page 11) of only 20% "prime" residential mortgage-backed securities (RMBS), but 48% of "mid-prime" RMBS, 20% subprime RMBS and 7% CDO-squared securities (often the dregs unsalable from prior securitizations); but a ratings expectation that 80% of its securities would be listed as AAA/Aaa notes and an additional 8% listed as AA/a2 notes. (See pitchbook link, below) The catch for S&P in this instance may be that they had actual knowledge that this particular securitization was crappy at the time that they issued their stellar rating opinion on most of the tranches. As pointed out in the Naked Capitalism post: the tripe-A rating was given in August but S&P started downgrading them before the end of the year; emails found by Senator Levin's investigatory panel indicated that S&P knew at least some of the securities backing the deal weren't of the type supposed to be put in it under the deal documents (which was already fairly low quality, as indicated above); and S&P had already downgraded 600 subordinated MBS bonds based on subprime loans in July of that year right before it rated this deal, which was one of the last CDOs before the bubble burst.
For other commentary on this issue, see:
David Dayen, SEC Puts Standard and Poor's on Notice for Civil Charges on 2007 MBS, Firedoglake, Sept. 27, 2011 (reminding us that Magnetar is "the hedge fund which famolusly created bad securities and then bet against them to make money" and quoting Pro Publica's excerpt from last year's Senate investigation).
Marian Wang, In a First, SEC Warns Rating Agency It May Bring Financial Crisis Lawsuit, ProPublica.org, Sept. 26, 2011 (including the Delphinus CDO 2007-1 Pitchbook).
Some odds and ends regarding the pirchbook: The pitchbook --developed in 2007--shows a "lifetime impairment rate by asset type" graph that uses data through 2005 for securities issued from 1993-2004, a period that likely fails to capture the known information about the rapid deterioration of these kinds of deals at the time. Another interesting tidbit from the deal pitchbook--the collateral manager (Delaware Investments, a member of the Lincoln Financial Group (primarily an insurance group of firms) shows its 'fixed income assets under management' on page 24, consisting of about one-third structured products made up of CDOs, CMBS, ABS, mortgage loans (24.5%) and MBS (43.2%), for which it also provides the "quality rating" (except fot the mortgage loans) showing that 74.9% have a rating agency rating of triple-A. So the rating agency influences the buyer both through the direct rating of the securitization tranches and through the rating of the products held by the asset manager (as an indirect indication of the quality of that manager). It also brags about the 10 CDOs with assets of about $6 billion that it launched since 2000 (page 26), including a synthetic municipal bond CDO and four synthetic corporate CDOs, and its "long term commitment to the CDO business" and assurance that it operates "in the best interests of investors in our CDOs" to "deliver CDO products of the best possible quality to investors" with "a large number of experienced investment professionals" managing the ABS and CDOs, at least one of whom is described as having "deep insight on the economy, consumer credit, and housing market". It mentions that several of its investment professionals are real quants--the head of the derivatives trading desk and leader in synthetic credit trading activities whose "quantitative research skills in synthetic structured products and CMBS are highly beneficial"; the specialist in synthetic CDOs who "specializes in analyzing complicated financial instruments using quantitative analysis"; and another quant who "has written a book on ABA and MBS." The pitchbook also reminds one of a car salesman's sales puffery, doesn't it...