Rapp & Matasar on Potential Rating Agency Liability & subprime backed-securities

Rating agencies assigned credit ratings to subprime Residential Mortgage-Backed Securities (RMBS) and Collateralized Debt Obligations (CDOs). In making investment decisions, many investors relied on these credit ratings. However, the accuracy and integrity of these ratings have come under question, and because of this, the rating agencies could be liable for investment losses. In this Commentary, Robert N. Rapp and Scott C. Matasar discuss subprime RMBS and CDOs and analyze rating agency liability for RMBS and CDO losses. They write:
     The [July 2008] SEC Staff Report addressed underlying rating agency concerns not only in terms of information failures, but also as to conflicts of interest in the rating process. The report does not address rating agencies culpability for information failures in offerings, but it does address emergent facts that will ultimately bear on that determination. In addition to conflicts of interest, these include indications that rating agencies did not conduct adequate due diligence; failed to establish well-defined procedures; did not disclose relevant ratings criteria; and knowingly deviated from or overrode established methodologies and procedures, all without making any public disclosure, in order to assign higher ratings.
     RMBS and CDOs are "structured" securities that offer tranched pools of credit risk exposure. For RMBS the tranches are all based on the same underlying pool of mortgage loans. CDOs, although structured the same way, are based on a managed, or potentially changing, pool of debt securities that in the current environment most often consist of subprime RMBS or their derivatives most commonly "credit default swaps." CDOs may package multiple RMBS, the result being further securitization of several already securitized pools of mortgages or other debt instruments. The securities are structured in a laddered or "waterfall" manner, such that the default risk of any one tranche is determined by the amount of risk borne by, i.e., the extent to which losses are absorbed by, the tranches below.
     Rating agencies make credit risk assessments of the assets and collateral of RMBS and CDOs, and assign alphanumeric ratings to tranches that form the structure of such offerings. Appreciating the role that rating agencies play requires little more than recognizing that in the structure of subprime RBMS and CDOs, even where a AAA or equivalent high credit risk rating is assigned to the senior tranche in the structure, the rating is actually derived from mortgages that by definition involve borrowers with poor credit and who present a higher risk of delinquency and default.
(footnotes omitted)

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