S&P, Moody's masking $200 billion of subprime bond risk


By Mark Pittman
Bloomberg News Service
Friday, June 29, 2007


NEW YORK -- 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.

The highest default rates on home loans in a decade have reduced prices of some bonds backed by mortgages to people with poor or limited credit by more than 50 cents on the dollar and forced New York-based Bear Stearns Cos. to offer $3.2 billion to bail out a money-losing hedge fund. 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.

That may just be the beginning. 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.

"You'll see massive losses from banks, insurance companies, and pension managers," said Joshua Rosner, a managing director at investment research firm Graham Fisher & Co. in New York and co-author of a study last month that said S&P, Moody's and Fitch understate the risks of subprime mortgage bonds. "The longer they wait, the worse it's going to be."

...Loss Estimates

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.

Executives at New York-based S&P, Moody's and Fitch say they are waiting until foreclosure sales show that the collateral backing the bonds has declined enough to create losses before lowering ratings on some of the $6.65 trillion in outstanding mortgage-backed debt.

...'Knee-Jerk Responses'

Homeowners may be delinquent on mortgage payments for at least three months before foreclosure proceedings begin, and the process can be delayed if a borrower files for bankruptcy or fights eviction. Even when lenders repossess a home, the value of the mortgage isn't written down until the house is sold. Bondholders see a loss only if the price of a house is lower than the loan used as collateral for debt securities.

"We're taking action as we see it," said Brian Clarkson, Moody's global head of the structured products in New York. "We're not doing knee-jerk responses."

Ratings companies are postponing the inevitable as defaults by subprime borrowers increase, investors and analysts say.

Downgrades of CDOs "could finally force the hand of ratings-sensitive holders," Morgan Stanley analysts led by Vishwanath Tirupattur in New York wrote in a report dated June 28. "Our worry is that this selling would be very unbalanced, with no established taker of risk on the other side, even at current market levels."

...Increased Delinquencies

Lehman Brothers Holdings Inc., the biggest underwriter of mortgage bonds, sold $2.43 billion of Structured Asset Investment Loan Trust bonds a year ago. An $18 million portion of the bonds rated BBB fell to 43 cents on the dollar from 98 cents in January, according to prices compiled by New York-based Merrill Lynch & Co.

More than 15 percent of the mortgages in the securities are at least 60 days delinquent and another 8 percent are in foreclosure, according to the bond trustee. Moody's and S&P say they are considering downgrading the debt.

Ratings downgrades in CDOs containing asset-backed securities "are inevitable and material," the Morgan Stanley analysts said in the report. "The shoe is still waiting to drop."

A total of 11 percent of the loan collateral for all subprime mortgage bonds had payments at least 90 days late, were in foreclosure or had the underlying property seized, according to a June 1 report by Friedman, Billings, Ramsey Group Inc., a securities firm in Arlington, Virginia. In May 2005, that amount was 5.4 percent.

...'Petri Dish'

The increase in delinquencies means CDO investors, who sometimes use borrowed money to magnify their bets, may be holding securities that are riskier than their ratings indicate, said Bill Gross, chief investment officer at Pacific Investment Management Co., based in Newport Beach, California.

"The Petri dish turns from a benign experiment in financial engineering to a destructive virus," Gross, who oversees the world's biggest bond fund, said this week in a commentary on the firm's Web site. The companies gave the mortgage bonds investment-grade ratings, duped by the "six-inch hooker heels" of collateral that can't be trusted, he said.

CDOs aren't required to disclose the contents of their holdings to the U.S. Securities and Exchange Commission and most can change them after the bonds are sold.

Losses reflect the decline of the U.S. housing market, where the national median home sale price is poised for its first annual drop since the Great Depression, according to the National Association of Realtors.

...Investors Retreat

Investors are responding by retreating from all sorts of riskier assets, threatening to reduce credit. Companies canceled at least $3 billion of bond sales worldwide in the past two weeks. U.S. Treasury notes snapped a six-week losing streak last week, pushing yields down from the highest in five years, as investors sought the haven of government bonds.

The subprime meltdown is sending shock waves through the capital markets in part because mortgage bonds are the world's biggest debt market, according to the Securities Industry Financial Markets Association.

Thousands of investors own mortgage bonds, ranging from fund managers such as Pimco, a unit of Munich-based Allianz SE, to the California Public Employees' Retirement System, the biggest U.S. public pension fund, and foreign banks like Fortis SA in Brussels.

CDOs are created by taking bonds, loans, and other securities, pooling them together and chopping them into new securities with ratings ranging from the safest AAA to ones so risky they have no rankings. Investors snapped up $500 billion of the securities globally last year because they typically yield more than bonds with the same credit ratings. Sales of CDOs have risen five-fold since 2001, according to JPMorgan Chase & Co.

...Higher Yields

One reason for the higher yields on some CDOs is that subprime-related debt made up about 45 percent of the collateral backing the $375 billion of CDOs sold in the U.S. in 2006, data compiled by Moody's and New York-based Morgan Stanley show.

Credit Suisse Group, based in Zurich, created a $1 billion CDO called Class V Funding III Ltd. in February by combining the A-rated portions of 91 other CDOs that invest in debt backed by consumer obligations.

The biggest portion, or $859.2 million of bonds, is rated AAA and pays interest as low as 5.70 percent. The smallest piece, or $2.5 million, is ranked BBB and has a coupon of 10.61 percent, according to a May 22 report produced by the trustee for the CDO.

At the time of the report, AAA rated corporate bonds had an average yield of 5.45 percent, while BBB debt yielded 6.03 percent, according to Merrill Lynch index data.

...Drexel Creation

Demand for CDOs, first used in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc., is drying up as mortgage bond losses spread. Planned sales of CDOs that rely on high-rated asset-backed debt dropped to $3 billion this month from $20 billion in May, according to analysts at JPMorgan, the third- largest U.S. bank.

"A lot of these should be downgraded sooner rather than later," said Jeff Given at John Hancock Advisors LLC in Boston, who oversees $3.5 billion of mortgage bonds. The ratings companies may be embarrassed to downgrade the bonds, he said. "It's easier to say two years from now that you were wrong on a rating than it is to say you were wrong five months after you rated it."

Fitch is "deliberate" in its actions, John Bonfiglio, the firm's head of U.S. structured finance ratings, said in an interview in his New York office. Fitch is a unit of Paris-based Fimalac AS. "I would not say we were slow."

...First-Year Downgrades

The ratings companies point out they have downgraded bonds less than a year after they were sold, the first time that has ever happened. S&P has lowered a total of 15 subprime bonds sold in 2005, or 0.31 percent of the total, and 32 sold in 2006, or 0.68 percent.

"People are surprised there haven't been more downgrades," Claire Robinson, a managing director at Moody's, said during an investor conference sponsored by the firm in New York on June 5. "What they don't understand about the rating process is that we don't change our ratings on speculation about what's going to happen."

Accurate rankings for mortgage bonds and CDOs become even more important because the securities rarely trade, so investors can't immediately value their holdings when market conditions change. Instead, they often rely on sales of similar securities or computer models that use ratings and past performance of the underlying collateral to come up with a value.

...Bear Stearns Jolt

CDO investors were jolted this month by the losses in the Bear Stearns hedge funds.

The funds, called High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund, had borrowed $10 billion from securities firms and banks to make bets on CDOs, mortgage bonds and other securities. As the values of the holdings declined, creditors seized some of the collateral pledged for the loans and sold them through auctions.

A concern was that a forced sale would slash prices on CDOs, providing new, lower benchmarks that investors would have to use to value their holdings, resulting in billions of dollars of losses.

"We remain nervous about the end of the week, when many leveraged investors in the CDO markets will have to mark down their positions," debt strategists at Barclays Capital in New York said in a June 28 report. "The worry is that this will be large enough to trigger margin calls which, in turn, will cause other liquidations and so on."

...UBS, Queen's Walk

Merrill Lynch threatened to take and sell $850 million of bonds held as collateral for loans it had made to the funds. Lehman, JPMorgan and Cantor Fitzgerald LP, all based in New York, also pulled out.

Bear Stearns avoided an even worse fallout by offering to provide one of the funds with loans. The original $3.2 billion provision was reduced to $1.6 billion after the firm sold securities and lenders took some of the collateral.

Other hedge funds are closing down or reporting losses because of subprime losses. Zurich-based UBS AG shuttered a hedge fund unit that saddled the biggest money manager for wealthy investors with 150 million Swiss francs ($122 million) of first- quarter losses.

Queen's Walk Investment Ltd., a London-based fund, reported a loss of 67.7 million euros ($91.2 million) last week for the year ended March 31. Cambridge Place Investment Management LLP, another London money manager, said yesterday that it will close Caliber Global Investment Ltd., a fund that had $908 million of assets in March.

...'Massive Downgrades'

A sweeping downgrade of bonds would lead to sales of assets by investors, banks, and pension funds who operate under rules that would cause them to adjust their portfolios to reflect the new ratings. S&P, Moody's and Fitch have restricted their ratings changes on BBB-rated mortgage bonds to 1.3 percent of those outstanding, according to Credit Suisse analyst Rod Dubitsky in New York. About 80 percent of the remainder will eventually have their ratings reduced, he said.

"We're talking about massive, massive downgrades here," Dubitsky, the No. 2 asset-backed real estate debt analyst in last year's Institutional Investor magazine poll of researchers, said in a telephone interview.

S&P abandoned 7-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.

...'Warrant Our Attention'

All but five of 120 securities in BBB or BBB-rated portions of the mortgage-backed securities would have failed S&P's criteria, according to data compiled by Bloomberg.

None have been downgraded, though S&P and Moody's have parts of three pools of securities linked to the index under review for a downgrade. Fitch has downgraded parts of three mortgage pools tied to the ABX and put four on watch for downgrade.

"Don't misunderstand me: I'm not saying these others are performing great," Robert Pollsen, a director in S&P's residential mortgage surveillance in New York, said in an interview last month. "And they certainly might warrant our attention several months from now, which obviously we're going to do."

Some investors say the ratings companies are waiting too long before downgrading the mortgage bonds and the CDOs that contain them. They noted that S&P and Moody's maintained their investment-grade ranking on Enron Corp. until days before the Houston-based energy trader filed for bankruptcy.

"That's like saying these trees are just fine as there's a forest fire on the other side of the hill," said James Melcher, president of money-management firm Balestra Capital Ltd. in New York, who runs a $105 million hedge fund.

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