Toward a More Perfect Substitute: How Pressure on the Issuers of Private-Label Mortgage-Backed Securities Can Improve the Accuracy of Ratings

Abstract

From 2000 to 2007, individuals, institutions, and pension funds rushed to invest in private-label mortgage-backed securities (MBS). They were attracted by reasonable returns and what they perceived to be very little risk. They were encouraged by agency ratings — incorporated into the offering documents — that rated each MBS as investment grade, often AAA.

With the beginning of the 2008 financial crisis, these same investors watched as their investments were downgraded to junk status, CCC or worse. They sought redress against the issuers under Section 11 of the Securities Act of 1933, which allows a harmed investor to recover damages where a registration statement contained an untrue statement of a material fact. Unfortunately — one after another — their lawsuits were dismissed on the grounds that the ratings were not a material fact. Such reasoning defies reality. Ratings were the primary indicator of risk that investors considered in making their investment decision.

This Article proposes a novel solution. Where a harmed investor brings a cause of action pursuant to Section 11 of the Securities Act of 1933 against a private-label MBS issuer, based upon an allegation that the registration statement contained an inaccurate rating, the burden should shift to the issuer to establish (1) that the loss model used was state-of-the-art, and (2) all inputs were correct and up-to-date. If the issuer fails to meet this burden, then the plaintiff will have established a material misstatement, satisfying the most troublesome element of a Section 11 claim. In addition to allowing harmed investors an avenue for recovery, this Article’s proposal will also lead to better disclosure. Once private-label MBS issuers are liable for inaccurate ratings contained within MBS offering documents, they will choose rating agencies with a reputation for accuracy (not rating agencies with the reputation for giving the highest rating). This reputational pressure will lead to an improvement in loss models and inputs. Finally, the advantage of this proposal is that it allows investors an avenue to recovery, but with minimal government intervention, at least as compared to the new Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, which freezes out private-label MBS issuers in favor of agency issuers like Fannie Mae and Freddie Mac.

Keywords: MBS, RMBS, mortgage-backed, asset-backed, securities, securitization, mortgage, Section 11, material, rating agency, ratings, Securities Act of 1933, Dodd-Frank, rating model, rating input, loan-level data, macroeconomic, material misstatement, registration, prospectus

JEL Classification: K20, K22, G21, G28, N22