Tuesday, March 25, 2008

Fitch repeats subprime error?

(Naked Capitalism) Saying bad things about rating agencies may seem like beating a dead horse, except this horse is still very much alive. Even though by some measures Fitch has comported itself better than Moody's and S&P (it downgraded Ambac to AA and was early to point out excesses in commercial real estate lending), it has shown itself to be very much like its peers in other ways.

This little piece today from Research Recap was a reminder of why ratings are held in less than high esteem:
The U.S. unemployment rate would need to quadruple to 20% to have a major negative ratings impact on AAA-rated securities backed by credit card and auto debt, according to Fitch Research.

In a new report, Fitch analyzes the historical relationship between changes in the unemployment rate and changes in U.S. consumer ABS loss rates. Fitch’s forecast is for unemployment to increase steadily to the 5.5% range by year end.

According to analysis, increases in the unemployment rate are expected to cause auto loan and credit card loss rates to increase proportionally with subprime assets experiencing the highest proportional rate. For example, prime credit card chargeoffs should increase on a 1:1 basis. Accordingly, a 100% increase in the current unemployment rate, from 4.8% to 9.6%, would lead up to a 100% increase in current prime credit card chargeoffs, from 5.6% to 11.2%. For subprime credit cards and auto loans the proportional increase is closer to 1.3:1 meaning a 100% increase in unemployment would lead up to a 130% increase in chargeoffs or losses.

Based on this analysis, unemployment in isolation would have to increase, from 4.8% to more than 20% in order to cause a first dollar loss to typical ‘AAA’ rated credit card and auto transactions. Typical ‘BBB’ securities could withstand an increase in the unemployment rate to more than 9% for auto transactions and close to 11% for credit card transactions.
Consumer ABS transactions rated ‘AAA’ can withstand unemployment stresses to levels not seen since the Great Depression.

Fitch stated in February that it expects collateral performance to decline steadily throughout 2008 in the credit card receivable and auto loan assets. However, Fitch believes that the credit enhancement and structural features of the transactions are sufficient to stave off widespread negative rating actions in those sectors.

Now Fitch may turn out to be right (in part because unemployment levels will hopefully not even get close to the 20% level to test their thesis), but this so-called analysis is pretty dubious. I'll admit I did not read the entire report, but it is only 656 words, so there imuch to it.

Let's look at the methodology: it looks at the "historical relationship" between unemployment and ABS losses, and then claims that loss rates on auto loans, credit cards, and subprime should all move proportionally. That is, if subprime loss rates double, credit card loss rates will double (remember credit card loss rates are lower than subprime loss rates).

Now that may turn out to be a good assumption, but to call it anything more than that is intellectually dishonest. Why? Remember, recent subprimes bear no resemblance to historical subprimes; that's how the industry botched up so badly in the first place. Subprime pre 2000 were for the purchase of largely manufactures housing; as probably every reader knows, the more recent subprimes got dodgier and dodgies, with a sharp deterioration in issuance standards starting in 2005.

In addition, the old subprimes have only endured one business downturn (the tech wreck slowdown) and this one is almost certain to be more severe.

Similarly, the credit card industry has been generous in extending credit to weak borrowers, particularly with the use of low interest rates and balance transfers. Thus, the level of unsecured credit (which can be discharged in a Chapter 7 bankruptcy) could now be proportionally greater than in past cycles.

Again, the conclusion may be correct, but naively projecting out trend lines is exactly what created the housing market mess. The rating agencies seem either incapable of or unwilling to learn from their mistakes.

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