Tuesday, March 11, 2008

S&P and Moody's avoid cutting AAA subprime ratings

(Naked Capitalism) 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 feed. 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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