Monday, December 31, 2007

Long paper on credit agencies like Moody's

Voltron says: The author is a jerk who wrote an "expose" on Morgan Stanley titled F.I.A.S.C.O. He makes some good points though. Executive summary: The three ratings agencies are an government sanctioned oligopoly that hides behind free speech to profit from perpetuating the con of CDOs.

Would you trust your retirement to MBIA?

By Reggie Middleton for Seeking Alpha

Okay folks, it's official! According to Moody's, you can now put your retirement portfolio in Ambac (ABK) bonds in addition to those boring Treasuries, because it is just as safe - AAA safe!

Sunday, December 30, 2007

Robert Shiller is right

Times Online Logo 222 x 25

December 31, 2007

Top economist says America could plunge into recession

Losses arising from America’s housing recession could triple over the next few years and they represent the greatest threat to growth in the United States, one of the world’s leading economists has told The Times.

Robert Shiller, Professor of Economics at Yale University, predicted that there was a very real possibility that the US would be plunged into a Japan-style slump, with house prices declining for years.

Professor Shiller, co-founder of the respected S&P Case/Shiller house-price index, said: “American real estate values have already lost around $1 trillion [£503 billion]. That could easily increase threefold over the next few years. This is a much bigger issue than sub-prime. We are talking trillions of dollars’ worth of losses.”

He said that US futures markets had priced in further declines in house prices in the short term, with contracts on the S&P Shiller index pointing to decreases of up to 14 per cent.

“Over the next five years, the futures contracts are pointing to losses of around 35 per cent in some areas, such as Florida, California and Las Vegas. There is a good chance that this housing recession will go on for years,” he said.

Professor Shiller, author of Irrational Exuberance, a phrase later used by Alan Greenspan, the former Federal Reserve chairman, said: “This is a classic bubble scenario. A few years ago house prices got very high, pushed up because of investor expectations. Americans have fuelled the myth that prices would never fall, that values could only go up. People believed the story. Now there is a very real chance of a big recession.”

He pointed out that signs at the beginning of 2007 that had indicated that some states were beginning to experience a recovery in house prices had proved to be false: “States such as Massachusetts had seen some increases at the beginning of the year. Denver also looked like it had a different path. Now all states are falling.”

Until two years ago, each of America’s 50 states had experienced a prolonged housing boom, with properties in some – such as Florida, California, Arizona and Nevada – doubling in price, fuelled by cheap credit and lax lending practices to borrowers who ordinarily would not have been able to secure a mortgage. Two years ago, the northeastern states of America became the first to slide into a recession after 17 successive interest-rate rises between June 2004 and August 2006 hit the property market.

Last week, new numbers from the S&P/Case Shiller index showed that house prices had declined in October at their fastest rate for more than six years, with homes in Miami losing 12 per cent of their value.

Saturday, December 29, 2007

Buffett giveth and Buffett taketh away

The Wall Street Journal

December 29, 2007

Bond Insurers Brace for Buffett

Market's Major Players
Already Under Pressure
From Mortgage Fiasco
December 29, 2007; Page B3

Bond insurers put on a brave face in welcoming a new rival backed by Warren Buffett, even as investors dumped their shares on fears that a well-financed competitor would cripple their beleaguered business.

[Warren Buffett]

The Wall Street Journal reported1 Friday that Mr. Buffett, chairman of Omaha, Neb.-based Berkshire Hathaway Inc., has set up Berkshire Hathaway Assurance Corp. to sell insurance to cities, counties and municipalities seeking to sell bonds to finance public projects. That puts Berkshire in direct competition with some of the nation's biggest bond insurers, such as Ambac Financial Corp. and MBIA Inc. These companies' stocks have been pummeled in recent weeks on fears they will lose their coveted triple-A ratings because of exposure to mortgage-related bonds.

With Berkshire, which is well-capitalized and carries a triple-A rating, entering the business, the market position of incumbent insurers could be threatened. Shares of MBIA Inc., the nation's biggest bond insurer, were down 15.9% to $18.74 in 4 p.m. composite trading on the New York Stock Exchange. For the year, they are down 74%. Shares of rival Ambac Financial Corp. were off 13.8% at $25.12, and down 72% this year.

Nevertheless, officials from the incumbent insurers urged investors to look at the silver lining. Mr. Buffett's entry "is a significant validation of the valuable role our industry plays in helping public entities issue debt," said Willard Hill, chief marketing officer for MBIA.

Brian Moore, head of investor relations at Financial Guaranty Insurance Corp., a private bond insurer, said the new rival "highlights the fundamental strengths of the market place."

[MBIA stock chart]

Some analysts said the Berkshire bond-insurer, which will guarantee the interest and principal of only U.S. municipal bonds, won't take enough share to hurt the incumbents because the size of the market is so large. Ambac and MBIA insure a combined $700 billion in municipal debt, while Mr. Buffett's new venture is currently capitalized to write about $16 billion in new business, according to Steve Stelmach, an analyst at FBR Research.

Mr. Buffett told The Wall Street Journal he intends to commit "quite a bit of capital" to the business if it proves successful. Also, unlike the other bond insurers, Mr. Buffett's company won't insure structured-finance products such as collateralized debt obligations or any asset-backed securities, which require more capital. Such business comprises as much as half of the revenue for the other bond insurers and has carried much of the risk that has imperiled their credit ratings.

Separately, Berkshire reached a deal to buy a reinsurer from Dutch financial-services giant ING for $433 million.

--Steve Goldstein contributed to this article.

Write to Karen Richardson at karen.richardson@wsj.com2

Wednesday, December 26, 2007


Voltron says: If you believe this argument, I have a bridge to sell you.

Ambac, MBIA Might Be `Buys' for the Few, the Brave: Joe Mysak

Commentary by Joe Mysak

Dec. 26 (Bloomberg) -- Buy the bond insurers.

That's a distinctly contrarian view, sure, especially after the year the bond insurers have had. Their fairly recent forays into subprime mortgages have put them in danger of losing their AAA ratings, which is what their business is based upon.

Yet if you look past the headlines, and the accompanying hysteria, maybe things are about to look up. The stocks of Ambac Financial Group Inc. and MBIA Inc., which both lost about 70 percent of their value the past three months, are showing up on some securities firms' lists of buy recommendations.

I wouldn't be putting my retirement nest egg into Ambac and MBIA stock, and if the last few years have taught us anything, it's that we shouldn't listen to the buy recommendations of Wall Street analysts or trust the companies that sell ratings. But at some point, someone is going to figure that the stocks are at least worth a speculation.

We know what's happened to the bond insurers. Most of it seemed to have taken place in the past fortnight, as the rating companies, with whom the future of the insurers is inextricably linked, announced the results of their reassessments of the guarantors.

Moody's Investors Service said it might downgrade FGIC Corp., and changed its outlook on MBIA to negative. Standard & Poor's Corp. cut the rating on ACA Financial Guaranty Corp. to CCC from A, lowered its outlooks on Ambac and MBIA, and was reviewing FGIC for a possible downgrade. Fitch Ratings said that Ambac, MBIA and FGIC all needed to raise more capital.

Money for Sale

That's it? The rating companies have given the financial guarantors a big, fat holiday gift, in the form of more time, and that's the most precious gift of all.

So that's the past. What's ahead for the financial guarantors? What's next?

They need to raise capital to avoid losing their AAA ratings. Make that billions of dollars, not tens of billions. And you know what? You can get anything for a price, and money is no exception, so I suspect that the insurers will get what they need. Current management may be sent packing, and staffs may be cut, but that's the price of survival.

The amazing thing about these insurers is that they could, if need be, close down, and still remain viable, going concerns. That is, they could stop doing new business, and because of the annuitant nature of their earnings, still make money.

All About Time

When it comes to the bond insurers, it's all about time.

The insurers are paid a premium upfront, but they only recognize earnings over time, as the bonds they insure mature. Think about it this way: Say the insurer is paid a $100 premium to insure some bonds for 10 years. The insurer has to put the premium aside, and earns only $10 a year.

The exception is if the issuer decides, let's say in three years, to refinance the bonds. Then the insurer can take the big gulp and the remaining $70. This is very simplified, but that's the model.

Remember, too, that the insurers make the regularly scheduled debt-service payments on bonds that default. They don't accelerate payment. If your 10-year bond goes into default, you don't get 100 percent of your money back right away. You get what you are owed over the next 10 years, while the insurer pursues remedies to the default.

They Love It

Is the bond insurance business going to go away?

I don't think so. The new management may decide that certain very profitable lines of business just aren't worth the trouble, but it doesn't look as if municipal bond issuers, underwriters or investors are willing to give up on the product.

Issuers like insurance because it lowers their borrowing costs -- or is supposed to. Whether it actually has in recent weeks, I have my doubts. Investors like insurance because it brings them peace of mind. Underwriters like insurance because it makes municipal bonds, which are particular and specific to a remarkable degree, into a commodity, and so easier to sell.

I kept looking for signs that this would change, but even in the midst of a barrage of bad news, almost half of the number of issues were being insured, and not only by FSA, the only guarantor not tainted by the subprime mess, but also by the ones that were most implicated: Ambac, MBIA and FGIC. The dollar volume that was insured declined a bit, but the number of issues, which usually runs around 50 percent, remained about the same.

It looks like one of the big stories of 2008 may be the survival of the bond insurers.

(Joe Mysak is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Joe Mysak in New York at

Last Updated: December 26, 2007 00:24 EST

Monday, December 24, 2007

December 21, 2007

Not Your Father's Deflation
by Peter Schiff

Among those rational enough to perceive the looming economic downturn, a heated debate has arisen that centers on whether the slowdown will be accompanied by inflation or deflation.

Those in the deflation camp believe that money supply will collapse as a natural consequence of the implosion of the biggest credit bubble in U.S. history. As loans go bad, assets, which collateralize these loans, will be sold at fire sale prices to satisfy creditors. It is also argued that a recession will reduce consumer discretionary spending, causing retailers to slash prices to move their bloated inventories. This is the way the situation played out in the 1930's and this is how many expect it to happen today.

However there are several key differences between then and now, which argue against the classic deflationary scenario. In particular, the Fed's ability to pump liquidity into the market in the 1930's was limited by the gold backing requirements on U.S. currency. No such limitations exist today. This distinction is critical. When credit was destroyed after the Crash of 1929, the Fed was not able to simply replace it out of thin air. Today however, the Fed will likely print as much money as necessary to prevent nominal prices from collapsing. In fact, in the infamous speech that spawned his "helicopter" sobriquet, Ben Bernanke explained how the printing press can be used to stop deflation dead in its tracks.

To fully understand the way inflation and deflation affect prices, we need to differentiate between assets, such as stocks and real estate, and consumer goods, such as shoes and potato chips. If we measure prices in gold, as we did during the 1930's, both asset and consumer goods prices will fall, with the former falling faster than the latter. So in that sense the deflationist are correct. However, in terms of today's paper dollars, this outcome is completely impossible. During deflation, money gains value, so prices naturally fall as fewer monetary units are required to buy a given quantity of goods. In the coming deflation, real money (gold) will gain considerable value, so prices will therefore fall sharply in gold terms. Paper dollars however, which have no intrinsic value at all, will lose value, not only as the Fed increases their supply, but as global demand for the currency implodes.

The way I see it there are only two possible scenarios. The more benign outcome would we be one where asset prices fall, even in terms of paper dollars, but consumer goods prices continue to rise. This would be the stagflation scenario. The more catastrophic scenario is one where asset prices hold steady or even resume their ascent, while consumer goods prices rise even faster. This of course is the hyper-inflation scenario, and is the worst possible outcome. I see no possible scenario where consumer goods prices fall in term of paper dollars.

Many mistakenly believe that when the U.S. economy falls into recession, reduced domestic demand will lead to falling consumer prices. However, what is often overlooked is the fact that as the dollar loses value, the rising relative values of foreign currencies will increase consumer demand abroad. As fewer foreign-made products are imported and more domestic-made products are exported, the result will be far fewer products available for Americans to consume. So even if the domestic money supply were to contract, the supply of goods for sale would contract even faster. Shrinking supply will be a major factor in pushing consumer prices higher in America.

In addition, since trillions of dollars now reside with our foreign creditors, even if many of these dollars are lost due to defaulted loans, those that are not will be used to buy up American consumer goods and assets. As a result of this huge influx of foreign-held dollars, the domestic dollar supply will likely rise even if the Fed were to allow the global supply of dollars to contract, forcing consumer prices even higher. In fact, a contraction in the domestic supply of consumer goods will likely coincide with an expansion of the domestic supply of money. The result will be much higher consumer prices despite the recession. So even though Americans will consume much less, they will pay much more for the privilege.

The real risk of course is that the Fed gets more aggressive as it realizes that the additional credit it is supplying is not flowing where it wants. If the Fed drops enough money from helicopters it will eventually reverse the nominal declines in asset prices. Unfortunately, that road leads to hyper-inflation and disaster. No matter what, even if the Fed succeeds in propping up nominal asset prices, they can do nothing to sustain their real values. Consumer goods prices will always rise faster, leaving the owners of those assets poorer no matter how high their nominal values climb.

The big problem politically is that hyper-inflation may superficially appear to be the lesser evil. If asset prices are allowed to collapse, ownership of those assets will pass to our creditors. If instead we repay our debts with debased currency, we retain ownership of our assets and shift the losses to our creditors. Since American debtors can vote in U.S. elections and foreign creditors can not, the choice seems obvious. Of course there are some American creditors as well, but since they comprise such a small percentage of the electorate, my guess is that their losses will be seen as acceptable collateral damage.

Saturday, December 22, 2007

Moody's franchise is eroding

Egan-Jones says it wins status as ratings agency

SEC decision creates competitor for S&P, Moody's, Fitch

SAN FRANCISCO (MarketWatch) -- Egan-Jones Ratings said late Friday that the Securities and Exchange Commission has granted the firm status as an official ratings agency, providing more competition for firms like Standard & Poor's, Moody's Investors Service, Fitch Ratings and Dominion Bond Rating Service.

The SEC issued an order on Friday granting Egan-Jones status as a nationally recognized statistical rating organization, or NRSRO.

There are now eight NRSROs. Two Japanese firms, Japan Credit Rating Agency and Ratings and Investment Information, were recognized by the SEC earlier this year and insurance specialist A.M. Best was granted the status in 2005.

The SEC's decision means that Egan-Jones' ratings will now hold more weight. Many institutional investors are restricted from buying securities that are rated below certain levels by officially recognized agencies. Companies also can sell debt more easily if they have a higher rating from an NRSRO.

It may be less positive for established rating agencies like Moody's (MCO) .

During the 1990s there were far fewer NRSROs, leaving Moody's and S&P without much
competition. But controversy about the accuracy and timeliness of official credit ratings, combined with political pressure, encouraged the SEC to grant NRSRO status to more firms in recent years.

This year's subprime-mortgage crisis has heightened controversy surrounding rating agencies. Several mortgage-related securities have been downgraded this year from AAA to junk status overnight. That's increased concerns that leading ratings agencies overlooked the risks of these securities when they were sold, and were slow to respond as the underlying collateral deteriorated. End of Story

Alistair Barr is a reporter for MarketWatch in San Francisco.

Barron's Cover Story on Moody's

Barron's Online
Monday, December 24, 2007

Failing Grade


THOUGH WALL STREET WAS SLOW to realize it, July 10 turned out to be Pearl Harbor Day for the global credit markets. On that day, credit-rating giants Moody's (MCO) and Standard & Poor's both shocked investors by announcing separately that they were taking negative rating actions against nearly $20 billion of 2006-vintage subprime-mortgage bonds because of spiraling delinquencies and foreclosures on the loans.

The credit downgrades have only increased since then, with Moody's alone chopping the ratings on more than half the 2006 subprime residential-mortgage-backed securities it had rated, including a whopping 97% of the slices, or tranches, it deemed single-A or below, according to a compilation made by Morgan Stanley Fixed Income Research.

Even worse has been the stunning speed with which the ratings agencies have acted. Investors in some $800 million of asset-backed commercial paper in Rhinebridge LLC, a bank-sponsored structured investment vehicle, or SIV, filled with U.S. subprime debt, suffered whiplash when the paper and related medium-term notes swung from S&P's highest credit ratings to default in four days in October. And this followed a Moody's report in July titled "SIVs, An Oasis of Calm in the Sub-Prime Maelstrom." Such precipitous ratings declines have come to be known as express-train downgrades, since there are no stops between Blue-Chip Land and oblivion.

All of this has landed the credit-rating agencies in the crosshairs of Congress, the Securities and Exchange Commission and several state attorneys general, just five years after the industry was taken to the woodshed for its failure to suss out the impending collapse of companies like Enron and WorldCom.

That spasm of reformist zeal resulted in the 2006 Credit Agency Reform Act -- but the law clearly didn't go far enough. That's why Barron's now proposes some fresh and far-reaching measures to fix the rating system, starting with steps to greatly increase competition. Moody's and Standard & Poor's have held far too strong a grip on the industry for anyone's good. It is high time for a change.

MAKE NO MISTAKE: THE LATEST debacle dwarfs the rating contretemps earlier in the millennium. In all, $650 billion of 2006 subprime mortgages were securitized in the past year. Moody's officials point out that only 15% or so of the dollar amount of that rated debt -- counting all tranches -- has gone bad, requiring downgrades. But the ripple effect of those downgrades has wreaked havoc throughout the global credit markets.

For one thing, many of the now-downgraded slices of subprime residential-mortgage-backed debt rated A or below were bundled or re-securitized into instruments called collateralized debt obligations, or CDOs.

[cross out]
The agencies were key enablers of the mortgage mess, blessing many dubious securities.

Fatefully, the rating agencies decided to allow securitizers to slice these CDOs into a new capital structure that transmogrified 80% of the bonds into triple-A credits. It was assumed -- incorrectly -- that the 20% of the structure rated single-A or below would be more than adequate to absorb any losses suffered by the underlying mortgage pools from delinquencies or foreclosures. The reality: Price declines in these supposedly pristine triple-A tranches have triggered much of the mayhem.

This CDO paper, with a dollar value of $200 billion or more, spread like anthrax through the global credit markets. Banks and non-bank financial companies now are liquidating $350 billion of off-balance- sheet SIVs because the subprime CDO contagion has ruined their liquidity. A number of bond funds, state-government liquidity funds and even money-market funds have suffered losses as a result of investing in what they were led to believe was top-rated commercial paper and medium-term notes issued by the SIVs.

Moreover, major banking concerns from Merrill Lynch (ticker: MER) and Bear Stearns (BSC) to Citigroup (C), HSBC (HBC) and Deutsche Bank (DB) are taking nearly $100 billion in capital-depleting write-downs on CDOs and other subprime paper they either held on their balance sheets or had to put back on them.

These institutions may deserve the punishment, since they were among the biggest spewers of this poison. But global lending and liquidity has suffered mightily as a result, despite the best efforts of central banks in the U.S., England and Europe to unblock the system. Even interbank lending has ground to a halt. Banks simply don't trust one another's balance sheets, stuffed as they are with exotic mortgage paper that can't be valued with any precision.

To be sure, the rating agencies aren't solely responsible for this credit seizure. They were just one link in a subprime production line that stretched from sleazy storefront mortgage brokers, corrupt appraisers and avaricious originators to fee-crazed securitizers and, yes, mendacious borrowers.

But the rating agencies unquestionably were key enablers, by countenancing and legitimizing lethal capital structures. "We certainly saw as early as 2003 and 2004 that the subprime market was getting out of hand," Brian Clarkson, the president of Moody's, notes ruefully to Barron's. "We misjudged the magnitude of the problem, the fact that what we expected to be a tropical disturbance ended up being a Category 5 hurricane."

Standard & Poor's executives declined to speak with Barron's; a spokesman directed us to the company's published reports.

TO MAKE SURE SOMETHING like this doesn't happen again, policy makers and regulators must take bold action. Most important, the SEC should promote more competition in the industry by speeding up its approval of new agencies, designating them "nationally recognized statistical rating organization(s)."

Even though it is estimated that some 150 credit-rating agencies exist around the globe, the SEC has accorded this official status to only seven. They are the Big Three -- Moody's, S&P and Fitch -- plus insurance-industry specialist A.M. Best; the Canadian specialist Dominion Bond Rating Service, and two smaller Japanese bond raters.

Moody's and S&P dominate the industry, with a combined market share of 80%, leaving Fitch scrambling for about 10% to 15%. It's an industry with scant price competition. Most regulations, whether governing the asset quality of money-market holdings, bank or insurance-company loss reserves, broker-dealer net capital or investments of surplus corporate cash, require that the holdings be adjudged investment-grade by two officially designated agencies.

More often than not, Moody's and S&P get the assignment.


As a result, the two top dogs preside over what the Justice Department terms a partner monopoly, as opposed to an oligopoly. Rather than having to compete vigorously against each other as oligopolists, one's good fortune in winning a piece of business is typically followed by the other's receiving the same deal at the same lush fee level.

This duopoly has proven inordinately profitable, which perhaps explains why Warren Buffett is Moody's top shareholder, with a nearly 19% stake. S&P's results are buried in the financials of its publisher parent, McGraw Hill (MHP), but pure-play Moody's (MCO) earns some of the fattest margins in the S&P 500, with pretax income last year of $1.1 billion on a mere $2 billion in revenue. Even monopolists like Microsoft would kill for Moody's operating margins, typically 50% or more.

Competition from new agencies might create a healthy diversity of opinion, leading to more accurate assessments of debt issues' default probabilities.

Today, the Big Three often seem to operate in a universe of harmonic convergence, with ratings of the different agencies moving in elegantly choreographed lockstep up or down their rating scales. Like wildebeests -- or lemmings -- the agencies seemingly seek safety in numbers.

True, the agencies have long escaped any legal liability for issuing errant ratings by asserting that their actions constitute free speech protected by the First Amendment. In essence, they portray their ratings as nothing more than editorial opinion. And by sticking together, the agencies are less likely to incur the wrath of debt issuers and major investors when they voice negative opinions.

Obviously, the SEC worries that opening the gates too widely and precipitously to new rating-agency registrants might lead to an industry race to the bottom, with new entrants trying to scare up business by offering inflated ratings to issuers ranging from municipal-bond districts to corporations to securitizers.

This is by no means a trivial concern.

Dozens of Canadian corporations and government entities are stuck with some $40 billion of commercial paper in various non-bank Canadian SIVs that has been frozen indefinitely because Dominion Bond Rating Service failed to make sure that adequate backup liquidity facilities were in place when it gave the paper its top rating. Moody's and S&P were excluded from the ratings assignment because they insisted on tougher liquidity requirements. (A Dominion spokeswoman says the firm has now changed its methodology "to reflect tighter liquidity-backup requirements.")

Industry expert and Columbia Law School professor John Coffee Jr. has suggested an elegant solution to bolster rating-agency quality control, both to Barron's and in recent congressional testimony. He wants the SEC to require raters that have been granted official status to disclose in a central database the historical default rates of all classes of financial products that they've rated. Regulators and investors would thus have an effective means of assessing the raters' rigor.

"It's tremendously liberating to just work for investors and not worry about angering the issuer community," partner Sean Egan tells Barron's. "Not only have we been able to give investors earlier warnings of corporate frauds and other negative credit situations, but in many cases we've led the industry on upward credit revisions of worthy recipients."

Furthermore, Coffee argues, the SEC should discipline miscreant agencies by temporarily yanking their registration in areas where their ratings have been notably wrong.

Another good idea: Change how the agencies are paid. Currently, all seven agencies get most of their fee income from the issuers of debt and structured products like subprime CDOs, rather than from the buyers, investors.

Many critics ascribe the rating industry's woes to this stark conflict of interest. Former Clinton Secretary of Labor Robert Reich writes on his blog that the system is tantamount to movie studios' hiring critics to review their films and paying them only "if their reviews are positive enough to get lots of people to see the movie."

One investor-subscription-based rating service, Egan-Jones, has been trying fruitlessly to win official agency status for more than a decade. In that time, the Philadelphia concern has been miles ahead of the established agencies in downgrading the likes of Enron and WorldCom and more recently the mortgage and bond insurers, mortgage originators and investment banks caught up in the subprime-mortgage crisis.

The traditional rating agencies have been given an exemption from fair disclosure rules, allowing them special access to material nonpublic information from the issuer community. This information monopoly constitutes a serious barrier to competition from other rating concerns and puts the investor community at a severe disadvantage.

A sensible reform would end this special treatment and require systematic, timely release of credit information to all participants, particularly in complex structured products like mortgage CDOs. Not that the agencies made effective use of their inside knowledge of the myriad mortgage pools that backed many now-pancaked CDOS and SIVs.

BOTH MOODY'S AND S&P officials claim that their woes in the 2006 subprime arena are a result of unusual factors, including fraud by a number of borrowers and lenders. There's some validity to the claim. Nonetheless, the rating agencies shouldn't be absolved from responsibility.

Shortcomings by the agencies are hardly new. As economists Joseph Mason and Charles Calomiris reported recently, using Moody's own data, the agencies have had a less-than-sterling rating history with other classes of structured products, long before the blowup in 2006-vintage securitizations.

They noted that the five-year cumulative default rate between 1993 and 2005 was 24% for CDOs receiving Moody's lowest investment-grade rating of Baa. This compares with a five-year default rate of 2.2% on corporate bonds similarly rated from 1983 through 2005. Moody's later amended the CDO default rate to 17%, though at the end of 2006, to reflect subsequent asset recoveries on the busted debt. Even so, the almost eight-to-one loss ratio between the two classes of debt represents a yawning gap.

Several theories explain this discrepancy and none is particularly flattering to the rating agencies.

For one thing, it appears that investment banks have been pushing the agencies to inflate their ratings. The motivation isn't a mystery. Large structured-product securitizations bring banks upfront fees of as much as $2 million, with annual maintenance charges of $50,000 not uncommon. Likewise, the banks are large, repeat customers that can exert much more pressure on the agencies than the corporate client who makes only sporadic use of their services.


Structured products also represent the most lucrative, fastest-growing part of agency business. Moody's officials told Barron's that they accounted for more than 40% of the firm's revenue of late. One can surmise that structured products also have made an outsized contribution to agency profitability: Moody's earnings have more than doubled in the past four years.

Issuers aren't shy about punishing raters that don't play ball. Moody's recently revealed that its market share in commercial mortgage-backed securities had dropped from 75% to 25%. Why? Issuers apparently were retaliating for its tightened rating standards in the wake of the subprime debacle. Radian (RDN), a mortgage and bond insurer, dumped Fitch this year after the firm had downgraded the rating on Radian's financial-guaranty business below the single-A that the other rating agencies had delivered.

A hedge-fund manager suggests that social Darwinism may be at work in the apparent grade inflation of structured products. He maintains that the comparatively lower-paid rating-agency employees -- including many night-school MBAs -- are simply overmatched by the Harvard MBAs, MIT Ph.D.s and sophisticated computer models that the banks marshal in their pre-securitization discussions with the rating agencies.

The models or black boxes that the agencies have been using to rate structured products were flawed in their weighting of variables and underlying assumptions. Among other things, they failed to take into account investment bubbles that developed in all manner of structured products that led to heavy defaults in the past decade.

High-rated manufactured-housing securitizations, for instance, performed miserably early in the millennium, along with some earlier home- and commercial-mortgage securitizations and post-tech-wreck high-yield bond issues. Student-loan securitizations may be the next rating area to blow, and the triple-A ratings of bond insurers like MBIA (MBI) already are being called into question (see "A Roaring Buy2,").

But the subprime models have proved most damaging to the reputations of the rating agencies, not to mention the global credit markets. Recent reports by the research boutique CreditSights cite a number of problems with the rating agencies' assumptions. For one thing, CreditSights maintains, the agencies badly overestimated the size of the recoveries that sales of foreclosed properties would yield. The industry term for trends in housing prices -- "HPA," for home-price appreciation -- betrays a certain underlying bias that home prices will always rise over time. Not until summer did the rating agencies seem to wake up to the fact that HPA had become HPD -- home-price depreciation -- and was likely to trend down for some time.

Likewise, the agencies labored under the assumption that housing markets were regional and not national and therefore "uncorrelated." In other words, if Southern California hit the skids, rising prices in metropolitan New York would compensate for the downturn in the Golden State. Sadly, this historical behavior no longer holds in the current, nationwide crisis.

In addition, the rating agencies relied on spurious historical data to predict default rates, says Jeffrey Gundlach, chief investment officer at TCW, which oversees some $90 billion in mostly mortgage-backed debt. The models looked at the delinquency and default behavior of home owners over many decades. But the data in large part were based on conventional 30-year, fixed-rate mortgages that required borrowers to have significant equity in their homes.

This had little relevance to the suped-up subprime-mortgage environment of 2006, in which borrowers had no home equity, were encouraged to lie about their assets and income and often were speculating on homes or condominiums in which they didn't even plan to live. "The surge of defaults from the prime to subprime housing markets was absolutely predictable," Gundlach asserts. "If a borrower has no economic skin in the game as a result of a 100% or higher loan-to-value, then he's crazy to make even one monthly payment in a falling home market."

Gundlach has an excellent suggestion for reforming the rating industry that he has made to several agency executives: "Just Say No" when Wall Street asks them to rate securities that lack historically relevant data.

In today's credit panic, investors are fleeing from all manner of structured products, including securitizations backed by car loans, because of the fear unleashed by the subprime crisis. This bodes poorly for the rating agencies, both on the business and regulatory fronts.

Fast times are over for the now-chastened agencies, at least until the next bubble begins to inflate. Is there a chance the industry will act more responsibly the next time around?

Sure, but only if the reforms we pose are enacted.

SIV negative

Voltron says: will this reverse the artificial pop that the SIV announcement generated? Don't bet on it. Bull market psychology means market goes up on good or bad news.

The New York Times

December 22, 2007

Big Fund to Prop Up Securities Is Scrapped

Some of the country’s biggest banks have pulled the plug on a plan backed by the Treasury Department to rescue troubled investment vehicles that were leveled by the subprime mortgage crisis.

The decision came Friday after it became clear that neither the banks nor the structured investment vehicles were willing to create a giant fund to bail out the SIVs.

The reversal is a setback for Treasury Secretary Henry M. Paulson Jr., who had urged the banks to create the so-called super SIV to keep the crisis in housing-related debt from worsening.

A separate proposal by the Bush administration to modify home loans for troubled borrowers has also met with skepticism.

“It is somewhat politically embarrassing for the administration,” said Bert Ely, a banking industry consultant. “The mortgage modification program is much more significant and will get much more media attention if it doesn’t get the results that have been promised. That discussion will put the SIV plan into ancient history.”

At the Treasury’s behest, Bank of America, Citigroup and JPMorgan Chase hammered out the SIV plan this fall in hopes of avoiding a sharp sell-off in securities owned by these vehicles. Such a fire sale might rock the already jittery credit markets.

Originally it was thought that the giant fund, called a Master Liquidity Enhancement Conduit, or M-LEC, might raise as much as $80 billion to buy assets from the SIVs. But it quickly became clear that the fund would be scaled back or scrapped. Many of the 30 or so troubled SIVs moved to solve their problems themselves, sharply reducing their holdings of asset-backed securities. Many banks, meantime, were reluctant to commit financing to the super SIV.

As recently as Tuesday, leading banks and BlackRock, which was to manage the super SIV, said they were committed to the rescue fund. During the past two days, however, bank representatives and senior Treasury Department officials began to discuss whether to abandon the plan. Mr. Paulson was briefed before they made the final decision Friday afternoon.

Still, major banks left open the possibility that the super SIV could re-emerge if necessary. “The consortium will continue to monitor market conditions and remain committed to work collaboratively on any appropriate solutions, including activation of the M-LEC, if needed,” the group said in a statement.

Friday, December 21, 2007

Nouriel Roubini's Global EconoMonitor

It is now time to downgrade the monoliners: a business model that cannot survive without an AAA rating is a business model that cannot fundamentally deserve an AAA rating

Nouriel Roubini | Dec 20, 2007

The shocking and surprising revelation by MBIA – one the leading monoliners, i.e. bond insurers – that it has guaranteed $8.1 billion of collateralized debt obligations repackaging other CDOs and securities linked to subprime mortgages (i.e. it is holding the very risky CDOs of CDOs) – is the last drop in this monoliners’ farce: it is time for the credit rating agencies to downgrade most of these monoliners from their AAA rating status. One can spend a long time discussing the relative riskiness of each of these monoliners and whether the capital injections that some of them are now receiving is enough to prevent the downgrade that rating agencies are considering. But discussing these important details risks losing the vision of the forest while being obsessed with watching the trees or individual leaves on each monoliner tree.

The forest issues is simple: a business – the monoliners’ insurance of securities and holding of risky ABS securities – that is fundamentally based on having a AAA rating is a business that does not deserve a AAA rating in the first place: it is clear to all that if a monoliner were to lose its AAA rating the essence of its business model would fail and such monoliner would have to close shop. But in any industry you have firms that can do business and thrive with an AA or A or even lower rating, even among major financial institutions. Here we have instead an industry that would go bankrupt as soon as its AAA rating is lost: by definition this is not an industry that can deserve a AAA rating. So the issue is not one of how sound these monoliners are managed or whether they have enough capital or whether they can raise new capital to maintain their AAA status. There is a fundamental and conceptual flaw in a business model that is conditional on a AAA rating and that is in a business that insures assets and firms that do not have a AAA rating. This is analogue to the voodoo finance of taking subprime and BBB mortgage backed securities and turning them into AAA by the black magic of CDO tranching.

Add to this mess the fact that monoliners collectively insure $3,300bn of principal and interest (less than 30% of it ABS) with only a $22bn capital base. Of course a downgrade of monoliners will have a severe knock-on effect of potential downgrade on muni and other bond markets; analysts have estimated that such downgrades could cause losses writedowns of about $200bn. But these risks cannot be an excuse for not admitting that the monoliners don’t deserve an AAA rating. As long as monoliners were only in the muni bonds insurance business one could have made the argument that a prudent monoliner did deserve an AAA rating; but now that monoliners have vastly expanded in the ABS world of insuring toxic RMBSs, CDO, CDOs of CDOs and in some cases even holding these assets on their portfolios such an AAA rating does not make any sense.

So enough of wasting time on dissecting the assets and liabilities and capital of individual monoliners; their business model is conceptually flawed in the first place; and their actual business practices have been even more flawed as they have now insured for years toxic RMBS, CDOs, and CDOs of CDOs. The wariness of rating agencies to downgrade the monoliners is understandable: such a downgrade will imply an instant death sentence for any monoliner that is downgraded; it will lead to loss of business for the rating agencies themselves; and it will trigger massive losses on muni bonds.

But the current charade of pretending that the monoliners are under review to give them time to raise more capital to avoid such a downgrade is another case of rating agencies supporting a rotten business model. The actual behavior of such monoliners has proven that they are not transparent, that they hold or insure a mass of skeletons and toxic waste securities and they have been dishonest in hiding from investors the toxic waste that they hold and insure. So it is time to stop this charade of rating forbearance and admit that the emperor has no clothes: a business model that cannot survive without an AAA rating is conceptually a business model that cannot deserve under any circumstance an AAA rating; period! Arguing otherwise is believing in voodoo black magic.

Falling prices driving crisis

Fed: Foreclosures not primarily due to high loan payments

The recent spike in home foreclosures in Massachusetts is caused primarily by falling housing prices, and not by rising mortgage payments, according to research released yesterday by the Federal Reserve Bank of Boston.

The contrarian report suggests the common understanding of the foreclosure crisis is somewhat mistaken. Unaffordable loans don't cause foreclosures directly. Even as subprime lending became more common, even when people fell behind on mortgage payments - during the economic downturn in 2001, for example - foreclosures were rare because house prices continued to rise.

In part, people were able to escape trouble by selling their homes at prices high enough to cover their debts. But the research also suggests that troubled borrowers tried harder to make the necessary payments, in the expectation they would profit eventually.

Conversely, when prices started falling, people struggling to make payments had less incentive to find the money. And the value of the home could drop below the outstanding debt, making it impossible to sell. Over the last two years, the number of foreclosures exploded.

Housing price movement "plays a dominant role in generating foreclosures," the report concluded.

One implication of the report is that current attempts by local and federal officials to help borrowers may be ineffective.

US Treasury Secretary Henry Paulson is negotiating a deal to freeze monthly mortgage payments on some subprime loans by delaying scheduled interest rate increases. Paulson reiterated yesterday the plan could be announced this week.

Meanwhile, states including Massachusetts have introduced programs to refinance troubled borrowers into more affordable loans. Those programs have struggled as most of the applicants are unable to qualify.

But government efforts to make payments more affordable may not matter to borrowers mostly concerned about home values.

Instead, the number of foreclosures will be determined mostly by "how far housing prices fall," said Boston Fed president Eric Rosengren, who introduced the report yesterday during a speech to the Massachusetts Institute for a New Commonwealth.

Rosengren nonetheless endorsed government efforts to help subprime borrowers.

Subprime borrowers are particularly likely to face foreclosure, because their grip on ownership is more tenuous. They pay more, they own less of the home, and they have fewer resources. The Boston Fed found subprime borrowers are about six times more likely to face foreclosure than conventional borrowers.

Many subprime borrowers now face increased mortgage payments, as the interest rates on their adjustable loans reset to higher levels. Analysts predict widespread foreclosures will follow.

"Getting people into other products may be much more straightforward and much less costly than helping people once they're already in trouble," Rosengren said in an interview.

The Fed found one-quarter of subprime borrowers in New England are good candidates for more affordable loans. The evaluation is based primarily on these borrowers having sufficiently good credit, and that their homes are worth more than what they owe on their mortgages.

The list of lenders serving subprime borrowers has diminished dramatically. Eight of the 10 companies that made the most subprime loans in Massachusetts over the last decade have stopped making loans. But Rosengren said he was hopeful other companies, including local banks, would step forward.

Freezing the rates on subprime loans would also help, he said.

Critics of the plan have questioned whether investors who own the rights to collect the mortgage payments will agree to forego a portion of those payments.

Rosengren highlighted a reason for optimism. On a typical subprime loan, the interest rate increases after the second year. Historically, most borrowers either sell or refinance before the rate resets. Rosengren said investors were never counting on a long-term income stream.

"It's not like they expected the borrowers to be there for 30 years," he said.

Binyamin Appelbaum can be reached at

Bear Stearns duped by "G-money"

The Wall Street Journal

December 21, 2007


Fraud Seen as a Driver
In Wave of Foreclosures

Atlanta Ring Scams
Bear Stearns, Getting
$6.8 Million in Loans
December 21, 2007; Page A1

ATLANTA -- Skyrocketing foreclosures are a testament to how easy it was to borrow from mortgage lenders in recent years.

It may also have been easy to steal from them, to judge from a multimillion-dollar fraud scheme that federal prosecutors unraveled here in Atlanta. The criminals obtained $6.8 million in mortgages from Bear Stearns Cos., including a $1.8 million mortgage to Calvin Wright, a New Yorker who told the investment bank that he and his wife earned more than $50,000 a month as the top officers of a marketing firm. Mr. Wright submitted statements showing assets of $3 million, a federal indictment alleged.

In fact, Mr. Wright was a phone technician earning only $105,000 a year, with assets of only $35,000, and his wife was a homemaker. The palm-tree-lined mansion they purchased with Bear Stearns's $1.8 million recently sold out of foreclosure for just $1.1 million. Bear Stearns, meanwhile, posted the first quarterly loss in its 84-year history as it wrote down $1.9 billion of mortgage assets yesterday. (See related article1.)

Fraud goes a long way toward explaining why mortgage defaults and foreclosures are rocking financial institutions, Wall Street and the economy. The Federal Bureau of Investigation says the share of its white-collar agents and analysts devoted to prosecuting mortgage fraud has risen to 28%, up from 7% in 2003. Suspicious Activity Reports, which many lenders are required to file with the Treasury Department's Financial Crimes Enforcement Network when they suspect fraud, shot up nearly 700% between 2000 and 2006.

In 2006, losses from fraud could total a record $4.5 billion, a 100% increase from the previous year, says Arthur Prieston, chairman of the Prieston Group, which provides lenders with mortgage-fraud insurance and training. The surge ranges from one-off cases of fudging and fibbing to organized criminal rings. The FBI says its active mortgage-fraud cases have increased to 1,210 this year from 436 in 2003. In some regions, fraud may account for half of all foreclosures. "We've created a culture where a great many people know how to take advantage of the system," says Mr. Prieston.

Yet the system itself bears blame. The evolution of mortgages into a securities instrument turned loan origination into a competition. Caution gave way to a push for speed and volume. Embroiled in an all-out war for market share, issuers reduced barriers to credit, for example, by offering so-called "stated-income" loans, which require no proof of income. "The stated-income loan deserves the nickname used by many in the industry, the 'liar's loan,' " says the Mortgage Asset Research Institute, which works with lenders to prevent fraud. A recent review of a sampling of about 100 stated-income loans revealed that almost 60% of the stated amounts were exaggerated by more than 50%, MARI says.

It didn't take a rocket scientist to steal a fortune from mortgage lenders in recent years. That much is clear from the Atlanta scheme. It was perpetrated in large part by a 23-year-old college dropout named Gregory Jerome Wings Jr., aka G-Money. His accomplices included a young nightclub owner, along with the director of an underground documentary called "Crackheads Gone Wild," a cautionary tale about drug addiction.

Their scam was garden variety: recruit borrowers with good credit to apply for gigantic loans, often of the stated-income variety, using false income and asset statements. Find a mortgage broker willing to submit false information, and find appraisers who will approve inflated values. The perpetrators line their pockets with the proceeds, using some as down payments or for future renovations. Some buyers diverted proceeds to themselves through shell companies.

The brazenness of the scheme is illustrated by the case of Mr. Wright, the New York telephone worker who posed as a highly paid executive to obtain a $1.8 million mortgage from Bear Stearns. Recruited into the scheme by an acquaintance in Atlanta, Mr. Wright, with the help of ring leaders, diverted hundreds of thousands of dollars from that Bear Stearns mortgage to himself, to Mr. Wings and to others in the scheme, according to a federal indictment.

In the very same week, Mr. Wright obtained a $1.9 million mortgage on a second value-inflated mansion near Atlanta, this time from BankFirst, a unit of Minneapolis-based Marshall BankFirst Corp. This deal also brought enormous spoils to Mr. Wright, Mr. Wings and other accomplices.

"It was so easy, it's incredible," says Akil Secret, attorney for Mr. Wright, who has pleaded guilty to bank fraud and is awaiting sentencing.

'Seemed Clean and OK'

As profits from the scheme fattened their wallets, these young men became the envy of their peers, especially since their actions involved none of the dangers of street crime. "You see a guy who is 23 and he's driving a fancy car. You go into clubs and everyone seems to know him, and you kind of want to be like him," says defense attorney Rickey Richardson, explaining how his client, Daryl Smith, got involved in the scheme. "This wasn't drugs. This wasn't guns. This seemed clean and OK."


Residents of some fancy Atlanta suburbs spotted the scheme. They became suspicious when new homes in their neighborhoods sold for sky-high prices, then remained vacant. After the same individual bought several such homes in one ritzy development, neighbors alerted authorities. One homeowner who helped expose the fraud and other schemes in his neighborhood now carries a loaded handgun in his truck. "This is serious stuff," he says. "We are putting people in prison for many, many years."

Since federal authorities issued an indictment in April 2006, Mr. Wings, Mr. Smith, Mr. Wright and about 10 others have pleaded guilty to various counts, including bank fraud, and are awaiting sentencing. Another ringleader was convicted in federal court last month. Their sentences could be lengthy: In an unrelated case, an Atlanta attorney with no prior criminal record was sentenced in August 2005 to 30 years in federal prison on a mortgage-fraud conviction. Mr. Wings declined to comment for this story, as did Messrs. Wright and Smith.

In the wake of their downfall, debate has been intense about how such an unaccomplished group could defraud top-tier financial institutions out of millions.

Prosecutors call the scheme sophisticated, noting its reliance upon forged and falsified documentation.

Lenders agree. Bear Stearns says the scheme evaded its antifraud efforts by supplying false information at every step of the application process. "We as an industry cannot eliminate fraud entirely," Tom Marano, head of mortgages and asset-backed securities for Bear Sterns, said in a statement about the Atlanta ring. "We can and do continue to develop systems and detection techniques that evolve with the complexity of criminal schemes.'"

But others contend that the Atlanta case illustrates the recklessness with which lenders were issuing mortgages in recent years. "This case should have been an indictment of the mortgage industry," says Patrick Deering, an Atlanta defense attorney involved in the case.

In an eye-opening setback for prosecutors, Mr. Deering and other defense attorneys successfully defended three home builders against charges that they had participated in the scheme. Prosecutors had attacked the home builders for failing to raise red flags when they witnessed mortgages being issued far in excess of what the builders were being paid.

Artificially Raised Values

In some neighborhoods, the fraud scheme itself may have artificially raised values. Another explanation is that the appraisal market is fiercely competitive. Experts say some appraisers may offer inflated values in exchange for their standard fee of several hundred dollars -- a strategy that can win business without exposing an appraiser to charges of fraud. "Appraisers get sucked into these schemes because they are starving for work and many of them don't know what the heck they are doing," says Carl Heckman, co-founder of the Georgia Real Estate Fraud Prevention and Awareness Coalition, composed of appraisers, lenders, mortgage brokers and residents.

In the neighborhoods where the Atlanta scheme operated, values have plummeted. Many homes associated with the scheme are now in foreclosure. Some have sold for as low as 50% of what buyers in the fraud ring paid. "The banks are getting more and more aggressive in their pricing because they don't want to own these homes," says Warren Lovett, a real estate agent with Coldwell Banker in Atlanta.

Mr. Lovett has taken listings for about 60 foreclosed properties this year. He estimates that half of the foreclosures he's encountered are due to fraud.