Ex Moody's staff raise alarm over ABS meltdown

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Ex-Moody’s staff raise alarm over ABS ‘meltdown’
By Madison Marriage
A Moody's sign is displayed on 7 World Trade Center, the company's corporate headquarters in New York, in this February 6, 2013 file photo©Reuters
A former senior executive at Moody’s has warned that credit rating agencies are using “deluded” processes to calculate the risks of asset-backed securities. He fears this could trigger another financial meltdown.
William Harrington, who spearheaded analysis on derivatives between 1999 and 2010 at Moody’s Investors Services, said rating agencies are “glossing over” risks when assigning ratings to asset-backed securities by failing to take into account adequate counterparty risk.
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He said: “It is a situation where you keep putting more untenable assumptions into the system, but little by little that story is unravelling. It might not take a counterparty default to create all the little leaks that cause the boat to sink.”
Asset-backed securities, which include mortgage, credit-card and car loans bundled together, fuelled the financial crisis when the US subprime mortgage-backed security market collapsed in 2007.
However, institutional investors such as pension funds and insurers, have begun to increase their exposure to ABS once again, as low interest rates force them to search for alternative sources of yield.
Underpinning Mr Harrington’s fears is the fact that recent legal decisions in the US have failed to uphold “flip contracts”. They are written into structured finance deals to ensure that if a counterparty goes bankrupt, noteholders are given priority with payment obligations.
This undermines the triple A ratings many asset-backed securities receive, according to Mr Harrington, creating “a major systemic problem that could lead to another asset-backed meltdown”.
Richard Michalek, a former senior legal analyst at Moody’s, agreed that assigning triple A ratings to ABS without addressing the fact that flip clauses are not enforceable represents “a serious shortcoming”.
Finance Watch, the European investor protection group, added that rating agency methodologies for securities are “too focused on whether the underlying asset pool benefits from full or partial support, and not enough on the quality of the underlying pool”.
A spokesperson for Moody’s said: “Uncertainty as to whether a flip clause is legally enforceable generally does not have rating significance.” Standard & Poor’s declined to comment.
Mr Harrington is currently in discussions with several commissioners at the US Securities and Exchange Commission and the European Securities and Markets Authority to discuss the risks posed by asset-backed securities. Both regulators are in the process of reviewing rules on credit rating agencies and the ABS market.
The former Moody’s analyst is also concerned that asset-back securities receive triple A ratings on the incorrect assumption that the counterparties that serve them are too big to fail. These counterparties serve roughly $5tn of ABS in the US and Europe, he estimated.
Mr Michalek said: “While we may still be well in advance of a counterparty bankruptcy, investors are getting the wrong message. The uncertainty of the outcome from bankruptcy should be directly addressed in the ratings. [This] is a glaring error.”
A spokesperson for the SEC said: “Ensuring rating methodologies are done in a systematic and proper fashion is an ongoing concern for us.”
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It has often been said that Moody's grading is not the most scientific and when you consider how lowering a grade for a Country affects their Credit Worthiness it is worrying.