Tuesday, April 1, 2008

Moody's, S&P Defer Cuts on AAA Subprime, Hiding Loss

By Mark Pittman

March 11 (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.''

Holding Capital

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.

Regulators require banks to hold more capital against lower- rated securities to protect against losses; a downgrade would force them either to sell the securities or bolster reserves. While most banks haven't disclosed the ratings of their subprime holdings, S&P estimated in January that losses on the debt may exceed $265 billion. American International Group Inc., the world's largest insurer, has $20.8 billion invested in AAA rated subprime-mortgage debt, not including asset-backed securities that caused the company's biggest-ever quarterly loss last period, according to the New York-based company's disclosures.

Credit Support

S&P and Moody's, the two biggest rating companies, are lagging behind Fitch Ratings, their smaller competitor. S&P, owned by McGraw-Hill Cos., and Moody's, a unit of Moody's Corp., have cut a combined 112 AAA ratings since July, about a quarter of Fitch's 390, according to Bloomberg data. S&P lowered one AAA bond in an ABX index, Moody's refrained altogether, and Fitch cut 19.

``We have built in 20 percent more home price declines from the end of '07,'' said Glenn Costello, managing director for residential mortgage-backed securities at Fitch. ``When you build in that much home price decline, I feel good when I pick up the paper and I see that home prices are only down another 3 percent. My ratings are still good.''

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.

Performance Testing

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 used until last year, 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 BBB- and above by S&P and Baa3 by Moody's.

S&P and Moody's, both based in New York, failed to anticipate the record foreclosures on home loans and slumping house prices. New foreclosures jumped to 0.83 percent of all home loans in the fourth quarter, up from 0.54 percent a year earlier, the Mortgage Bankers Association said March 6. Home prices fell 9 percent, the biggest decline in 20 years of record-keeping, according to the S&P/Case-Shiller home-price index.

Increasing Losses

As defaults on subprime loans increased, the three ratings companies increased their assumptions in the past six months for losses on the mortgages within the bonds and changed the computer models that predict declines in credit quality. S&P has twice increased its prediction for losses and is now forecasting as much as 19 percent for subprime bonds, compared with as little as 5 percent less than a year ago.

The companies began cutting in July and have since either downgraded or put on review a total of 38,000 subprime bonds, according to Bloomberg data. Moody's and S&P combined have downgraded more than 9,513 of the securities dating from 2005.

``We continue to monitor these securities, have placed many of them on CreditWatch negative, and will take additional action when, in our judgment, a rating action is warranted,'' said S&P spokesman Chris Atkins. ``We do not forbear or refrain from taking action for anyone else.''

Moody's, S&P and Fitch were all criticized by New York Attorney General Andrew Cuomo and lawmakers such as U.S. Senator Richard Shelby, who said they granted excessively high ratings on subprime-mortgage debt, then reacted too slowly when defaults reached record rates.

Reputation Damaged

``We said we would be taking more ratings action, and we will,'' said Claire Robinson, a senior managing director at Moody's in New York. ``We have to dig into the peculiarities of each deal because they're all different.''

Moody's cut its 2008 forecast for revenue and profit today, saying the slump in credit markets will go on longer than previously anticipated.

``I think our reputation has been hurt by what's been going on and it would be disingenuous of me to say it hadn't,'' Chief Executive Officer Raymond McDaniel told the Bear Stearns Cos. investor conference in Palm Springs, Florida. ``We are in a business where reputational capital is more important and this is of particular concern to me. That restoration of confidence is under way, not through marketing but through action.''

Rising Losses

The AAA securities included in the ABX are the most junior because they get repaid after other AAA securities from the same mortgage pools. The ABX is used by investors to place bets by buying credit-default swaps linked to the indexes. Credit-default swaps are financial instruments based on bonds and loans and used to speculate on a borrower's ability to repay debt. Contracts on asset-backed securities cover losses if the securities aren't repaid as expected, in return for regular insurance-like premiums.

Within one AAA index, the $79 million Deutsche Bank bond, known as ACE 2005-HE-7 A2D, is rated AAA by S&P and Moody's even though 18 percent of its loans are in foreclosure, 15 percent of the properties have been seized by lenders and about 10 percent have been delinquent for more than 90 days. When the bonds were created, Moody's and S&P required capital support to cover a loss rate of no more than 7 percent for all three loss categories combined. Fitch doesn't rate the debt.

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.

Years to Fix?

``It will take years for the ratings agencies to fix their problems,'' said Janet Tavakoli, president of Chicago-based Tavakoli Structured Finance. The firms are in a ``crisis of confidence,'' she said.

A $242 million Morgan Stanley Capital Inc. issue, the 2006- WMC2 A2D, has credit support of 64 percent relative to its delinquent mortgages, the lowest of any in the AAA index. The credit should be at least twice the delinquent mortgages. Moody's and S&P both give it the top rating. S&P is reviewing it for a downgrade and calculates that the pool will lose 24 percent of its collateral loan values. Fitch rates it BBB and said it may cut further.

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.

`800-Pound Gorilla'

The bank would either have to sell the bonds at a loss or make up the difference in cash. Citigroup Inc., the largest U.S. bank, have already written down $19.9 billion of subprime mortgages and CDOs. Merrill Lynch & Co. cut its investments' value by $24.5 billion.

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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