by Jerome a Paris
Thu Jul 5th, 2007 at 08:24:14 AM EST
Laurent Guerby pointed me to this story in yesterday's open thread, but this story from a few days ago on Bloomberg news is both scary and fascinating:
S&P, Moody's Mask $200 Billion of Subprime Bond Risk
Standard & Poor's, Moody's Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans.
These securities are portfolios of loans to home owners which are put together to create the equivalent of large loans. They are then sliced in different tranches, with some a lot more risky than others (i.e. some will be the first not to be repaid if the underlying loans do not perform, while other will be hit only later).
From the diaries - afew
These securities are sold to all sorts of investors, who rely on two things (i) is that the underlying risk is a highly diversified client base in the largest asset class in the world (real estate in the US) and (ii) these securities are rated by the rating agencies; such rating suppsedly giving a good measure of their riskiness. Many investors are restricted by policy, and siometimes by law, to assets with at least a given rating (thus the distinction between 'investment grade' and 'junk bond' - one bond has the right rating, above the limit, the other does not).
In many cases, the rating is the single most important tool in the decision to invest or not. As Bloomerg notes:
Downgrades by S&P, Moody's and Fitch would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by subprime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets.
A lot of investors would be forced by policy to sell, in the case of downgrades, thus triggering massive slaes and price collapses.
And...
Almost 65 percent of the bonds in indexes that track subprime mortgage debt don't meet the ratings criteria in place when they were sold, according to data compiled by Bloomberg.
(...)
S&P abandoned seven-year-old criteria for determining a bond's protection against default in February.
Under the old guidelines, S&P said a bond's ``credit support'' must be twice the rolling 90-day average of the sum of value of mortgages delinquent by three months or in foreclosure plus real estate that has been seized by the lender.
Credit Support
Credit support for a bond is determined by looking at the number of lower-rated securities that would have to go bust before it suffered losses, the dollar amount of mortgages available to pay back the interest and the annualized interest the mortgages generate in excess of what needs to be paid to bondholders.
The measure was one of four tests used by S&P, said Chris Atkins, a spokesman for the company, a unit of New York-based McGraw-Hill Cos. A failure to meet the credit support standard wouldn't have automatically resulted in a downgrade, he said.
Of the 300 bonds in ABX indexes, the benchmarks for the subprime mortgage debt market, 190 fail to meet the credit support standard, according to data released in May by trustees responsible for funneling interest payments to debt investors.
Most of those, representing about $200 billion, are rated below AAA. Some contain so many defaulted loans that the credit support is outweighed by potential losses. Fifty of the 60 A rated bonds fail the criteria, as do 22 of the 60 AA rated bonds and three of the 60 AAA bonds.
There's a lot more data in the article about the scope of the coming problem, but that last line is extraordinarily scary. A ratings are supposed to be high quality stuff already, with default rates below half a percent. Most of these 'A' bonds have this alarm ringing; while this does not imply a default yet, it's a stunning, and deeply worrying number.
Just to give you an idea:
Rosner estimates that collateralized debt obligations, which have packaged thousands of bonds and derivatives into new securities, will lose $125 billion. Institutional Risk Analytics, a Hawthorne, California-based company that writes computer programs for accounting firms, says 25 percent of the face value of CDOs is in jeopardy, or $250 billion.
Losses may rival the savings and loan crisis of the 1980s and 1990s. The Resolution Trust Corp., formed by the U.S. government to resolve the thrift crisis, sold $452 billion of assets at a cost to taxpayers of about $140 billion.
The current debacle threatens the growth of asset-backed bonds, securities that use consumer, commercial and other loans and receivables as collateral. That market, which includes mortgage securities, has doubled to about $10 trillion since 2000, according to the Securities Industry Financial Markets Association, a New York-based trade group.
This will get really, really ugly.
But current policy is to hide the thermometer.
