Moody’s and S&P Avoid Cutting Ratings on AAA Subprime

A kind reader Tim e-mailed me this Bloomberg story, which apparently is only up on the professional version (yes, I am a member of the great unwashed who lacks a Bloomberg . Now you know what to get me for Christmas). I’ll add a proper link once it migrates over.

The rating agencies have taken some steps to show a new toughmindedness. Standard & Poor’s announced with some fanfare in January that they were going to either downgrade or put on negative watch $534 billion of debt. S&P was also so kind as to estimate that these moves could increase bank losses, now at roughly $130 billion, to $265 billion.

A week later, S&P announced some internal changes in an effort to bolster its damaged reputation. These moves seemed a bit late in coming, given the firestorm of well-deserved criticism aimed at rating agencies. Indeed, the timing was a bit sus, as they would say in Australia, coming only as international regulators are considering how to improve rating agency conduct. The decision to issue the press release now could be viewed as an effort to take the wind out the sails of the International Organization of Securities Commissions plans to implement a code of conduct.

The Bloomberg story confirms our cynicism about the S&P’s and Moody’s. It reports that the rating agencies have held back from downgrading AAA subprime related securities.

Why is this important? In most deals, roughly 80% is of the value of the transaction was in the AAA tranches. These are far and away the most important in terms of economic value. But, not surprisingly, many of the buyers of this paper did so because they had portfolio constraints or capital requirements that made top-rated instruments particularly desirable. Thus in many cases, downgrades of this paper would have a pronounced impact, leading in many cases to sales, depressing prices.

As with the monoline insurer fiasco, the rating agencies give critics more evidence that their grades are a sham, dictated by political considerations instead of economic reality. Some sources for the story expect ratings to be lowered in six weeks. I wouldn’t hold my breath.

From Bloomberg:

Even after downgrading almost 10,000 subprime-mortgage bonds, Standard & Poor’s and Moody’s Investors Service haven’t cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments.

None of the 80 AAA securities in ABX indexes that track subprime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg. A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.

Sticking to the rules would strip at least $120 billion in bonds of their AAA status, extending the pain of a mortgage crisis that’s triggered $188 billion in writedowns for the world’s largest financial firms. AAA debt fell as low as 61 cents on the dollar after record home foreclosures and a decline to AA may push the value of the debt to 26 cents, according to Credit Suisse Group.

“The fact that they’ve kept those ratings where they are is laughable,” said Kyle Bass, chief executive officer of Hayman Capital Partners, a Dallas-based hedge fund that made $500 million last year betting lower-rated subprime-mortgage bonds would decline in value. “Downgrades of AAA and AA bonds are imminent, and they’re going to be significant.”

Bass estimates most of AAA subprime bonds in the ABX indexes will be cut by an average of six or seven levels within six weeks.

The 20 ABX indexes are the only public source of prices on debt tied to home loans that were made to subprime borrowers with poor credit histories. About $650 billion of subprime bonds are still outstanding, according to Deutsche Bank. About 75 percent were rated AAA at issuance…..

S&P and Moody’s, the two biggest rating companies, are lagging behind Fitch Ratings, their smaller competitor….

The ratings methods balance estimated losses against so-called credit support, a measure of how likely it is that owners of each piece of the bond will incur losses. For AAA rated debt, credit support needs to be five times the expected losses, according to Sylvain Raynes, author of The Analysis of Structured Securities, a college textbook.

All but six of the 80 AAA ABX bonds failed an S&P test for investment-grade status, which requires credit support to be twice the percentage of troubled collateral. The guideline was one of four tests used by S&P, and a failure to meet the standard wouldn’t have automatically resulted in a downgrade. The other companies used similar metrics to grade bonds, Raynes
said. Investment grade refers to all bonds rated above BBB- by S&P and Baa3 by Moody’s….

On a $118 million Washington Mutual bond issued in 2007, WMHE 2007-HE2 2A4, 5.6 percent of its loans are in foreclosure
and its safety margin, or the debt available to absorb losses, is less than the combined total of its loans at risk. Both S&P
and Moody’s rate it AAA.

Fitch rates that bond B, five levels below investment grade and 15 levels less than its rivals….

The problem extends past the mortgage bonds. Financial firms own high-grade collateralized debt obligations, which package securities such as mortgage bonds and slice them into pieces with varying risk. As the underlying mortgage bonds are downgraded, those securities will also lose their ratings and tumble in value.

A bank would have to increase its capital against $100 million of bonds to $16 million from $1.6 million if a bond was downgraded to below investment grade from AAA, under global accounting rules…..

Bond insurers such as MBIA Inc. and Ambac Financial Group Inc. also have to hold more capital against insurance they write
if the securities’ credit quality declines.

The prospect of losses may be holding the ratings companies back, said Frank Partnoy, a University of San Diego law professor and former Morgan Stanley banker who has been writing about the impact of credit ratings companies since 1997.

“If the 800-pound gorilla moves, it’s going to crush someone, so it’s not going to want to move,” Partnoy said. “They know they will trigger a price collapse. They are understandably reluctant.”

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15 comments

  1. Anonymous

    What we need here is for some public spirited folks to put together a website with photos of the executives and managers at Moody’s and S&P. With just a bit of help from those firms, visitors to the website could also arrange phone calls or other interactions — say, with time frames of anywhere from 5 minutes to an hour and prices ranging from, say, 1 to 5 million dollars.

    We could call the website “The Emperors Without Clothes Club”

  2. barbadkatte

    Here is the advantage in not downgrading

    from

    The Federal Reserve announced today an expansion of its securities lending program. Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label residential MBS.

  3. Paul Amery

    What haircut will the Fed be charging on these private-label “AAA” bonds?

    The Markit ABX-HE-AAA 07-2 index is trading at 52 cents in the dollar.

  4. Anonymous

    Here’s the updated public link:

    Great article that, as you say, demonstrates the hypocrisy of the so-called “independent” rating agencies. More of a “you cover my tail, I’ll cover yours.”

  5. Francois

    The writing is on the wall; short Moody’s and S&P, buy Fitch.

    These clowns are going to pay a very dear price for these scams; no trust, no biz.

  6. Anonymous

    Bloomberg journalism is so misleading and incorrect it hurts my brain. Moody’s and S&P are completely inept but their effect on the market is much smaller than it used to be.

    The market stopped pricing bonds to their credit rating many months ago. The implication that reratings will cause a repricing to true value is incorrect, this repricing has been taking place since the summer. As Paul points out 07-1 AAA is already priced at 52, cash bonds are going to be marked to the same level. The importance of ratings isn’t mentioned until the end of the article, its effect on capital requirements. This is a real problem as it will cause forced selling and more capital strain but the discussion here is very weak.

    The reporter clearly doesn’t understand ratings methodology, neither its current overstated form or a hypothetical correct application. Investment grade criteria are not and should not be credit support = 2 * troubled collateral. A simple example is a AAA bond with 90% credit support and 50% “troubled collateral”. That bond fails the quoted test but in reality it is as AAA as can be. To take a loss 100% of the collateral will need to default with a loss severity of more than 90%. Loss severities in the subprime wasteland are only running at 50%. That AAA bond is pretty attractive since it gets paid down with 10% prepays or 20% defaults, recoveries are applied just like principal payments to the top of the capital structure.

    As for Paul’s question haircuts will probably be similiar to the discount window. 8% for AAA 10 yr duration private label mortgages

  7. Anonymous

    One more note, only AAA bonds that are not on review for the Fed program so the ABX 07-1 constituents won’t be eligible.

  8. Anonymous

    Regarding the earlier comment of someone about AAA passing the test:

    First, AAA’s on home equity deals did not have 90% credit support. 15-20% credit support was more typical until late 2007.

    Second, market prices show that AA tranches are not likely to get paid and AAA tranches will likely lose some principal.

    Third, when the market is discussing how many pennies it will get on the dollar on an investment, AAA rating is obviously meaningless.

  9. Anonymous

    Bloomberg has PULLED the article and replaced the links with an article on Moody’s and S&P missing profit forecasts!

    Feels like 1984! Rewriting the news to suit. Graph gone. Article gone. Try it. It’s been “Updated”.

  10. Mark

    Bloomberg allows finance workers who happen to be “between jobs” to use Bloomberg at home. Yves, if you know any such people, ask if you could rent the Bloomberg software from them…

  11. Jim M

    Now we know why. The Fed is buying “AAA” paper through the new facility announced today. Yay! Everybody still gets a Maybach bonus!

  12. Anonymous

    “First, AAA’s on home equity deals did not have 90% credit support. 15-20% credit support was more typical until late 2007.”

    I never said they did. This is true but as deals season they delever (or used to anyway). The Bloomberg article misleadingly applies this ratings test to seasoned deals in the ABX. My example was an exaggeration but similiar cases appear in the BBerg analysis. They highlight LMBLT 05-WL2 3A4 as not deserving a AAA rating despite 62.5% CE and 32.8% 90+ DQ. I didn’t even mention the fact that they make the mistake of saying “investment grade” is the same thing as “AAA”.

    “Second, market prices show that AA tranches are not likely to get paid and AAA tranches will likely lose some principal.

    Third, when the market is discussing how many pennies it will get on the dollar on an investment, AAA rating is obviously meaningless.”

    I agree with both of these. Since I read the article BBerg actually toned down the article quite a bit, the first version had many more errors than the current one.

  13. Anonymous

    I am not a lawyer, but isn’t this financial fraud? Shouldn’t somebody be doing the perp walk?

  14. Anonymous

    “A simple example is a AAA bond with 90% credit support and 50% “troubled collateral”. That bond fails the quoted test but in reality it is as AAA as can be.”

    Sir, you seem to overlook the fact that AAA rating should imply a very low expected loss. The loss magnitude and distribution of AAA rated securities historically has been very low. For example the average annual default rate for AAA rated debt by corporate issuers from 1990 to 2001 was 0.00% according to Fitch.

  15. Yves Smith

    I’m also not certain re the 50% loss severity stat (it obviously varies by market). A large scale study of loans originated from 2000 through 2004 found that loss severity was highly correlated with home price appreciation. 15% appreciation lead to loss severity of 1%. at a mere 3% HPA, loss severity was 60%.

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