When a Deal Goes Bad, Blame the Ratings

Did you make an incredibly bad decision during the great credit bubble?

Don’t worry. Join the crowd denying responsibility. Explain that nobody should have expected you to do any homework before investing.

Until now, my favorite denial of responsibility had come from MBIA, the bond insurance company. It had insured some very risky mortgage-backed securities without doing much to inspect what it was insuring.

“It would be enormously expensive, even if it were logistically feasible, for a credit insurer to investigate the health of these ground-level loans,” MBIA argued in a suit against Merrill Lynch, contending that Merrill Lynch lied about the quality of loans backing the securities that MBIA insured.

MBIA explained that if it did such research, it would have to charge much higher premiums. MBIA said its premiums were as low as $77,500 for each $100 million of insurance.

My new favorite denial came this week, when the trustee for two Bear Stearns hedge funds that went broke in 2007 said it was absolutely not the managers’ fault.

They bought some of the more dubious securities around â€" securities whose payment depended on securities that in turn depended on securities that depended on subprime mortgages â€" while knowing little about what they were buying.

Those securities paid a low return, but the managers got around that by borrowing as much as 10 times the actual capital invested in the initial fund. Their second fund â€" the “enhanced leverage fund” â€" promised even better returns by borrowing more money. It was started in August 2006, with timing that could not have been much worse, and was destroyed within a year.

The way the funds’ trustees see it, all of the blame should go to the ratings agencies â€" Standard & Poor’s, Moody’s and Fitch. They gave ratings of AAA and AA to securities that turned out to be junk, and the managers rightly relied on those ratings. “Market participants, such as the funds, did not and could not know the loan level detail of the mortgages underlying the structured finance products at issue,” the suit states.

Could not? MBIA could claim it could not afford to do due diligence, given the low premiums it took in, but hedge fund management fees are anything but low. Could the fund managers not do the research?

I have gone over several of the investments cited in the suit and can confirm that there is little public information available. Presumably money managers could have gained more information about deals they purchased. But even then, it would have been difficult.

Before going further into that, what follows is a short primer on the private-label R.M.B.S. (residential mortgage-backed securities) market and the related C.D.O. (collateralized debt obligation) market.

The R.M.B.S. market is relatively straightforward. A bunch of mortgages are put together into a securitization, with several tranches of securities. The senior tranches of securities pay relatively low interest rates but are first in line to collect mortgage payments. Lower tranches get higher rates but will become worthless sooner if enough homeowners default.

What made this market possible was the conclusion â€" eagerly endorsed by the rating agencies â€" that tranches secured by risky assets, like subprime mortgages, could nonetheless receive AAA ratings, signifying virtually no risk. That was because there were extra mortgages in the pool and because more junior tranches would lose money first.

It was not that difficult to obtain some decent information about the mortgages in any particular R.M.B.S. deal, although it later turned out that those making the loans had often failed to live up to their promises about the creditworthiness of borrowers. But that information generally became available only weeks after the deal was sold to investors. The rating agencies rated, and the funds bought, based on what the sponsors said would be included. By the time the real information was available, fund managers presumably had moved on to other investments.

C.D.O.’s took that one step further. What backed a C.D.O. was not mortgages; it was tranches from previous mortgage securitizations. The rating agencies concluded you could take a bunch of R.M.B.S. tranches with relatively low ratings, like A, put them together, and create more AAA-rated paper.

Some of what the Bear Stearns funds bought was what we will call normal C.D.O.’s. I managed to obtain offering documents for some of those cited in the lawsuit but learned little about the actual investments. The offering documents described the tranches they would acquire in broad, general terms but gave no specifics. Presumably those specifics later became available, but researching them would have taken a great amount of effort.

Floyd Norris comments on finance and the economy at nytimes.com/economix.