Washington Post, Sunday, May 11, 2008
By Elizabeth Razzi
Laurel Wittman and her husband, Eduardo Lopes, are examples of a rare species: successful short-sale buyers.
The unfortunate trio of nothing-down mortgages, sharp increases in adjustable-rate payments and shrinking home values has driven more strapped owners to ask their lenders to approve short sales as an alternative to foreclosure. The sales price is short of the amount owed to the lender, but lenders will sometimes accept such deals because foreclosures cost them even more money.
It's not an easy way to buy a house.
Wittman and Lopes endured a five-month wait to buy a five-bedroom Fairfax County house that was headed for foreclosure. They offered to pay the full asking price, aware that their offer would have to be approved by the seller's lender.
They didn't expect to be the only ones interested in making the deal.
Months went by with no response from the lender, SunTrust Mortgage. At times, the couple wondered if the deal was worth the hassle.
But persistence won them a nice house with a garage for $510,000, which was $90,000 less than its recent appraised value and nearly $117,000 less than the latest tax assessment. If you believe that time is money, though, they paid plenty. "If you had any urgency, you couldn't have done this," Wittman said. "It was all about just trying to get anyone to respond."
The couple wanted to move from their house in Dale City to be closer to Wittman's job in Alexandria. They planned to rent out the Dale City house, which allowed them a more flexible schedule than if they had to coordinate a sale and a purchase.
The Dutch Colonial they found sits smack against Interstate 66 near Falls Church.
The house has several features that made it a good choice for Lopes, who has used a wheelchair since 2005 because of multiple sclerosis. There's a main-level bedroom and bathroom, plus an updated kitchen with plenty of maneuvering room. It can easily accommodate a ramp to the front porch and a chair lift to the back door.
The home went on the market last May at $575,000, which was out of the couple's price range. By September, the asking price was down to $550,000, still more than they could afford. On Sept. 19, the asking price dropped to $499,950.
Until then, Lopes hadn't wanted to get involved with the hassle of trying to buy anything at a short sale, but that price cut changed his mind. "Suddenly, it was inside our price range, and it was a lot of house," Lopes said. "It became worth our time."
They thought the lender's review would add only a few weeks to the process. After all, they were offering the full asking price. So their purchase offer called for settlement no later than Nov. 15 -- only six weeks away.
"We thought that was reasonable," Wittman said. And the waiting began.
Their home inspection revealed problems with heating and plumbing systems, plus an elevated radon level. The seller had no money to cover any repairs, so they removed the inspection contingency from their offer and estimated that they could face as much as $20,000 in repairs.
But they found the lack of communication about the sale particularly frustrating. "We could not directly contact the lender," Lopes said. The lender would communicate only with the seller and the seller's real estate agent.
Repeatedly, the couple extended the expiration date on their purchase offer. They said the seller and his agent seemed at times unaware that the contract was about to expire, but Wittman and Lopes needed to keep the deal alive so they would not have to reapply for a mortgage.
Behind the scenes, SunTrust, the lender that held both a first mortgage for $480,000and a second mortgage for $120,000 on the home, was communicating with the title insurance company, AIG United Guaranty. According to a letter Lopes obtained, the mortgage insurer told the lender that it wanted to increase the payoff on the second mortgage to $50,000. Wittman and Lopes weren't sure whether that meant they were going to get a counteroffer raising the price by $50,000.
"At that price, we weren't going to be able to do it, but we might have counteroffered," Wittman said. But there was nothing for them to respond to. Neither the bank nor the seller had made them a counteroffer, and their original offer continued to gather dust.
"At this point, we just started having doubts," Wittman said. They began to look at other houses. With hope that it might finally nudge the deal along, on Dec. 24 they increased their offer by $10,000, to $510,000. "It was just kind of a shot in the dark," Wittman said. "This was our last, best offer."
Their patience was running out. "You almost get a little offended," she said. After all, they weren't the ones who were behind on payments. All they wanted to do was to buy the house -- and for more than the listed price.
It took another month to get a response. On Jan. 25, SunTrust informed the seller's agent that it would accept the $510,000 offer. The commission to the seller's agent was cut to 2 percent of the sales price. The buyer's agent was also asked to cut his commission, but he refused.
The net to SunTrust: $476,548, nearly $124,000 less than was owed. I don't know what additional compensation, if any, the bank received from mortgage insurance. SunTrust representatives did not respond to requests for comment.
SunTrust required closing by Feb. 29. But Wittman and Lopes needed to close more quickly, as their mortgage commitment would expire Feb. 18. If they had to reapply for a loan, they would have had to increase their down payment by $25,000, which would have killed the deal.
Through the process, they never knew how close the bank was to foreclosing.
"Nobody was putting pressure except us to get this done," Wittman said. Probably that's because they were the only ones to walk away with a gain. The seller lost his house. The bank lost money, but its sluggishness very nearly cost it a sale, too.
13 May 2008
Rent and Wait, or Sell and Cringe?
Washington Post, Saturday, May 10, 2008
By Benny L. Kass
We have lived in our house for 15 years and have decided to move. We bought a new house six months ago and tried to sell our old one "by owner." We had no success. We had a real estate agent give us a price that he thought the home would sell for. My husband did not like that number. He thinks prices will come up again.
Do you think we should sell our home at the going rate or rent it out for a while until the prices come up again? I'm not sure they will, so I think we should just sell it at the best offer, but we thought we would ask for your professional advice.
My "professional advice" is probably as good -- or as bad -- as that of anyone else who is trying to predict when or even if the real estate market will bounce back. Whether to sell or rent is a personal question that only you and your husband can decide, after taking into consideration a number of important factors. Here are some things to consider:
· Tax implications. I suspect that during the 15 years you have lived there, your house has increased in value. You do not want to get hit with capital gains tax on the profit you have made. That means you will have to have lived in the house for at least two of the five years before it is sold. If you can meet this test, and assuming that you and your husband file a joint income tax return, you can exclude up to $500,000 of the gain from tax. (Single people and those married but filing separately can exclude up to $250,000.)
This means that if you move out and rent the house, you want to sell it before three years have elapsed.
Selling a house that has a tenant is not always easy. Some tenants do not keep the house in the same condition that you or a potential purchaser would like. Some tenants refuse to let you show your house to prospective buyers, even if your lease specifically permits you to do so. You may have to take the tenant to court to get a judge to order showings.
Thus, even with the best intentions of selling the house within three years, you may find yourself thwarted and so lose the valuable tax exclusion.
· Being a landlord. Not everyone is cut out to be a landlord. You have to learn the local landlord-tenant laws and make sure that your lease conforms to those laws. For example, some jurisdictions place limits on the amount of the security deposit you can collect when you lease the house. In the District, tenants have a number of rights they don't have elsewhere, including the opportunity to buy the house even if you find a buyer.
If a tenant does not pay rent, eviction can be time-consuming and expensive.
More important, do you want to get calls in the middle of the night complaining that the toilet is overflowing or that the roof is leaking?
· Carrying costs. You have already bought another home. Can you afford to pay for two houses? Keep in mind that to have a buffer between you and your tenant, you may want to hire a property manager. And the manager will want to get paid whether or not you have a tenant -- and whether or not the tenant is paying rent.
When you rent out a house, there will be months when it is vacant. But you still have to pay the mortgage and the real estate tax, and carry adequate insurance. Maintenance bills don't stop, either.
· Benefits of renting. Yes, there are also benefits to being a landlord. You can get tax deductions that are not available to homeowners, such as depreciation. Discuss the details with your financial adviser.
· Future of the market. Here, no one can assist you. Some "experts" predict that the real estate market will come back by the end of this year, while others say it may take two or three years. The crystal ball on my desk is cloudy.
But here's a suggestion: If you decide to rent out the house and you have a lot of equity, you may want to consider refinancing and pulling out some of that money (assuming you can find a lender in today's economy that is willing to make a cash-out loan). However, first calculate all the potential income and expenses involved with the rental. You do not want to pull out too much money, only to find that the new mortgage payments and other expenses will exceed the monthly rental income.
Another suggestion: Take your time and see if you can get a better offer for your house. Spring is usually a good time to try to sell. Perhaps you will get lucky and find a buyer who will come closer to your price.
In the final analysis, however, if you decide to sell, I am sure you will make a profit. It might not be as large as you would like, or as much as your neighbor got for a similar house two years ago, but it will still be a profit. Too many people want to forget that property values were going crazy in the past few years and are disappointed that they cannot sell at those same exorbitant prices. There's no room for that mind-set today.
By Benny L. Kass
We have lived in our house for 15 years and have decided to move. We bought a new house six months ago and tried to sell our old one "by owner." We had no success. We had a real estate agent give us a price that he thought the home would sell for. My husband did not like that number. He thinks prices will come up again.
Do you think we should sell our home at the going rate or rent it out for a while until the prices come up again? I'm not sure they will, so I think we should just sell it at the best offer, but we thought we would ask for your professional advice.
My "professional advice" is probably as good -- or as bad -- as that of anyone else who is trying to predict when or even if the real estate market will bounce back. Whether to sell or rent is a personal question that only you and your husband can decide, after taking into consideration a number of important factors. Here are some things to consider:
· Tax implications. I suspect that during the 15 years you have lived there, your house has increased in value. You do not want to get hit with capital gains tax on the profit you have made. That means you will have to have lived in the house for at least two of the five years before it is sold. If you can meet this test, and assuming that you and your husband file a joint income tax return, you can exclude up to $500,000 of the gain from tax. (Single people and those married but filing separately can exclude up to $250,000.)
This means that if you move out and rent the house, you want to sell it before three years have elapsed.
Selling a house that has a tenant is not always easy. Some tenants do not keep the house in the same condition that you or a potential purchaser would like. Some tenants refuse to let you show your house to prospective buyers, even if your lease specifically permits you to do so. You may have to take the tenant to court to get a judge to order showings.
Thus, even with the best intentions of selling the house within three years, you may find yourself thwarted and so lose the valuable tax exclusion.
· Being a landlord. Not everyone is cut out to be a landlord. You have to learn the local landlord-tenant laws and make sure that your lease conforms to those laws. For example, some jurisdictions place limits on the amount of the security deposit you can collect when you lease the house. In the District, tenants have a number of rights they don't have elsewhere, including the opportunity to buy the house even if you find a buyer.
If a tenant does not pay rent, eviction can be time-consuming and expensive.
More important, do you want to get calls in the middle of the night complaining that the toilet is overflowing or that the roof is leaking?
· Carrying costs. You have already bought another home. Can you afford to pay for two houses? Keep in mind that to have a buffer between you and your tenant, you may want to hire a property manager. And the manager will want to get paid whether or not you have a tenant -- and whether or not the tenant is paying rent.
When you rent out a house, there will be months when it is vacant. But you still have to pay the mortgage and the real estate tax, and carry adequate insurance. Maintenance bills don't stop, either.
· Benefits of renting. Yes, there are also benefits to being a landlord. You can get tax deductions that are not available to homeowners, such as depreciation. Discuss the details with your financial adviser.
· Future of the market. Here, no one can assist you. Some "experts" predict that the real estate market will come back by the end of this year, while others say it may take two or three years. The crystal ball on my desk is cloudy.
But here's a suggestion: If you decide to rent out the house and you have a lot of equity, you may want to consider refinancing and pulling out some of that money (assuming you can find a lender in today's economy that is willing to make a cash-out loan). However, first calculate all the potential income and expenses involved with the rental. You do not want to pull out too much money, only to find that the new mortgage payments and other expenses will exceed the monthly rental income.
Another suggestion: Take your time and see if you can get a better offer for your house. Spring is usually a good time to try to sell. Perhaps you will get lucky and find a buyer who will come closer to your price.
In the final analysis, however, if you decide to sell, I am sure you will make a profit. It might not be as large as you would like, or as much as your neighbor got for a similar house two years ago, but it will still be a profit. Too many people want to forget that property values were going crazy in the past few years and are disappointed that they cannot sell at those same exorbitant prices. There's no room for that mind-set today.
Buyers and Sellers Cash in with Patience
Washington Post, May 9, 2008
By Michele Lerner
'Patience is the best remedy for every trouble," wrote Roman playwright Titus Maccius Plautus sometime between 254 and 184 B.C. He clearly had no inkling of the tribulations of the modern-day real estate market.
Yet his advice, centuries later, is just what local real estate experts are urging for frustrated buyers and sellers.
Real estate agents with 20 to 30 years of experience with the local real estate market may be a bit more sanguine than newcomers to the real estate market, mostly because they have seen home values drop and sales slow in the past and witnessed the ensuing market comeback.
Some local agents report a lively spring market, with open houses attracting plenty of potential buyers and contracts on the rise.
The Washington-area real estate market is extremely local, with many areas within the District and in close-in suburbs feeling very little effect from the national real estate slowdown.
Other areas, particularly Prince William, Loudoun and Prince George's County, have been hit harder, with slower sales and dropping prices.
Evelyn Lugo, a Realtor with Long & Foster Real Estate in District, with more than 20 years in the real estate business, says that this current real estate cycle is different from the 1990s.
"In the 1990s, we had this huge real estate boom and then a terrible crash," Ms. Lugo says. "This time, especially inside the Beltway, it didn't happen that way. This has been more of an adjustment, which just had to take place since housing prices were increasing so fast. But, at least inside the Beltway, I think the real estate market is recession-proof because of the strong employment with government jobs and government contractors. Now consumers can feel confident that because of this employment infrastructure, there won't be a huge drop in home values."
Ms. Lugo acknowledges that this holds true inside the Beltway, with different scenarios in more distant suburbs.
Barbara Miles, associate broker with Coldwell Banker Residential Brokerage in Bethesda, has been in the real estate business for 25 years. She says this is the third slow market she has experienced.
"People have been saying the same things today that they have said in previous markets, such as that this is the end of the real estate world, but it always comes back," Ms. Miles says. "Recently at a company, we were read quotes from the 1940s that could have been media quotes about today's real estate market. Historically, real estate always goes up, and people need to understand this."
Ms. Miles says she never recommends buying a home for consumers staying in the Washington area for only two years or less, suggesting instead that they rent. She says buying and selling a home costs about 10 percent of the value of the home, which can be hard to make up in just two years.
"If you are not intending to move for at least three or four years, though, it just makes sense to buy a home," Ms. Miles says. "By buying, you have the pride of ownership, a tax write-off, a roof over your head, and, eventually, the value will go up."
Ms. Miles says home values dropped 20 percent overnight in 1992, but then rose in double digits every year between 1999 and 2005.
Dee Rosenberg, associate broker with RE/MAX Realty Group in Gaithersburg with 29 years in the real estate business, says that buyers and sellers need to be patient in this particular market. Sellers may find it takes a long time for their home to go under contract, and buyers may find it hard to choose the right home and obtain financing.
"This real estate market is different because I have never seen so many foreclosures before," Ms. Rosenberg says. "Foreclosures are a big part of the competition for sellers, but they are not always in as good condition, either."
Don Noll, associate broker with RE/MAX Select Properties in Sterling, has been in the real estate business for 25 years.
"The slow market is a lot different this time around because of what I call the 'funny money' loans," Mr. Noll says. "So many of the homes on the market right now are foreclosures and short sales, and not all of them are coming from subprime loans. Some of them are because people went in with these no-documentation loans and 100 percent financing, and they just didn't have a vested interest in the property. It has been easier for them to walk away from the responsibility of owning a home. Other people were just using their home equity as an ATM machine so they could take trips to Hawaii, and now they can't sell their homes because they owe more than it's worth."
On the positive side, Mr. Noll says that while the upturn in home values took place from 1995 to 2005, the Washington area has not seen home values drop all the way down to 1995 prices.
"The people that are hardest hit are those who bought in 2004 and 2005 when prices peaked," Mr. Noll says. "The market won't recover until some of the inventory is absorbed. In Northern Virginia, we have about one year's worth of inventory available. The farther out you are from the city, the longer it will take because now residents are also hurt by rising gas prices that make commuting so expensive."
Ms. Lugo says the biggest hit on the market right now is coming from mortgage lenders.
"Most lenders now want buyers to put 10 to 20 percent down, but consumers have become accustomed to needing little or no money down," says Ms. Lugo. "Single-family homes in this area often cost $600,000, so you are asking people to come up with $60,000 to $120,000 in cash."
Ms. Lugo thinks the recent change in FHA loan limits to $729,750 in the Washington area is already having a big impact on the local market.
"Raising the loan limits on FHA loans has opened up the market to people who want to buy a home with just 3 percent down," Ms. Lugo says. "That down payment can be a gift, too, and they can accept seller contributions towards closing costs of up to 6 percent."
FHA loans typically have easier qualification standards that allow consumers with lower credit scores to be approved.
Barbara Haardt, a senior loan officer with Prosperity Mortgage in the District, says that FHA loans, like other mortgage programs, qualify consumers based on income, assets and credit scores, and require full documentation through tax returns and bank statements.
"The difference is that for FHA loans of $392,900 and below, no minimum credit score is required," Ms. Haardt says. "For higher loan amounts, a minimum score of 600 to 620 is required."
Ms. Haardt says lenders in today's real estate market carefully analyze a variety of factors to determine whether each individual county is considered a stable or declining market, which can impact the approval of mortgage loans in that area.
"Lenders look at the number of units on the market, the values of homes in that market and the number of units on the market for more than 180 days to determine market status," Ms. Haardt says. "Currently, the D.C. market, including Northern Virginia and Prince George's County, is considered a declining or distressed market. Montgomery County has already improved to a soft market."
Ms. Haardt says in a declining or distressed market, most lenders require a minimum down payment of 10 percent for conventional loans. FHA loans are not impacted by this designation.
"Some lenders will automatically insist in lowering appraisals on homes in declining markets by 5 percent," Ms. Haardt says.
Two key pieces of advice that each real estate agent offered are these: Buyers should think conservatively when it comes to determining how much they can afford, and sellers should recognize that while they may sell low, they are also buying low.
"Sellers need to realize that if their home value is down by 10 percent from its peak, so is the value of the home you want to buy," Ms. Miles says. "You may have lost $30,000 by not selling your home in 2005, but you are gaining $60,000 on what the owner of your next house thought he would get. You just need to keep it all in perspective."
Ms. Miles says buyers need to compromise and not overextend themselves when purchasing a home. Plus, they need to make sure they understand their loan program, she says.
"You can always sell and move up later," Ms. Miles says.
Ms. Lugo says potential first-time buyers are "crazy" if they are not buying a home right now, since interest rates are low, financing is available and plenty of homes are available.
Ms. Rosenberg suggests that buyers be patient, since it may take more than one attempt to arrange appropriate financing and find the home they want. She says buyers should expect to make a down payment of at least 3 percent (with an FHA loan) or more, and they need to make sure they have a good credit score.
"Buyers need to be very specific with their buyer agent to make sure the agent understands exactly what they are looking for," Ms. Rosenberg says. "The most important thing is to make sure you are comfortable with the payment and your income. Do not push yourself into a more expensive home until you become uncomfortable with the payments."
Mr. Noll says that when he started in the real estate business, buyers had to make at least a 5 percent down payment, if not more.
"Now lenders are returning to that pattern and cracking down," Mr. Noll says. "They want buyers to have a vested interest in the home. So buyers may need some patience while they fix their credit and save money for a down payment."
Both Ms. Rosenberg and Mr. Noll suggest that sellers who do not have to sell their home now wait out the market.
"If you do have to sell, you need to be patient and understand that you are in it for the long haul," Ms. Rosenberg says. "You have to stage your home to make sure it looks the best it can, and you need to assume you will have to adjust your price."
Mr. Noll preaches patience, as well. "Buyers and sellers need to have realistic expectations in this market," he says. "They need a lot of patience until the market turns around again."
By Michele Lerner
'Patience is the best remedy for every trouble," wrote Roman playwright Titus Maccius Plautus sometime between 254 and 184 B.C. He clearly had no inkling of the tribulations of the modern-day real estate market.
Yet his advice, centuries later, is just what local real estate experts are urging for frustrated buyers and sellers.
Real estate agents with 20 to 30 years of experience with the local real estate market may be a bit more sanguine than newcomers to the real estate market, mostly because they have seen home values drop and sales slow in the past and witnessed the ensuing market comeback.
Some local agents report a lively spring market, with open houses attracting plenty of potential buyers and contracts on the rise.
The Washington-area real estate market is extremely local, with many areas within the District and in close-in suburbs feeling very little effect from the national real estate slowdown.
Other areas, particularly Prince William, Loudoun and Prince George's County, have been hit harder, with slower sales and dropping prices.
Evelyn Lugo, a Realtor with Long & Foster Real Estate in District, with more than 20 years in the real estate business, says that this current real estate cycle is different from the 1990s.
"In the 1990s, we had this huge real estate boom and then a terrible crash," Ms. Lugo says. "This time, especially inside the Beltway, it didn't happen that way. This has been more of an adjustment, which just had to take place since housing prices were increasing so fast. But, at least inside the Beltway, I think the real estate market is recession-proof because of the strong employment with government jobs and government contractors. Now consumers can feel confident that because of this employment infrastructure, there won't be a huge drop in home values."
Ms. Lugo acknowledges that this holds true inside the Beltway, with different scenarios in more distant suburbs.
Barbara Miles, associate broker with Coldwell Banker Residential Brokerage in Bethesda, has been in the real estate business for 25 years. She says this is the third slow market she has experienced.
"People have been saying the same things today that they have said in previous markets, such as that this is the end of the real estate world, but it always comes back," Ms. Miles says. "Recently at a company, we were read quotes from the 1940s that could have been media quotes about today's real estate market. Historically, real estate always goes up, and people need to understand this."
Ms. Miles says she never recommends buying a home for consumers staying in the Washington area for only two years or less, suggesting instead that they rent. She says buying and selling a home costs about 10 percent of the value of the home, which can be hard to make up in just two years.
"If you are not intending to move for at least three or four years, though, it just makes sense to buy a home," Ms. Miles says. "By buying, you have the pride of ownership, a tax write-off, a roof over your head, and, eventually, the value will go up."
Ms. Miles says home values dropped 20 percent overnight in 1992, but then rose in double digits every year between 1999 and 2005.
Dee Rosenberg, associate broker with RE/MAX Realty Group in Gaithersburg with 29 years in the real estate business, says that buyers and sellers need to be patient in this particular market. Sellers may find it takes a long time for their home to go under contract, and buyers may find it hard to choose the right home and obtain financing.
"This real estate market is different because I have never seen so many foreclosures before," Ms. Rosenberg says. "Foreclosures are a big part of the competition for sellers, but they are not always in as good condition, either."
Don Noll, associate broker with RE/MAX Select Properties in Sterling, has been in the real estate business for 25 years.
"The slow market is a lot different this time around because of what I call the 'funny money' loans," Mr. Noll says. "So many of the homes on the market right now are foreclosures and short sales, and not all of them are coming from subprime loans. Some of them are because people went in with these no-documentation loans and 100 percent financing, and they just didn't have a vested interest in the property. It has been easier for them to walk away from the responsibility of owning a home. Other people were just using their home equity as an ATM machine so they could take trips to Hawaii, and now they can't sell their homes because they owe more than it's worth."
On the positive side, Mr. Noll says that while the upturn in home values took place from 1995 to 2005, the Washington area has not seen home values drop all the way down to 1995 prices.
"The people that are hardest hit are those who bought in 2004 and 2005 when prices peaked," Mr. Noll says. "The market won't recover until some of the inventory is absorbed. In Northern Virginia, we have about one year's worth of inventory available. The farther out you are from the city, the longer it will take because now residents are also hurt by rising gas prices that make commuting so expensive."
Ms. Lugo says the biggest hit on the market right now is coming from mortgage lenders.
"Most lenders now want buyers to put 10 to 20 percent down, but consumers have become accustomed to needing little or no money down," says Ms. Lugo. "Single-family homes in this area often cost $600,000, so you are asking people to come up with $60,000 to $120,000 in cash."
Ms. Lugo thinks the recent change in FHA loan limits to $729,750 in the Washington area is already having a big impact on the local market.
"Raising the loan limits on FHA loans has opened up the market to people who want to buy a home with just 3 percent down," Ms. Lugo says. "That down payment can be a gift, too, and they can accept seller contributions towards closing costs of up to 6 percent."
FHA loans typically have easier qualification standards that allow consumers with lower credit scores to be approved.
Barbara Haardt, a senior loan officer with Prosperity Mortgage in the District, says that FHA loans, like other mortgage programs, qualify consumers based on income, assets and credit scores, and require full documentation through tax returns and bank statements.
"The difference is that for FHA loans of $392,900 and below, no minimum credit score is required," Ms. Haardt says. "For higher loan amounts, a minimum score of 600 to 620 is required."
Ms. Haardt says lenders in today's real estate market carefully analyze a variety of factors to determine whether each individual county is considered a stable or declining market, which can impact the approval of mortgage loans in that area.
"Lenders look at the number of units on the market, the values of homes in that market and the number of units on the market for more than 180 days to determine market status," Ms. Haardt says. "Currently, the D.C. market, including Northern Virginia and Prince George's County, is considered a declining or distressed market. Montgomery County has already improved to a soft market."
Ms. Haardt says in a declining or distressed market, most lenders require a minimum down payment of 10 percent for conventional loans. FHA loans are not impacted by this designation.
"Some lenders will automatically insist in lowering appraisals on homes in declining markets by 5 percent," Ms. Haardt says.
Two key pieces of advice that each real estate agent offered are these: Buyers should think conservatively when it comes to determining how much they can afford, and sellers should recognize that while they may sell low, they are also buying low.
"Sellers need to realize that if their home value is down by 10 percent from its peak, so is the value of the home you want to buy," Ms. Miles says. "You may have lost $30,000 by not selling your home in 2005, but you are gaining $60,000 on what the owner of your next house thought he would get. You just need to keep it all in perspective."
Ms. Miles says buyers need to compromise and not overextend themselves when purchasing a home. Plus, they need to make sure they understand their loan program, she says.
"You can always sell and move up later," Ms. Miles says.
Ms. Lugo says potential first-time buyers are "crazy" if they are not buying a home right now, since interest rates are low, financing is available and plenty of homes are available.
Ms. Rosenberg suggests that buyers be patient, since it may take more than one attempt to arrange appropriate financing and find the home they want. She says buyers should expect to make a down payment of at least 3 percent (with an FHA loan) or more, and they need to make sure they have a good credit score.
"Buyers need to be very specific with their buyer agent to make sure the agent understands exactly what they are looking for," Ms. Rosenberg says. "The most important thing is to make sure you are comfortable with the payment and your income. Do not push yourself into a more expensive home until you become uncomfortable with the payments."
Mr. Noll says that when he started in the real estate business, buyers had to make at least a 5 percent down payment, if not more.
"Now lenders are returning to that pattern and cracking down," Mr. Noll says. "They want buyers to have a vested interest in the home. So buyers may need some patience while they fix their credit and save money for a down payment."
Both Ms. Rosenberg and Mr. Noll suggest that sellers who do not have to sell their home now wait out the market.
"If you do have to sell, you need to be patient and understand that you are in it for the long haul," Ms. Rosenberg says. "You have to stage your home to make sure it looks the best it can, and you need to assume you will have to adjust your price."
Mr. Noll preaches patience, as well. "Buyers and sellers need to have realistic expectations in this market," he says. "They need a lot of patience until the market turns around again."
Bernanke Urges More Action to Stem Home Foreclosure Crisis
Associated Press, May 5, 10:04 PM
By JEANNINE AVERSA
WASHINGTON (AP) - A rising tide of late mortgage payments and home foreclosures poses considerable dangers to the national economy, Federal Reserve Chairman Ben Bernanke warned anew Monday as he urged Congress to take additional steps to alleviate the problems.
"High rates of delinquency and foreclosure can have substantial spillover effects on the housing market, the financial markets and the broader economy," Bernanke said in a dinner speech to Columbia Business School in New York. "Therefore, doing what we can to avoid preventable foreclosures is not just in the interest of lenders and borrowers. It's in everybody's interest," he said.
Some 1.5 million U.S. homes entered into the foreclosure process last year, up 53 percent from 2006, Bernanke said. The rate of new foreclosures looks likely to be even higher this year, he said.
To provide more relief, Bernanke again called on Congress to give the Federal Housing Administration, which insures mortgages, more flexibility to help distressed borrowers at risk of losing their homes. He also again urged lawmakers to move ahead on legislation revamping Fannie Mae (FNM) and Freddie Mac (FRE), which finance mortgages. And, he called on the two mortgage giants to quickly raise new capital.
House leaders plan action on those and other housing measures this week.
"Conditions in mortgage markets remain quite difficult," the Fed chief said. A copy of the speech was made available in Washington.
The reasons behind surging late payments and foreclosures can vary and that needs to be taken into account when developing solutions, Bernanke said. For instance, parts of New England, states in the Great Lakes, including Minnesota, Michigan and Wisconsin, show increased mortgage delinquencies and "notable increases" in unemployment rates, he said.
California, Florida and parts of Colorado, on the other hand, saw delinquencies rise during a period when unemployment generally decreased but the value of homes declined, he said.
Mortgage companies are used to dealing with delinquencies related to life events, such as job loss or an illness, with the most common approaches being a temporary repayment plan or the folding of missed payments into the principal balance, Bernanke said.
"A widespread decline in home prices, by contrast, is a relatively novel phenomenon, and lenders and servicers will have to develop new and flexible strategies to deal with this issue," Bernanke said.
The current housing crises has clobbered some borrowers home prices dropped. That left them with mortgages that are bigger than the value of their home. When that's the primary problem, Bernanke said the best solution may be reducing the amount that the borrower owes on the loan or some other permanent modification to the loan.
Rising foreclosures add to the glut of unsold homes and that put more downward pressure on prices, aggravating the housing slump, he said. More rapid declines in house prices could have an "adverse impact" on the broader economy and the stability of the financial system, he said.
In his remarks, Bernanke did not talk about the interest rate policy or the state of the economy.
To help bolster the economy, the Federal Reserve last Wednesday cut a key interest rate by one-quarter percentage point to 2 percent and strongly hinted that it may take a breather in its rate-cutting campaign that started last September.
The Fed hopes that its powerful series of rate cuts - its most aggressive in decades - along with the government's $168 billion stimulus package - including tax rebates that started flowing to bank accounts last week - will be sufficient to lift the country out of its slump in the second half of this year.
The mortgage meltdown started with problems with subprime mortgages - those made to people with tarnished credit. However, they have spread to more creditworthy borrowers.
The trio of crises - housing, credit and financial - have threatened to plunge the country into its first recession since 2001. The situation has roiled Wall Street, rattled consumers and has galvanized politicians in the White House, in Congress and on the campaign trail to come up with proposals to provide relief.
"The Realtor's mantra is 'location, location, location' ... local variation in housing and mortgage markets is considerable," Bernanke said. "This variation is useful for understanding the sources of the increase in mortgage delinquencies and foreclosures, and it should be taken into account as servicers and policymakers consider how best to avoid preventable foreclosures," he said.
By JEANNINE AVERSA
WASHINGTON (AP) - A rising tide of late mortgage payments and home foreclosures poses considerable dangers to the national economy, Federal Reserve Chairman Ben Bernanke warned anew Monday as he urged Congress to take additional steps to alleviate the problems.
"High rates of delinquency and foreclosure can have substantial spillover effects on the housing market, the financial markets and the broader economy," Bernanke said in a dinner speech to Columbia Business School in New York. "Therefore, doing what we can to avoid preventable foreclosures is not just in the interest of lenders and borrowers. It's in everybody's interest," he said.
Some 1.5 million U.S. homes entered into the foreclosure process last year, up 53 percent from 2006, Bernanke said. The rate of new foreclosures looks likely to be even higher this year, he said.
To provide more relief, Bernanke again called on Congress to give the Federal Housing Administration, which insures mortgages, more flexibility to help distressed borrowers at risk of losing their homes. He also again urged lawmakers to move ahead on legislation revamping Fannie Mae (FNM) and Freddie Mac (FRE), which finance mortgages. And, he called on the two mortgage giants to quickly raise new capital.
House leaders plan action on those and other housing measures this week.
"Conditions in mortgage markets remain quite difficult," the Fed chief said. A copy of the speech was made available in Washington.
The reasons behind surging late payments and foreclosures can vary and that needs to be taken into account when developing solutions, Bernanke said. For instance, parts of New England, states in the Great Lakes, including Minnesota, Michigan and Wisconsin, show increased mortgage delinquencies and "notable increases" in unemployment rates, he said.
California, Florida and parts of Colorado, on the other hand, saw delinquencies rise during a period when unemployment generally decreased but the value of homes declined, he said.
Mortgage companies are used to dealing with delinquencies related to life events, such as job loss or an illness, with the most common approaches being a temporary repayment plan or the folding of missed payments into the principal balance, Bernanke said.
"A widespread decline in home prices, by contrast, is a relatively novel phenomenon, and lenders and servicers will have to develop new and flexible strategies to deal with this issue," Bernanke said.
The current housing crises has clobbered some borrowers home prices dropped. That left them with mortgages that are bigger than the value of their home. When that's the primary problem, Bernanke said the best solution may be reducing the amount that the borrower owes on the loan or some other permanent modification to the loan.
Rising foreclosures add to the glut of unsold homes and that put more downward pressure on prices, aggravating the housing slump, he said. More rapid declines in house prices could have an "adverse impact" on the broader economy and the stability of the financial system, he said.
In his remarks, Bernanke did not talk about the interest rate policy or the state of the economy.
To help bolster the economy, the Federal Reserve last Wednesday cut a key interest rate by one-quarter percentage point to 2 percent and strongly hinted that it may take a breather in its rate-cutting campaign that started last September.
The Fed hopes that its powerful series of rate cuts - its most aggressive in decades - along with the government's $168 billion stimulus package - including tax rebates that started flowing to bank accounts last week - will be sufficient to lift the country out of its slump in the second half of this year.
The mortgage meltdown started with problems with subprime mortgages - those made to people with tarnished credit. However, they have spread to more creditworthy borrowers.
The trio of crises - housing, credit and financial - have threatened to plunge the country into its first recession since 2001. The situation has roiled Wall Street, rattled consumers and has galvanized politicians in the White House, in Congress and on the campaign trail to come up with proposals to provide relief.
"The Realtor's mantra is 'location, location, location' ... local variation in housing and mortgage markets is considerable," Bernanke said. "This variation is useful for understanding the sources of the increase in mortgage delinquencies and foreclosures, and it should be taken into account as servicers and policymakers consider how best to avoid preventable foreclosures," he said.
Triple-A Failure
New York Times Magazine, April 27, 2008
By ROGER LOWENSTEIN
The Ratings Game
In 1996, Thomas Friedman, the New York Times columnist, remarked on ''The NewsHour With Jim Lehrer'' that there were two superpowers in the world -- the United States and Moody's bond-rating service -- and it was sometimes unclear which was more powerful. Moody's was then a private company that rated corporate bonds, but it was, already, spreading its wings into the exotic business of rating securities backed by pools of residential mortgages.
Obscure and dry-seeming as it was, this business offered a certain magic. The magic consisted of turning risky mortgages into investments that would be suitable for investors who would know nothing about the underlying loans. To get why this is impressive, you have to think about all that determines whether a mortgage is safe. Who owns the property? What is his or her income? Bundle hundreds of mortgages into a single security and the questions multiply; no investor could begin to answer them. But suppose the security had a rating. If it were rated triple-A by a firm like Moody's, then the investor could forget about the underlying mortgages. He wouldn't need to know what properties were in the pool, only that the pool was triple-A -- it was just as safe, in theory, as other triple-A securities.
Over the last decade, Moody's and its two principal competitors, Standard & Poor's and Fitch, played this game to perfection -- putting what amounted to gold seals on mortgage securities that investors swept up with increasing élan. For the rating agencies, this business was extremely lucrative. Their profits surged, Moody's in particular: it went public, saw its stock increase sixfold and its earnings grow by 900 percent.
By providing the mortgage industry with an entree to Wall Street, the agencies also transformed what had been among the sleepiest corners of finance. No longer did mortgage banks have to wait 10 or 20 or 30 years to get their money back from homeowners. Now they sold their loans into securitized pools and -- their capital thus replenished -- wrote new loans at a much quicker pace.
Mortgage volume surged; in 2006, it topped $2.5 trillion. Also, many more mortgages were issued to risky subprime borrowers. Almost all of those subprime loans ended up in securitized pools; indeed, the reason banks were willing to issue so many risky loans is that they could fob them off on Wall Street.
But who was evaluating these securities? Who was passing judgment on the quality of the mortgages, on the equity behind them and on myriad other investment considerations? Certainly not the investors. They relied on a credit rating.
Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody's and Standard & Poor's that set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. Effectively, they did the job that was expected of banks and government regulators. And today, they are a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more.
In the wake of the housing collapse, Congress is exploring why the industry failed and whether it should be revamped (hearings in the Senate Banking Committee were expected to begin April 22). Two key questions are whether the credit agencies -- which benefit from a unique series of government charters -- enjoy too much official protection and whether their judgment was tainted. Presumably to forestall criticism and possible legislation, Moody's and S.&P. have announced reforms. But they reject the notion that they should have been more vigilant. Instead, they lay the blame on the mortgage holders who turned out to be deadbeats, many of whom lied to obtain their loans.
Arthur Levitt, the former chairman of the Securities and Exchange Commission, charges that ''the credit-rating agencies suffer from a conflict of interest -- perceived and apparent -- that may have distorted their judgment, especially when it came to complex structured financial products.'' Frank Partnoy, a professor at the University of San Diego School of Law who has written extensively about the credit-rating industry, says that the conflict is a serious problem. Thanks to the industry's close relationship with the banks whose securities it rates, Partnoy says, the agencies have behaved less like gatekeepers than gate openers. Last year, Moody's had to downgrade more than 5,000 mortgage securities -- a tacit acknowledgment that the mortgage bubble was abetted by its overly generous ratings. Mortgage securities rated by Standard & Poor's and Fitch have suffered a similar wave of downgrades.
Presto! How 2,393 Subprime Loans Become a High-Grade Investment
The business of assigning a rating to a mortgage security is a complicated affair, and Moody's recently was willing to walk me through an actual mortgage-backed security step by step. I was led down a carpeted hallway to a well-appointed conference room to meet with three specialists in mortgage-backed paper. Moody's was fair-minded in choosing an example; the case they showed me, which they masked with the name ''Subprime XYZ,'' was a pool of 2,393 mortgages with a total face value of $430 million.
Subprime XYZ typified the exuberance of the age. All the mortgages in the pool were subprime -- that is, they had been extended to borrowers with checkered credit histories. In an earlier era, such people would have been restricted from borrowing more than 75 percent or so of the value of their homes, but during the great bubble, no such limits applied.
Moody's did not have access to the individual loan files, much less did it communicate with the borrowers or try to verify the information they provided in their loan applications. ''We aren't loan officers,'' Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody's, told me. ''Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?''
The loans in Subprime XYZ were issued in early spring 2006 -- what would turn out to be the peak of the boom. They were originated by a West Coast company that Moody's identified as a ''nonbank lender.'' Traditionally, people have gotten their mortgages from banks, but in recent years, new types of lenders peddling sexier products grabbed an increasing share of the market. This particular lender took the loans it made to a New York investment bank; the bank designed an investment vehicle and brought the package to Moody's.
Moody's assigned an analyst to evaluate the package, subject to review by a committee. The investment bank provided an enormous spreadsheet chock with data on the borrowers' credit histories and much else that might, at very least, have given Moody's pause. Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs -- ''teaser'' loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble -- lending on the belief, or the hope, that new money will bail out the old.
Moody's learned that almost half of these borrowers -- 43 percent -- did not provide written verification of their incomes. The data also showed that 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside. That suggested a risky degree of concentration.
On the plus side, Moody's noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. ''That was a comfort feeling,'' Robinson said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, ''You'll give up your ski chalet first.''
Another factor giving Moody's comfort was that all of the ARM loans in the pool were first mortgages (as distinct from, say, home-equity loans). Nearly half of the borrowers, however, took out a simultaneous second loan. Most often, their two loans added up to all of their property's presumed resale value, which meant the borrowers had not a cent of equity.
In the frenetic, deal-happy climate of 2006, the Moody's analyst had only a single day to process the credit data from the bank. The analyst wasn't evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle -- a ghost corporation with no people or furniture and no assets either until the deal was struck -- would purchase the mortgages. Thereafter, monthly payments from the homeowners would go to the S.P.V. The S.P.V. would finance itself by selling bonds. The question for Moody's was whether the inflow of mortgage checks would cover the outgoing payments to bondholders. From the investment bank's point of view, the key to the deal was obtaining a triple-A rating -- without which the deal wouldn't be profitable. That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. ''People say, 'How can you create triple-A out of B-rated paper?' '' notes Arturo Cifuentes, a former Moody's credit analyst who now designs credit instruments. It may seem like a scam, but it's not.
The secret sauce is that the S.P.V. would float 12 classes of bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have first priority on the cash received from mortgage holders until they were fully paid, then the next tier of bonds, then the next and so on. The bonds at the bottom of the pile got the highest interest rate, but if homeowners defaulted, they would absorb the first losses.
It was this segregation of payments that protected the bonds at the top of the structure and enabled Moody's to classify them as triple-A. Imagine a seaside condo beset by flooding: just as the penthouse will not get wet until the lower floors are thoroughly soaked, so the triple-A bonds would not lose a dime unless the lower credits were wiped out.
Structured finance, of which this deal is typical, is both clever and useful; in the housing industry it has greatly expanded the pool of credit. But in extreme conditions, it can fail. The old-fashioned corner banker used his instincts, as well as his pencil, to apportion credit; modern finance is formulaic. However elegant its models, forecasting the behavior of 2,393 mortgage holders is an uncertain business. ''Everyone assumed the credit agencies knew what they were doing,'' says Joseph Mason, a credit expert at Drexel University. ''A structural engineer can predict what load a steel support will bear; in financial engineering we can't predict as well.''
Mortgage-backed securities like those in Subprime XYZ were not the terminus of the great mortgage machine. They were, in fact, building blocks for even more esoteric vehicles known as collateralized debt obligations, or C.D.O.'s. C.D.O.'s were financed with similar ladders of bonds, from triple-A on down, and the credit-rating agencies' role was just as central. The difference is that XYZ was a first-order derivative -- its assets included real mortgages owned by actual homeowners. C.D.O.'s were a step removed -- instead of buying mortgages, they bought bonds that were backed by mortgages, like the bonds issued by Subprime XYZ. (It is painful to consider, but there were also third-order instruments, known as C.D.O.'s squared, which bought bonds issued by other C.D.O.'s.)
Miscalculations that were damaging at the level of Subprime XYZ were devastating at the C.D.O. level. Just as bad weather will cause more serious delays to travelers with multiple flights, so, if the underlying mortgage bonds were misrated, the trouble was compounded in the case of the C.D.O.'s that purchased them.
Moody's used statistical models to assess C.D.O.'s; it relied on historical patterns of default. This assumed that the past would remain relevant in an era in which the mortgage industry was morphing into a wildly speculative business. The complexity of C.D.O.'s undermined the process as well. Jamie Dimon, the chief executive of JPMorgan Chase, which recently scooped up the mortally wounded Bear Stearns, says, ''There was a large failure of common sense'' by rating agencies and also by banks like his. ''Very complex securities shouldn't have been rated as if they were easy-to-value bonds.''
The Accidental Watchdog
John Moody, a Wall Street analyst and former errand runner, hit on the idea of synthesizing all kinds of credit information into a single rating in 1909, when he published the manual ''Moody's Analyses of Railroad Investments.'' The idea caught on with investors, who subscribed to his service, and by the mid-'20s, Moody's faced three competitors: Standard Statistics and Poor's Publishing (which later merged) and Fitch.
Then as now, Moody's graded bonds on a scale with 21 steps, from Aaa to C. (There are small differences in the agencies' nomenclatures, just as a grande latte at Starbucks becomes a ''medium'' at Peet's. At Moody's, ratings that start with the letter ''A'' carry minimal to low credit risk; those starting with ''B'' carry moderate to high risk; and ''C'' ratings denote bonds in poor standing or actual default.) The ratings are meant to be an estimate of probabilities, not a buy or sell recommendation. For instance, Ba bonds default far more often than triple-As. But Moody's, as it is wont to remind people, is not in the business of advising investors whether to buy Ba's; it merely publishes a rating.
Until the 1970s, its business grew slowly. But several trends coalesced to speed it up. The first was the collapse of Penn Central in 1970 -- a shattering event that the credit agencies failed to foresee. It so unnerved investors that they began to pay more attention to credit risk.
Government responded. The Securities and Exchange Commission, faced with the question of how to measure the capital of broker-dealers, decided to penalize brokers for holding bonds that were less than investment-grade (the term applies to Moody's 10 top grades). This prompted a question: investment grade according to whom? The S.E.C. opted to create a new category of officially designated rating agencies, and grandfathered the big three -- S.&P., Moody's and Fitch. In effect, the government outsourced its regulatory function to three for-profit companies.
Bank regulators issued similar rules for banks. Pension funds, mutual funds, insurance regulators followed. Over the '80s and '90s, a latticework of such rules redefined credit markets. Many classes of investors were now forbidden to buy noninvestment-grade bonds at all.
Issuers thus were forced to seek credit ratings (or else their bonds would not be marketable). The agencies -- realizing they had a hot product and, what's more, a captive market -- started charging the very organizations whose bonds they were rating. This was an efficient way to do business, but it put the agencies in a conflicted position. As Partnoy says, rather than selling opinions to investors, the rating agencies were now selling ''licenses'' to borrowers. Indeed, whether their opinions were accurate no longer mattered so much. Just as a police officer stopping a motorist will want to see his license but not inquire how well he did on his road test, it was the rating -- not its accuracy -- that mattered to Wall Street.
The case of Enron is illustrative. Throughout the summer and fall of 2001, even though its credit was rapidly deteriorating, the rating agencies kept it at investment grade. This was not unusual; the agencies typically lag behind the news. On Nov. 28, 2001, S.&P. finally dropped Enron's bonds to subinvestment grade. Although its action merely validated the market consensus, it caused the stock to collapse. To investors, S.&P.'s action was a signal that Enron was locked out of credit markets; it had lost its ''license'' to borrow. Four days later it filed for bankruptcy.
Another trend that spurred the agencies' growth was that more companies began borrowing in bond markets instead of from banks. According to Chris Mahoney, a just-retired Moody's veteran of 22 years, ''The agencies went from being obscure and unimportant players to central ones.''
A Conflict of Interest?
Nothing sent the agencies into high gear as much as the development of structured finance. As Wall Street bankers designed ever more securitized products -- using mortgages, credit-card debt, car loans, corporate debt, every type of paper imaginable -- the agencies became truly powerful.
In structured-credit vehicles like Subprime XYZ, the agencies played a much more pivotal role than they had with (conventional) bonds. According to Lewis Ranieri, the Salomon Brothers banker who was a pioneer in mortgage bonds, ''The whole creation of mortgage securities was involved with a rating.''
What the bankers in these deals are really doing is buying a bunch of I.O.U.'s and repackaging them in a different form. Something has to make the package worth -- or seem to be worth -- more that the sum of its parts, otherwise there would be no point in packaging such securities, nor would there be any profits from which to pay the bankers' fees.
That something is the rating. Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails. As with a would-be immigrant traveling from Mexico, there is a huge incentive to get over the line.
The challenge to investment banks is to design securities that just meet the rating agencies' tests. Risky mortgages serve their purpose; since the interest rate on them is higher, more money comes into the pool and is available for paying bond interest. But if the mortgages are too risky, Moody's will object. Banks are adroit at working the system, and pools like Subprime XYZ are intentionally designed to include a layer of Baa bonds, or those just over the border. ''Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,'' a former Moody's expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, ''Gaming is the whole thing.''
When a bank proposes a rating structure on a pool of debt, the rating agency will insist on a cushion of extra capital, known as an ''enhancement.'' The bank inevitably lobbies for a thin cushion (the thinner the capitalization, the fatter the bank's profits). It's up to the agency to make sure that the cushion is big enough to safeguard the bonds. The process involves extended consultations between the agency and its client. In short, obtaining a rating is a collaborative process.
The evidence on whether rating agencies bend to the bankers' will is mixed. The agencies do not deny that a conflict exists, but they assert that they are keen to the dangers and minimize them. For instance, they do not reward analysts on the basis of whether they approve deals. No smoking gun, no conspiratorial e-mail message, has surfaced to suggest that they are lying. But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody's has thousands of clients (virtually every corporation and municipality that sells bonds). No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. A deal the size of XYZ can bring Moody's $200,000 and more for complicated deals. And the banks pay only if Moody's delivers the desired rating. Tom McGuire, the Jesuit theologian who ran Moody's through the mid-'90s, says this arrangement is unhealthy. If Moody's and a client bank don't see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as ''ratings shopping.''
And it seems to have helped the banks get better ratings. Mason, of Drexel University, compared default rates for corporate bonds rated Baa with those of similarly rated collateralized debt obligations until 2005 (before the bubble burst). Mason found that the C.D.O.'s defaulted eight times as often. One interpretation of the data is that Moody's was far less discerning when the client was a Wall Street securitizer.
After Enron blew up, Congress ordered the S.E.C. to look at the rating industry and possibly reform it. The S.E.C. ducked. Congress looked again in 2006 and enacted a law making it easier for competing agencies to gain official recognition, but didn't change the industry's business model. By then, the mortgage boom was in high gear. From 2002 to 2006, Moody's profits nearly tripled, mostly thanks to the high margins the agencies charged in structured finance. In 2006, Moody's reported net income of $750 million. Raymond W. McDaniel Jr., its chief executive, gloated in the annual report for that year, ''I firmly believe that Moody's business stands on the 'right side of history' in terms of the alignment of our role and function with advancements in global capital markets.''
Using Weather in Antarctica To Forecast Conditions in Hawaii
Even as McDaniel was crowing, it was clear in some corners of Wall Street that the mortgage market was headed for trouble. The housing industry was cooling off fast. James Kragenbring, a money manager with Advantus Capital Management, complained to the agencies as early as 2005 that their ratings were too generous. A report from the hedge fund of John Paulson proclaimed astonishment at ''the mispricing of these securities.'' He started betting that mortgage debt would crash.
Even Mark Zandi, the very visible economist at Moody's forecasting division (which is separate from the ratings side), was worried about the chilling crosswinds blowing in credit markets. In a report published in May 2006, he noted that consumer borrowing had soared, household debt was at a record and a fifth of such debt was classified as subprime. At the same time, loan officers were loosening underwriting standards and easing rates to offer still more loans. Zandi fretted about the ''razor-thin'' level of homeowners' equity, the avalanche of teaser mortgages and the $750 billion of mortgages he judged to be at risk. Zandi concluded, ''The environment feels increasingly ripe for some type of financial event.''
A month after Zandi's report, Moody's rated Subprime XYZ. The analyst on the deal also had concerns. Moody's was aware that mortgage standards had been deteriorating, and it had been demanding more of a cushion in such pools. Nonetheless, its credit-rating model continued to envision rising home values. Largely for that reason, the analyst forecast losses for XYZ at only 4.9 percent of the underlying mortgage pool. Since even the lowest-rated bonds in XYZ would be covered up to a loss level of 7.25 percent, the bonds seemed safe.
XYZ now became the responsibility of a Moody's team that monitors securities and changes the ratings if need be (the analyst moved on to rate a new deal). Almost immediately, the team noticed a problem. Usually, people who finance a home stay current on their payments for at least a while. But a sliver of folks in XYZfell behind within 90 days of signing their papers. After six months, an alarming 6 percent of the mortgages were seriously delinquent. (Historically, it is rare for more than 1 percent of mortgages at that stage to be delinquent.)
Moody's monitors began to make inquiries with the lender and were shocked by what they heard. Some properties lacked sod or landscaping, and keys remained in the mailbox; the buyers had never moved in. The implication was that people had bought homes on spec: as the housing market turned, the buyers walked.
By the spring of 2007, 13 percent of Subprime XYZ was delinquent -- and it was worsening by the month. XYZ was hardly atypical; the entire class of 2006 was performing terribly. (The class of 2007 would turn out to be even worse.)
In April 2007, Moody's announced it was revising the model it used to evaluate subprime mortgages. It noted that the model ''was first introduced in 2002. Since then, the mortgage market has evolved considerably.'' This was a rather stunning admission; its model had been based on a world that no longer existed.
Poring over the data, Moody's discovered that the size of people's first mortgages was no longer a good predictor of whether they would default; rather, it was the size of their first and second loans -- that is, their total debt -- combined. This was rather intuitive; Moody's simply hadn't reckoned on it. Similarly, credit scores, long a mainstay of its analyses, had not proved to be a ''strong predictor'' of defaults this time. Translation: even people with good credit scores were defaulting. Amy Tobey, leader of the team that monitored XYZ, told me, ''It seems there was a shift in mentality; people are treating homes as investment assets.'' Indeed. And homeowners without equity were making what economists call a rational choice; they were abandoning properties rather than make payments on them. Homeowners' equity had never been as high as believed because appraisals had been inflated.
Over the summer and fall of 2007, Moody's and the other agencies repeatedly tightened their methodology for rating mortgage securities, but it was too late. They had to downgrade tens of billions of dollars of securities. By early this year, when I met with Moody's, an astonishing 27 percent of the mortgage holders in Subprime XYZ were delinquent. Losses on the pool were now estimated at 14 percent to 16 percent -- three times the original estimate. Seemingly high-quality bonds rated A3 by Moody's had been downgraded five notches to Ba2, as had the other bonds in the pool aside from its triple-A's.
The pain didn't stop there. Many of the lower-rated bonds issued by XYZ, and by mortgage pools like it, were purchased by C.D.O.'s, the second-order mortgage vehicles, which were eager to buy lower-rated mortgage paper because it paid a higher yield. As the agencies endowed C.D.O. securities with triple-A ratings, demand for them was red hot. Much of it was from global investors who knew nothing about the U.S. mortgage market. In 2006 and 2007, the banks created more than $200 billion of C.D.O.'s backed by lower-rated mortgage paper. Moody's assigned a different team to rate C.D.O.'s. This team knew far less about the underlying mortgages than did the committee that evaluated Subprime XYZ. In fact, Moody's rated C.D.O.'s without knowing which bonds the pool would buy.
A C.D.O. operates like a mutual fund; it can buy or sell mortgage bonds and frequently does so. Thus, the agencies rate pools with assets that are perpetually shifting. They base their ratings on an extensive set of guidelines or covenants that limit the C.D.O. manager's discretion.
Late in 2006, Moody's rated a C.D.O. with $750 million worth of securities. The covenants, which act as a template, restricted the C.D.O. to, at most, an 80 percent exposure to subprime assets, and many other such conditions. ''We're structure experts,'' Yuri Yoshizawa, the head of Moody's' derivative group, explained. ''We're not underlying-asset experts.'' They were checking the math, not the mortgages. But no C.D.O. can be better than its collateral.
Moody's rated three-quarters of this C.D.O.'s bonds triple-A. The ratings were derived using a mathematical construct known as a Monte Carlo simulation -- as if each of the underlying bonds would perform like cards drawn at random from a deck of mortgage bonds in the past. There were two problems with this approach. First, the bonds weren't like those in the past; the mortgage market had changed. As Mark Adelson, a former managing director in Moody's structured-finance division, remarks, it was ''like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.'' And second, the bonds weren't random. Moody's had underestimated the extent to which underwriting standards had weakened everywhere. When one mortgage bond failed, the odds were that others would, too.
Moody's estimated that this C.D.O. could potentially incur losses of 2 percent. It has since revised its estimate to 27 percent. The bonds it rated have been decimated, their market value having plunged by half or more. A triple-A layer of bonds has been downgraded 16 notches, all the way to B. Hundreds of C.D.O.'s have suffered similar fates (most of Wall Street's losses have been on C.D.O.'s). For Moody's and the other rating agencies, it has been an extraordinary rout.
Whom Can We Rely On?
The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate. This is what they pledge for the future. Moody's, S.&P. and Fitch say that they are tightening procedures -- they will demand more data and more verification and will subject their analysts to more outside checks. None of this, however, will remove the conflict of interest in the issuer-pays model. Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether.
Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves -- not farm the job out to Moody's. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less. Moody's itself favors doing away with the official designation, and it, like S.&P., embraces the idea that investors should not ''rely'' on ratings for buy-and-sell decisions.
This leaves an awkward question, with respect to insanely complex structured securities: What can they rely on? The agencies seem utterly too involved to serve as a neutral arbiter, and the banks are sure to invent new and equally hard-to-assess vehicles in the future. Vickie Tillman, the executive vice president of S.&P., told Congress last fall that in addition to the housing slump, ''ahistorical behavorial modes'' by homeowners were to blame for the wave of downgrades. She cited S.&P.'s data going back to the 1970s, as if consumers were at fault for not living up to the past. The real problem is that the agencies' mathematical formulas look backward while life is lived forward. That is unlikely to change.
By ROGER LOWENSTEIN
The Ratings Game
In 1996, Thomas Friedman, the New York Times columnist, remarked on ''The NewsHour With Jim Lehrer'' that there were two superpowers in the world -- the United States and Moody's bond-rating service -- and it was sometimes unclear which was more powerful. Moody's was then a private company that rated corporate bonds, but it was, already, spreading its wings into the exotic business of rating securities backed by pools of residential mortgages.
Obscure and dry-seeming as it was, this business offered a certain magic. The magic consisted of turning risky mortgages into investments that would be suitable for investors who would know nothing about the underlying loans. To get why this is impressive, you have to think about all that determines whether a mortgage is safe. Who owns the property? What is his or her income? Bundle hundreds of mortgages into a single security and the questions multiply; no investor could begin to answer them. But suppose the security had a rating. If it were rated triple-A by a firm like Moody's, then the investor could forget about the underlying mortgages. He wouldn't need to know what properties were in the pool, only that the pool was triple-A -- it was just as safe, in theory, as other triple-A securities.
Over the last decade, Moody's and its two principal competitors, Standard & Poor's and Fitch, played this game to perfection -- putting what amounted to gold seals on mortgage securities that investors swept up with increasing élan. For the rating agencies, this business was extremely lucrative. Their profits surged, Moody's in particular: it went public, saw its stock increase sixfold and its earnings grow by 900 percent.
By providing the mortgage industry with an entree to Wall Street, the agencies also transformed what had been among the sleepiest corners of finance. No longer did mortgage banks have to wait 10 or 20 or 30 years to get their money back from homeowners. Now they sold their loans into securitized pools and -- their capital thus replenished -- wrote new loans at a much quicker pace.
Mortgage volume surged; in 2006, it topped $2.5 trillion. Also, many more mortgages were issued to risky subprime borrowers. Almost all of those subprime loans ended up in securitized pools; indeed, the reason banks were willing to issue so many risky loans is that they could fob them off on Wall Street.
But who was evaluating these securities? Who was passing judgment on the quality of the mortgages, on the equity behind them and on myriad other investment considerations? Certainly not the investors. They relied on a credit rating.
Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody's and Standard & Poor's that set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. Effectively, they did the job that was expected of banks and government regulators. And today, they are a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more.
In the wake of the housing collapse, Congress is exploring why the industry failed and whether it should be revamped (hearings in the Senate Banking Committee were expected to begin April 22). Two key questions are whether the credit agencies -- which benefit from a unique series of government charters -- enjoy too much official protection and whether their judgment was tainted. Presumably to forestall criticism and possible legislation, Moody's and S.&P. have announced reforms. But they reject the notion that they should have been more vigilant. Instead, they lay the blame on the mortgage holders who turned out to be deadbeats, many of whom lied to obtain their loans.
Arthur Levitt, the former chairman of the Securities and Exchange Commission, charges that ''the credit-rating agencies suffer from a conflict of interest -- perceived and apparent -- that may have distorted their judgment, especially when it came to complex structured financial products.'' Frank Partnoy, a professor at the University of San Diego School of Law who has written extensively about the credit-rating industry, says that the conflict is a serious problem. Thanks to the industry's close relationship with the banks whose securities it rates, Partnoy says, the agencies have behaved less like gatekeepers than gate openers. Last year, Moody's had to downgrade more than 5,000 mortgage securities -- a tacit acknowledgment that the mortgage bubble was abetted by its overly generous ratings. Mortgage securities rated by Standard & Poor's and Fitch have suffered a similar wave of downgrades.
Presto! How 2,393 Subprime Loans Become a High-Grade Investment
The business of assigning a rating to a mortgage security is a complicated affair, and Moody's recently was willing to walk me through an actual mortgage-backed security step by step. I was led down a carpeted hallway to a well-appointed conference room to meet with three specialists in mortgage-backed paper. Moody's was fair-minded in choosing an example; the case they showed me, which they masked with the name ''Subprime XYZ,'' was a pool of 2,393 mortgages with a total face value of $430 million.
Subprime XYZ typified the exuberance of the age. All the mortgages in the pool were subprime -- that is, they had been extended to borrowers with checkered credit histories. In an earlier era, such people would have been restricted from borrowing more than 75 percent or so of the value of their homes, but during the great bubble, no such limits applied.
Moody's did not have access to the individual loan files, much less did it communicate with the borrowers or try to verify the information they provided in their loan applications. ''We aren't loan officers,'' Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody's, told me. ''Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?''
The loans in Subprime XYZ were issued in early spring 2006 -- what would turn out to be the peak of the boom. They were originated by a West Coast company that Moody's identified as a ''nonbank lender.'' Traditionally, people have gotten their mortgages from banks, but in recent years, new types of lenders peddling sexier products grabbed an increasing share of the market. This particular lender took the loans it made to a New York investment bank; the bank designed an investment vehicle and brought the package to Moody's.
Moody's assigned an analyst to evaluate the package, subject to review by a committee. The investment bank provided an enormous spreadsheet chock with data on the borrowers' credit histories and much else that might, at very least, have given Moody's pause. Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs -- ''teaser'' loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble -- lending on the belief, or the hope, that new money will bail out the old.
Moody's learned that almost half of these borrowers -- 43 percent -- did not provide written verification of their incomes. The data also showed that 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside. That suggested a risky degree of concentration.
On the plus side, Moody's noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. ''That was a comfort feeling,'' Robinson said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, ''You'll give up your ski chalet first.''
Another factor giving Moody's comfort was that all of the ARM loans in the pool were first mortgages (as distinct from, say, home-equity loans). Nearly half of the borrowers, however, took out a simultaneous second loan. Most often, their two loans added up to all of their property's presumed resale value, which meant the borrowers had not a cent of equity.
In the frenetic, deal-happy climate of 2006, the Moody's analyst had only a single day to process the credit data from the bank. The analyst wasn't evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle -- a ghost corporation with no people or furniture and no assets either until the deal was struck -- would purchase the mortgages. Thereafter, monthly payments from the homeowners would go to the S.P.V. The S.P.V. would finance itself by selling bonds. The question for Moody's was whether the inflow of mortgage checks would cover the outgoing payments to bondholders. From the investment bank's point of view, the key to the deal was obtaining a triple-A rating -- without which the deal wouldn't be profitable. That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. ''People say, 'How can you create triple-A out of B-rated paper?' '' notes Arturo Cifuentes, a former Moody's credit analyst who now designs credit instruments. It may seem like a scam, but it's not.
The secret sauce is that the S.P.V. would float 12 classes of bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have first priority on the cash received from mortgage holders until they were fully paid, then the next tier of bonds, then the next and so on. The bonds at the bottom of the pile got the highest interest rate, but if homeowners defaulted, they would absorb the first losses.
It was this segregation of payments that protected the bonds at the top of the structure and enabled Moody's to classify them as triple-A. Imagine a seaside condo beset by flooding: just as the penthouse will not get wet until the lower floors are thoroughly soaked, so the triple-A bonds would not lose a dime unless the lower credits were wiped out.
Structured finance, of which this deal is typical, is both clever and useful; in the housing industry it has greatly expanded the pool of credit. But in extreme conditions, it can fail. The old-fashioned corner banker used his instincts, as well as his pencil, to apportion credit; modern finance is formulaic. However elegant its models, forecasting the behavior of 2,393 mortgage holders is an uncertain business. ''Everyone assumed the credit agencies knew what they were doing,'' says Joseph Mason, a credit expert at Drexel University. ''A structural engineer can predict what load a steel support will bear; in financial engineering we can't predict as well.''
Mortgage-backed securities like those in Subprime XYZ were not the terminus of the great mortgage machine. They were, in fact, building blocks for even more esoteric vehicles known as collateralized debt obligations, or C.D.O.'s. C.D.O.'s were financed with similar ladders of bonds, from triple-A on down, and the credit-rating agencies' role was just as central. The difference is that XYZ was a first-order derivative -- its assets included real mortgages owned by actual homeowners. C.D.O.'s were a step removed -- instead of buying mortgages, they bought bonds that were backed by mortgages, like the bonds issued by Subprime XYZ. (It is painful to consider, but there were also third-order instruments, known as C.D.O.'s squared, which bought bonds issued by other C.D.O.'s.)
Miscalculations that were damaging at the level of Subprime XYZ were devastating at the C.D.O. level. Just as bad weather will cause more serious delays to travelers with multiple flights, so, if the underlying mortgage bonds were misrated, the trouble was compounded in the case of the C.D.O.'s that purchased them.
Moody's used statistical models to assess C.D.O.'s; it relied on historical patterns of default. This assumed that the past would remain relevant in an era in which the mortgage industry was morphing into a wildly speculative business. The complexity of C.D.O.'s undermined the process as well. Jamie Dimon, the chief executive of JPMorgan Chase, which recently scooped up the mortally wounded Bear Stearns, says, ''There was a large failure of common sense'' by rating agencies and also by banks like his. ''Very complex securities shouldn't have been rated as if they were easy-to-value bonds.''
The Accidental Watchdog
John Moody, a Wall Street analyst and former errand runner, hit on the idea of synthesizing all kinds of credit information into a single rating in 1909, when he published the manual ''Moody's Analyses of Railroad Investments.'' The idea caught on with investors, who subscribed to his service, and by the mid-'20s, Moody's faced three competitors: Standard Statistics and Poor's Publishing (which later merged) and Fitch.
Then as now, Moody's graded bonds on a scale with 21 steps, from Aaa to C. (There are small differences in the agencies' nomenclatures, just as a grande latte at Starbucks becomes a ''medium'' at Peet's. At Moody's, ratings that start with the letter ''A'' carry minimal to low credit risk; those starting with ''B'' carry moderate to high risk; and ''C'' ratings denote bonds in poor standing or actual default.) The ratings are meant to be an estimate of probabilities, not a buy or sell recommendation. For instance, Ba bonds default far more often than triple-As. But Moody's, as it is wont to remind people, is not in the business of advising investors whether to buy Ba's; it merely publishes a rating.
Until the 1970s, its business grew slowly. But several trends coalesced to speed it up. The first was the collapse of Penn Central in 1970 -- a shattering event that the credit agencies failed to foresee. It so unnerved investors that they began to pay more attention to credit risk.
Government responded. The Securities and Exchange Commission, faced with the question of how to measure the capital of broker-dealers, decided to penalize brokers for holding bonds that were less than investment-grade (the term applies to Moody's 10 top grades). This prompted a question: investment grade according to whom? The S.E.C. opted to create a new category of officially designated rating agencies, and grandfathered the big three -- S.&P., Moody's and Fitch. In effect, the government outsourced its regulatory function to three for-profit companies.
Bank regulators issued similar rules for banks. Pension funds, mutual funds, insurance regulators followed. Over the '80s and '90s, a latticework of such rules redefined credit markets. Many classes of investors were now forbidden to buy noninvestment-grade bonds at all.
Issuers thus were forced to seek credit ratings (or else their bonds would not be marketable). The agencies -- realizing they had a hot product and, what's more, a captive market -- started charging the very organizations whose bonds they were rating. This was an efficient way to do business, but it put the agencies in a conflicted position. As Partnoy says, rather than selling opinions to investors, the rating agencies were now selling ''licenses'' to borrowers. Indeed, whether their opinions were accurate no longer mattered so much. Just as a police officer stopping a motorist will want to see his license but not inquire how well he did on his road test, it was the rating -- not its accuracy -- that mattered to Wall Street.
The case of Enron is illustrative. Throughout the summer and fall of 2001, even though its credit was rapidly deteriorating, the rating agencies kept it at investment grade. This was not unusual; the agencies typically lag behind the news. On Nov. 28, 2001, S.&P. finally dropped Enron's bonds to subinvestment grade. Although its action merely validated the market consensus, it caused the stock to collapse. To investors, S.&P.'s action was a signal that Enron was locked out of credit markets; it had lost its ''license'' to borrow. Four days later it filed for bankruptcy.
Another trend that spurred the agencies' growth was that more companies began borrowing in bond markets instead of from banks. According to Chris Mahoney, a just-retired Moody's veteran of 22 years, ''The agencies went from being obscure and unimportant players to central ones.''
A Conflict of Interest?
Nothing sent the agencies into high gear as much as the development of structured finance. As Wall Street bankers designed ever more securitized products -- using mortgages, credit-card debt, car loans, corporate debt, every type of paper imaginable -- the agencies became truly powerful.
In structured-credit vehicles like Subprime XYZ, the agencies played a much more pivotal role than they had with (conventional) bonds. According to Lewis Ranieri, the Salomon Brothers banker who was a pioneer in mortgage bonds, ''The whole creation of mortgage securities was involved with a rating.''
What the bankers in these deals are really doing is buying a bunch of I.O.U.'s and repackaging them in a different form. Something has to make the package worth -- or seem to be worth -- more that the sum of its parts, otherwise there would be no point in packaging such securities, nor would there be any profits from which to pay the bankers' fees.
That something is the rating. Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails. As with a would-be immigrant traveling from Mexico, there is a huge incentive to get over the line.
The challenge to investment banks is to design securities that just meet the rating agencies' tests. Risky mortgages serve their purpose; since the interest rate on them is higher, more money comes into the pool and is available for paying bond interest. But if the mortgages are too risky, Moody's will object. Banks are adroit at working the system, and pools like Subprime XYZ are intentionally designed to include a layer of Baa bonds, or those just over the border. ''Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,'' a former Moody's expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, ''Gaming is the whole thing.''
When a bank proposes a rating structure on a pool of debt, the rating agency will insist on a cushion of extra capital, known as an ''enhancement.'' The bank inevitably lobbies for a thin cushion (the thinner the capitalization, the fatter the bank's profits). It's up to the agency to make sure that the cushion is big enough to safeguard the bonds. The process involves extended consultations between the agency and its client. In short, obtaining a rating is a collaborative process.
The evidence on whether rating agencies bend to the bankers' will is mixed. The agencies do not deny that a conflict exists, but they assert that they are keen to the dangers and minimize them. For instance, they do not reward analysts on the basis of whether they approve deals. No smoking gun, no conspiratorial e-mail message, has surfaced to suggest that they are lying. But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody's has thousands of clients (virtually every corporation and municipality that sells bonds). No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. A deal the size of XYZ can bring Moody's $200,000 and more for complicated deals. And the banks pay only if Moody's delivers the desired rating. Tom McGuire, the Jesuit theologian who ran Moody's through the mid-'90s, says this arrangement is unhealthy. If Moody's and a client bank don't see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as ''ratings shopping.''
And it seems to have helped the banks get better ratings. Mason, of Drexel University, compared default rates for corporate bonds rated Baa with those of similarly rated collateralized debt obligations until 2005 (before the bubble burst). Mason found that the C.D.O.'s defaulted eight times as often. One interpretation of the data is that Moody's was far less discerning when the client was a Wall Street securitizer.
After Enron blew up, Congress ordered the S.E.C. to look at the rating industry and possibly reform it. The S.E.C. ducked. Congress looked again in 2006 and enacted a law making it easier for competing agencies to gain official recognition, but didn't change the industry's business model. By then, the mortgage boom was in high gear. From 2002 to 2006, Moody's profits nearly tripled, mostly thanks to the high margins the agencies charged in structured finance. In 2006, Moody's reported net income of $750 million. Raymond W. McDaniel Jr., its chief executive, gloated in the annual report for that year, ''I firmly believe that Moody's business stands on the 'right side of history' in terms of the alignment of our role and function with advancements in global capital markets.''
Using Weather in Antarctica To Forecast Conditions in Hawaii
Even as McDaniel was crowing, it was clear in some corners of Wall Street that the mortgage market was headed for trouble. The housing industry was cooling off fast. James Kragenbring, a money manager with Advantus Capital Management, complained to the agencies as early as 2005 that their ratings were too generous. A report from the hedge fund of John Paulson proclaimed astonishment at ''the mispricing of these securities.'' He started betting that mortgage debt would crash.
Even Mark Zandi, the very visible economist at Moody's forecasting division (which is separate from the ratings side), was worried about the chilling crosswinds blowing in credit markets. In a report published in May 2006, he noted that consumer borrowing had soared, household debt was at a record and a fifth of such debt was classified as subprime. At the same time, loan officers were loosening underwriting standards and easing rates to offer still more loans. Zandi fretted about the ''razor-thin'' level of homeowners' equity, the avalanche of teaser mortgages and the $750 billion of mortgages he judged to be at risk. Zandi concluded, ''The environment feels increasingly ripe for some type of financial event.''
A month after Zandi's report, Moody's rated Subprime XYZ. The analyst on the deal also had concerns. Moody's was aware that mortgage standards had been deteriorating, and it had been demanding more of a cushion in such pools. Nonetheless, its credit-rating model continued to envision rising home values. Largely for that reason, the analyst forecast losses for XYZ at only 4.9 percent of the underlying mortgage pool. Since even the lowest-rated bonds in XYZ would be covered up to a loss level of 7.25 percent, the bonds seemed safe.
XYZ now became the responsibility of a Moody's team that monitors securities and changes the ratings if need be (the analyst moved on to rate a new deal). Almost immediately, the team noticed a problem. Usually, people who finance a home stay current on their payments for at least a while. But a sliver of folks in XYZfell behind within 90 days of signing their papers. After six months, an alarming 6 percent of the mortgages were seriously delinquent. (Historically, it is rare for more than 1 percent of mortgages at that stage to be delinquent.)
Moody's monitors began to make inquiries with the lender and were shocked by what they heard. Some properties lacked sod or landscaping, and keys remained in the mailbox; the buyers had never moved in. The implication was that people had bought homes on spec: as the housing market turned, the buyers walked.
By the spring of 2007, 13 percent of Subprime XYZ was delinquent -- and it was worsening by the month. XYZ was hardly atypical; the entire class of 2006 was performing terribly. (The class of 2007 would turn out to be even worse.)
In April 2007, Moody's announced it was revising the model it used to evaluate subprime mortgages. It noted that the model ''was first introduced in 2002. Since then, the mortgage market has evolved considerably.'' This was a rather stunning admission; its model had been based on a world that no longer existed.
Poring over the data, Moody's discovered that the size of people's first mortgages was no longer a good predictor of whether they would default; rather, it was the size of their first and second loans -- that is, their total debt -- combined. This was rather intuitive; Moody's simply hadn't reckoned on it. Similarly, credit scores, long a mainstay of its analyses, had not proved to be a ''strong predictor'' of defaults this time. Translation: even people with good credit scores were defaulting. Amy Tobey, leader of the team that monitored XYZ, told me, ''It seems there was a shift in mentality; people are treating homes as investment assets.'' Indeed. And homeowners without equity were making what economists call a rational choice; they were abandoning properties rather than make payments on them. Homeowners' equity had never been as high as believed because appraisals had been inflated.
Over the summer and fall of 2007, Moody's and the other agencies repeatedly tightened their methodology for rating mortgage securities, but it was too late. They had to downgrade tens of billions of dollars of securities. By early this year, when I met with Moody's, an astonishing 27 percent of the mortgage holders in Subprime XYZ were delinquent. Losses on the pool were now estimated at 14 percent to 16 percent -- three times the original estimate. Seemingly high-quality bonds rated A3 by Moody's had been downgraded five notches to Ba2, as had the other bonds in the pool aside from its triple-A's.
The pain didn't stop there. Many of the lower-rated bonds issued by XYZ, and by mortgage pools like it, were purchased by C.D.O.'s, the second-order mortgage vehicles, which were eager to buy lower-rated mortgage paper because it paid a higher yield. As the agencies endowed C.D.O. securities with triple-A ratings, demand for them was red hot. Much of it was from global investors who knew nothing about the U.S. mortgage market. In 2006 and 2007, the banks created more than $200 billion of C.D.O.'s backed by lower-rated mortgage paper. Moody's assigned a different team to rate C.D.O.'s. This team knew far less about the underlying mortgages than did the committee that evaluated Subprime XYZ. In fact, Moody's rated C.D.O.'s without knowing which bonds the pool would buy.
A C.D.O. operates like a mutual fund; it can buy or sell mortgage bonds and frequently does so. Thus, the agencies rate pools with assets that are perpetually shifting. They base their ratings on an extensive set of guidelines or covenants that limit the C.D.O. manager's discretion.
Late in 2006, Moody's rated a C.D.O. with $750 million worth of securities. The covenants, which act as a template, restricted the C.D.O. to, at most, an 80 percent exposure to subprime assets, and many other such conditions. ''We're structure experts,'' Yuri Yoshizawa, the head of Moody's' derivative group, explained. ''We're not underlying-asset experts.'' They were checking the math, not the mortgages. But no C.D.O. can be better than its collateral.
Moody's rated three-quarters of this C.D.O.'s bonds triple-A. The ratings were derived using a mathematical construct known as a Monte Carlo simulation -- as if each of the underlying bonds would perform like cards drawn at random from a deck of mortgage bonds in the past. There were two problems with this approach. First, the bonds weren't like those in the past; the mortgage market had changed. As Mark Adelson, a former managing director in Moody's structured-finance division, remarks, it was ''like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.'' And second, the bonds weren't random. Moody's had underestimated the extent to which underwriting standards had weakened everywhere. When one mortgage bond failed, the odds were that others would, too.
Moody's estimated that this C.D.O. could potentially incur losses of 2 percent. It has since revised its estimate to 27 percent. The bonds it rated have been decimated, their market value having plunged by half or more. A triple-A layer of bonds has been downgraded 16 notches, all the way to B. Hundreds of C.D.O.'s have suffered similar fates (most of Wall Street's losses have been on C.D.O.'s). For Moody's and the other rating agencies, it has been an extraordinary rout.
Whom Can We Rely On?
The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate. This is what they pledge for the future. Moody's, S.&P. and Fitch say that they are tightening procedures -- they will demand more data and more verification and will subject their analysts to more outside checks. None of this, however, will remove the conflict of interest in the issuer-pays model. Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether.
Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves -- not farm the job out to Moody's. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less. Moody's itself favors doing away with the official designation, and it, like S.&P., embraces the idea that investors should not ''rely'' on ratings for buy-and-sell decisions.
This leaves an awkward question, with respect to insanely complex structured securities: What can they rely on? The agencies seem utterly too involved to serve as a neutral arbiter, and the banks are sure to invent new and equally hard-to-assess vehicles in the future. Vickie Tillman, the executive vice president of S.&P., told Congress last fall that in addition to the housing slump, ''ahistorical behavorial modes'' by homeowners were to blame for the wave of downgrades. She cited S.&P.'s data going back to the 1970s, as if consumers were at fault for not living up to the past. The real problem is that the agencies' mathematical formulas look backward while life is lived forward. That is unlikely to change.
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