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Written by Bill Harrington
January 16, 2018
At the nexus of complex finance, poor regulatory oversight, and predatory practices regarding lending and debt servicing, inflated credit ratings played a critical role in enabling the mortgage meltdown a decade ago. With little reform of the ratings industry’s embedded conflicts of interest, similar problems of overinflated ratings have largely persisted since the financial crisis. Could the recent downgrade by Moody’s Investors Service (Moody’s) of bonds in nine complex deals that are backed by US student loans herald a welcome change in the assessment of complexly structured asset-backed securities (ABS)? As a former industry insider, I remain skeptical, but let’s hope the trend toward more sober assessments of undercapitalized ABS continues during 2018.
The Moody’s downgrades of 11 January address an extremely complicated financial contract that is embedded in each of the nine student loan ABS (SLABS) deals. This type of financial contract — “an ABS flip clause swap” — was a key feature of many of the ABS deals that ignited and fueled the financial crisis. As the student debt crisis continues with default rates hovering over 10 percent, SLABS are now exhibiting features eerily reminiscent of mortgage-backed securities during the housing crisis.
Navient Corporation (Navient), the large student loan company, sponsored seven of the nine deals with SLABS that Moody’s downgraded. Moreover, Navient is the sponsor of another 35 deals with SLABS that Moody’s did not downgrade but which also have an ABS flip clause swap that require similar scrutiny.
(For all 44 Navient SLABS deals with an ABS flip clause swap, please see my submission to the US Commodity Futures Trading Commission, “Capital Requirements for Swap Dealers and Major Swap Participants,” 4 May 2017. Pages 11-12 contain the Navient deals with ABS flip clause swaps as well as details on each swap.)
Navient owns the respective tail pieces or “residual positions” of its SLABS deals and counts the residual positions as assets on its balance sheet. For this reason, Moody’s should, if it intends to do its job correctly, now review the financial health of Navient itself.
So, too should other credit rating agencies (such as Fitch and S&P Global), other evaluation firms such as those that follow Navient stock (NAVI), and Navient auditors review the financial health of Navient in light of these downgrades.
My advocacy has focused on helping bring about exactly this type of outcome — namely, holding companies accountable for the continued use of crisis-era financing techniques. I resigned as the Moody’s senior vice president for ABS flip clause swaps in July 2010 to continue my independent evaluation of these swaps without the management pressures to go easy on rated companies that continue to plague the credit rating industry.
With support from colleagues at Wikirating.org, my work has pressured senior managers at Moody’s to begin to take a fresh look at the most egregious ABS flip clause swaps. This is a welcome change, but as I have highlighted in the past, bringing an end to inflated credit ratings is ultimately the responsibility of Moody’s most senior corporate leadership, including CEO Ray McDaniel, and Moody’s regulators such as the US Securities and Exchange Commission and the European Securities and Markets Authority.
10 years on from the financial crisis, making finance more sustainable means starting at the top.