Agencies Review Subprime Rating Practices

As the subprime crisis spreads to the bond insurers, the big bond rating agencies are conducting internal reviews of their practices to determine what caused them to miss one of the biggest financial debacles in years, sources tell CNBC.

The findings of the assessment are not complete. But here is a snapshot of why the agencies maintained the AAA rating on collatoral debt obligations (CDOs). In doing so, they failed to recognize the bond insurer's exposure of these risky securities.

It's hard to come up with a percentage, but a picture is emerging of the average subprime borrower as being someone with absolutely no clue about the type of loan they were taking out, when interest payments might kick in, and at what levels. FICO scores, a measure of credit risk, were not predictive. This means that many mortgage lenders must have lied about the ability of borrowers to pay.

Of all subprime loans that go into foreclosure, banks can only recover 30% of the loan. This shows that the appraised values of home purchased with subprime loans was unrealistic.

The rating agencies relied on the inaccurate statistics without questioning the underlying data. In the past the raters would say they were at fault for missing a debacle like Enron because of the alleged fraud of Skilling, Fastow etc. However, agencies now recognize that they should have scrutinized the underlying data of the subprime market more closely, particularly the historical anomaly of a housing boom that lasted so long.

By misreading the CDO market, rating agencies basically ignored the growing exposure to CDOs on behalf of the bond insurers. By their calculations the CDOs were triple-A securities. Raters didn't force MBIA and Ambac to hold increased capital against their CDO holdings even when the housing market started to implode. Missing the CDO meltdown as well as missing the bond insurers exposure to the warped securities was a double whammy for raters

Moody's and S&P are now afraid to downgrade insurers. A downgrade will force Ambac and MBIA -- the two most troubled insurers -- to increase capital requirements to keep their triple A rating. If they are unable to do so, they will lose the rating and will likely go out of business. According to sources, rating agencies would rather wait for a bailout of bond insurers to occur first, and then assess the damage.

-- Reported by Charles Gasparino, Written by