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For Ratings Firms Holding AAA Sacrosanct is Foolish

The Prince has been astonished at the recent decisions of the three major credit rating firms (Moody’s, Fitch, and S&P).  In many cases, with their reputations already seriously tarnished, the firms are still foolishly trying to not downgrade mortgage related tranches they originally rated AAA.  The ratings firms would be wise to take a page out of the Wall Street bank’s playbook of underpromising and overdelivering.  Wall Street banks took writedowns that were probably too large so they wouldn’t have to take more losses in the future.  The ratings firms continue to slowly downgrade CDO tranches as they appear to cling to the hope that some of these instruments will perform better than investors are expecting.  Why won’t the ratings firms get all the downgrades of AAA CDO tranches over with now, admit their mistakes, and assume the roll of reformed sinners.   Their poor decisions around managing their reputations and the validity of their opinions is undermining any confidence that investors will have in their future ratings.



In many cases the firms own predictions about losses on varing CDO tranches do not even come close to jiving with the ratings they currently have on these tranches.  For example, last week Moody’s issued a special report with loss projections for the 2006 vintage of mortgage CDOs.  Moody’s was willing to predict that average losses on the 2006 vintage will be 12-24%.  With the first quarter at 9-13% and forth quarter at 14-35%.  It is worth noting that at 35% loss the AAA 07-1 ABX (second half 2006 vintage) would recover almost zero.  That’s right, zero.  I wish I was able to post some of the reports of S&P and Moody’s but copyright restricts the Prince from posting the documents.  Now how can Moody’s justify rating some of these securities’ tranches AAA?  Just like S&P, Moody’s did suggest that further downgrades were coming but just like S&P, Moody’s is still trying to hold the AAA rating sacrosanct.  The Prince believes that this will and must come to end at some point.




Last week S&P did take some substantial actions to decrease ratings.  However, S&P still has not come to realistic acknowledgement of the depth of the problem.  The ratings firms may be hesitating to do downgrades because a widespread downgrade of AA and AAA bonds would have disastrous implications for high grade ABS CDOs and the bond monolines aka "bond insurers" (this is the case because bond insurers are some of the largest holders of high grade AAA debt).  Serious downgrades would also have ramifications to the holdings of GSEs and other investors where capital requirements or holdings are subject to ratings.  Right now, the GSEs holding a shocking 50% of AAA debt outstanding.  A broad base downgrade on conforming AAA debt, which would be consistent with the ratings firms’ loss projections, would be catastrophic for Fannie and Freddie.





S&P most recently downgraded many formerly A or A+ rated tranches to CCC or lower, while in the same securities, maintaining AA rated tranches ratings, or only putting them on watch for downgrade.  According to S&P’s rating criteria, a tranche is rated B if it can cover the base case expected loss.  S&P also generally assumes that to garner a higher rating, a bond must be able to sustain some multiple of the base case loss without losing interest or principal. These loss multiples for 2006 vintage securities are roughly:

B 1.0x

BB   around  1.8x

BBB  around  2.8x

A    around  3.9x

AA   around  5.2x

AAA  around  7.8x

If you look at these loss multiples for the 2006 vintage (what many consider the most toxic CDO issuances), it is easy to see that ratings of front and mid pay AAA bonds is much more secure than last cashflow AAA bonds.  The ABX AAA is composed entirely of last cashflow bonds.  Regardless, the downgrade of billions of AAA bonds (even if only last cashflow AAA) to BBB would have devastating consequences for adequacy ratios for may financial institutions.

The ratings agencies must adjust their ratings to coincide with their own predictions about losses on various CDO tranches if they want to begin to repair their reputations.  Making the necessary ratings changes now will in the short term have disastrous effects on many financial firms but in the long-term confidence in ratings will be restored.  Many of these financial firms, especially GSEs will be required to improve their capital adequacy ratios, which will be good the overall health of the financial system during these volatile times.  If they continue to hold their old AAA ratings sacrosanct they risk becoming irrelevant to investors trying to estimate the risks in inherent in credit securities.


  A SYMBIOTE'S LIFE IS NOT A HAPPY ONE: PART ONE:             BLAMING THE RATERS                                                    

Ratings Firms Scrutinized for Role in Credit Mess

Listen: Hear Gillian Tett, markets editor for the Financial Times newspaper in London


In Depth

The Mortgage Market: What Happened? An explanation of how the housing boom led to risky mortgages.

Credit Ratings Agencies and the Mortgage Monster: A discussion of how ratings firms helped create the current mortgage crisis.




People walk in front of the New York Stock Exchange.

Mario Tama

People walk in front of the New York Stock Exchange on a recent morning. Getty Images



Morning Edition, August 22, 2007 · Treasury Secretary Henry Paulson is trying to reassure investors that the U.S. will "work through" the problems of a turbulent credit market "just fine." But in a CNBC interview Tuesday, Paulson cautioned that there's no "quick solution."

That point was underscored by more worrisome data on home foreclosures: Foreclosure filings nearly doubled in July from the same time a year ago, according to the research firm RealtyTrac.

Senate Banking Committee Chairman Christopher Dodd (D-CT) held a private meeting Monday with Paulson and Federal Reserve Chairman Ben Bernanke. Dodd, who is running for president, complained afterwards about adjustable-rate mortgages that start with low monthly payments but quickly ratchet up.

"We may have as many as a million to 3 million people who could lose their homes — not because they lost their jobs, not because the economy collapsed, but because they got bad deals on mortgages," Dodd said.

Dodd encouraged people who are facing foreclosure to call a national hot line (888-995-HOPE) run by NeighborWorks America, a nonprofit group. The group offers financial counseling to homeowners and tries to renegotiate more favorable mortgage terms.

Helping Homeowners Renegotiate Loans

"What we often shoot for in that negotiation is a fixed rate and stretching the term back out to 30 years," said Gabe del Rio, vice president of lending with the group's San Diego affiliate. "That essentially provides a refinance product without going through a refinance."

That's important because in areas where home prices have fallen, distressed owners may not qualify for traditional refinancing of their mortgages.

The Neighborhood Assistance Corporation of America is also offering 30-year mortgages with low fixed rates to borrowers who've been victims of predatory lenders. The nonprofit group has access to $10 billion worth of loans, including $1 billion set aside for people at risk of foreclosure.

"That is a drop in a huge bucket," said CEO Bruce Marks. "The problem is, it's the only drop right now. So our goal is not just to provide people with the opportunity to refinance, but to force the major lenders to restructure their loans to make it affordable."

Dodd said the government-sponsored agencies Fannie Mae and Freddie Mac could encourage more favorable loans to distressed borrowers, if the Bush administration would relax restrictions on them. Paulson dismissed that idea, but said the administration is studying other ways to help troubled borrowers.

Eyeing the Practices of Ratings Agencies

Dodd also said the government needs to look at some underlying problems with the market, including the role of credit rating agencies. Until recently, Moody's, Standard and Poor's, and other agencies gave top ratings to securities backed by home mortgages — even those that turned out to be at high risk of default.

"These ratings were way, way off," Dodd said. "And obviously, there's an inherent problem if the agencies are being paid by the very people they're rating. You have some legitimate underlying questions of how reliable those ratings can be."

Rating agencies are paid by the Wall Street firms that bundle mortgages into securities for sale. The rating agencies coached Wall Street on just how many risky mortgages they could pack in, said finance professor Joseph Mason of Drexel University.

"The builders of the securities wanted to push the envelope. And I would say that the credit rating agencies, in order to maintain business in this highly lucrative and fast-growing area, went along with the game," Mason said.

Those credit ratings turned out to be overly optimistic. And when more and more homeowners started defaulting on their mortgages, investors were caught off guard, setting the stage for the current credit backlash.

Mason said that while many investors rely on credit ratings, there are few objective standards. A mortgage-backed security might boast the same high rating as a corporate bond, even though it carries up to 10 times the default risk. When rating agencies have that much leeway, it's little wonder they can be swayed by the people paying their fees, Mason said.

"Regulators don't seem to want to acknowledge that they've handed over this broad authority to the credit rating agencies. Now the credit rating agencies have responded to being handed that broad authority by selling it," Mason said.

Standard and Poor's declined to comment on the criticism. Moody's didn't return a call for comment. In recent weeks, rating agencies have been steadily downgrading securities backed by high-risk mortgages — a move critics say is too little, too late. 

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Main Points:

"This environment is certainly not getting better," he said. "Something tomorrow could turn it around, but this is a first step in series of steps we're going to take."

"I still think so, I've been proven wrong so far," he said. "But I can't believe when you're having the level of delinquencies, foreclosures … that this doesn't have a material effect on the psyche of American people and eventually on their wallet."

"perpetual preferred, this goes on forever"

"Countrywide is NOT a Bank. The mortgage bank does not have access to the window. The bank has access, but no assets."

Yelling fire by the Merill Lynch analyst was irrepsonsible. No basis in fact.

No company can guarantee they won't go into bankruptcy. 

Bull or Bear: Inside a traders mind

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Last week, the mini market meltdown was met with major intervention from central banks around the world. This generation has never seen the kind of synchronized movement we witnessed. And although the Rothschilds would be proud, what does this signal, and what comes next?

There are a few things to keep in mind.

1) Between March and July of 2008, most US mortgages will be recasting to a higher rate. The payment shock for those borrowers has not even been felt

2) Defaults are continuing to rise, and the peak probably isn't even until at least the fall of 2008.

3) Unemployment will rise in to 6% in 2008 (my prediction)

4) Consumer spending and the infallable American Consumer ARE FINALLY FINSIHED. Recent warnings by Home Depot and Walmart are a sign of the weakness to come. I consider Walmart a leading indicator of total aggregate consumerism in the US

and if you look at the 10 year chart of Walmart, its on a slow steady decent on its way to breaking 40 dollars to the downside. Someone is raising cash by selling WMT

Looking at the worldwide marketplace, there are a couple of things to watch and some that aren't truly involved in this unfolding scenario in the short term.

1) China is in its own world, not susceptible to the whims of the older, modern economies. I still remain short term bullish on mainland China. On of the few ways to play the volatility in China is the Ishare FXI. I believe we're about 2/3's the way through the upside in that country and probably will see the market retrenching into the 2008 olympics. Chinese dont have many investment options, are very bullish becouse its the year of the pig (and ultimately pigs get slaughtered) et. al. I would not short or put the market yet. It takes longer to form tops then bottoms.

2) The subprime meltdown is about half over. But its problems are moving into prime borrowers wallets. I see a major moneycenter bank (US or International) having issues by the late fall of 2007 or early 2008.

3) Financial Stocks (22% of current S&P value) are not at a bottom yet. The markets have made the highs for the year already. I would trade with a technical bias to the short side, or raise cash on rallies for most stocks. The Dow will hit 10K in 2008.

4) The dollar will continue to be under pressure. Especially watch the dollar vs. the Yen. If the Yen breaks 110, it is certain to penetrate 100 on the downside and create chaos in the carry trade most moneycenter banks have placed. (think of the speeding unwinding of carry trades as the subprime of the major moneycenter banks)

5) Commodities will continue to show strength since the dollar denominated markets will have to appreciate vs. other currencies. Worldwide demand will continue through 2009. Watch the CRB index

6) Asia and India will be the last areas of the world to find issues with the debt crisis (mainly through dropping exports to the US and devaluated dollar income). When you see those markets get rocked hard, its time to buy American and European stocks again (2010?).

7) Lawsuits resulting from market losses are going to explode in the US and Europe. The US has lost financial credibility and the repatriation of the dollar has now begun. Watch the eurodollar futures for some indication. Europe is in a better position to actually climb out of this mess faster then the US, partly becouse the EU is now showing the promise of integration that has taken over a decade to create.

Where to invest now? Watch upcoming postings for some ideas.....


The great credit rating scandal


When the history of the credit bubble comes to be written, the list of guilty actors will be lengthy indeed: irresponsible banks, greedy borrowers, foolish speculators, incompetent regulators, the central bankers who kept rates too low for too long. Yet one group of players has been especially culpable in creating the current mess.

The credit rating agencies have played a pivotal role in the global debt markets for over thirty years, with the stamp of approval from Moody’s, Standard and Poor’s or Fitch a prerequisite for the sale of a bond. The agencies’ scale of ratings – from AAA for an issuer of unimpeachable creditworthiness, to the Cs and Ds for issuers of highly speculative or defaulted securities (often called “junk”) – form the basis of the capital markets.

Credit ratings are written into the regulators’ rulebooks as the basis for bank capital requirements, and dictate how fund managers allocate their assets. For example, AAA ratings are a prerequisite for money market funds, the pooled vehicles that invest surplus cash and which have liquidity and safety of capital as their primary concerns.

In view of this important status, the rating agencies themselves have to be approved by national regulators – in the US, for example, an agency must be granted Nationally Recognized Statistical Rating Organization (or "NRSRO") status by the Securities and Exchange Commission.

Historically the “gold-plated” AAA rating was earned only by certain developed country governments and a few dozen corporations with strong balance sheets and a minimal risk of default. The number of AAA-rated US corporates actually dropped from 60 or so in the 1960s to 9 in 2005, as there was a general decline in creditworthiness. At the other end of the scale, C and D ratings (usually called “junk”) applied to issuers either in default on bond payments or at imminent risk of default. In between, the grades of double and single A and the “non-investment grade” BBB and below served to highlight subtle differences in borrowers’ ability to pay.

For most of their history, the rating agencies performed the worthy if rather boring task of applying ratings and then moving issuers up and down the scale as economic circumstances merited.

How the credit rating agencies' role has changed

However in the last decade a whole new area of business opened up, one far more lucrative than the bread and butter business of analysing company balance sheets or government accounts. The boom in structured finance – best described as the repackaging, restructuring and resale of existing debts – placed the ratings agencies in a qualitatively different role. Instead of rating already extant bond issues, they became intimately involved in the issuance process itself, advising the investment bankers and their clients on how to obtain the necessary ratings for their new loans.

The structured finance bond issuance production line offered fat fees to bond underwriters (the investment banks) and to the rating agencies.  Moody’s alone earned nearly US$1 billion a year from rating structured finance issues in 2005 and 2006, dwarfing revenues from the more traditional activity of rating government, municipal and corporate bonds.

With such earnings on offer, a conflict of interest inherent in the agencies’ remuneration scheme started to lead them increasingly astray. The agencies had always been paid by the issuers themselves for rating new bonds. Historically this had not been seen as a major problem. True, some investors complained that the raters were too slow to downgrade the bonds of issuers that were getting into trouble, for fear of jeopardising commercial interests (revenue from future bond issuance programmes). In several cases (for example, the Russian debt default of 1998) the ratings downgrades came late into the process of financial deterioration, after investors had already suffered heavy losses.  

In the area of structured finance, this built-in conflict of interest had far more grievous repercussions. 

Structured finance is intimately linked to the financial technique of securitisation, the pooling and repackaging of existing cash flows into a range of senior and subordinate tranches. Here, Wall Street financial engineers achieved a remarkable result, achieved by a kind of alchemy. By collecting and pooling a range of, say, BBB-rated credits, and then arranging them into a series of tranches which are paid off sequentially, they could create a new set of financial instruments with different levels of risk. 

The alchemy that led to more AAA ratings

Then, by modelling the likely default rates, the bankers could present the new bonds to credit rating agencies and get their approval. Here, seduced by the fees that securitisation offered and turning a blind eye to the fact that the models were in many cases untested or based on only a few years of benign economic data, the raters were only too happy to grant AAA-ratings to the top (senior) tranches.

The alchemy in the equation was the realisation that the mere securitisation process was enough to grant higher ratings overall – the (securitised) whole was, according to the raters, worth more, sometimes a lot more, than the starting pool of assets, if one judged by the ratings alone.

This might appear contrary to the laws of nature, similar to a perpetual motion machine. Indeed, many sceptics suggested that the securitised whole could not be worth more than the sum of the parts. If the risks appeared lower, they said, then it was because they were being hidden in the structure.

Such views remain heretical: securitisation has been a money machine for the banks for over twenty years, and has been the lynchpin of the enormous expansion of the global credit market. Yet in recent years the technique might be described as an all-devouring monster, as it was applied to debts of lower and lower quality.

US subprime market: a real money-spinner

The US sub-prime market became the most egregious example of the abuse of the credit rating process and, ultimately, of common sense. Mortgage loans made to lower-income and financially unsound Americans, who had in many cases lied about their incomes and borrowed many multiples of their (fictitious) salaries, were pooled and securitised, with their top-rated tranches granted the gold standard rating of AAA.

Not coincidentally, the commissions and fees involved in the sub-prime lending business were the highest of all, as the end borrower was being charged interest rates well above the the base or wholesale rate in recognition of his or her poor credit standing.

When bonds securitised in this way began to slide in price during 2007, as the US property market began to fall and it became clear that many of the underlying borrowers would default, the rating agencies initially did nothing. Eventually, when the AAA-rated tranches had lost up to 30% of their value, and the lower-rated pieces had become close to worthless, they moved to downgrade many of the issues.

However, rather than confront and explain the scale of their errors, the agencies made a sly and retrospective change in their policy. No-one had ever intended AAA for a securitised bond to mean the same as AAA for a government or corporate issue, they (quietly) argued.

If this was indeed the case, it was news to many investors.  Many funds have lost a lot of money by holding what they thought were safe bonds.  In the case of many hedge funds specialising in credit, such as the Bear Stearns funds that failed last summer, or the Australian Basis Capital, investors lost all their money, as leverage quickly reduced capital to zero.  While it is difficult to feel sympathy for an investor in a hedge fund, other, more vulnerable investors have also been hit.  

The Florida local government investment pool had heavy losses and could not meet redemption requests in November, freezing the cash of hundreds of school districts and towns. Across the Atlantic and far from the tropics, sub-prime losses from bonds issued by Citigroup hit eight northern Norwegian towns, threatening school budgets and elderly care homes.

Bond insurers begin to feel the strain

Meanwhile, as politicians worldwide argued that the sub-prime crisis was contained and markets would soon recover, another key group of participants in the global credit markets started to come under heavy strain. The bond insurers, Ambac and MBIA, used their AAA ratings to enhance the credit of hundreds of thousands of other issuers, and were heavily involved in the structured credit market. As sub-prime losses mounted, the likely payouts on defaulting bonds began to threaten the insurers’own financial health.  

For MBIA and Ambac, the maintenance of the highest rating was critical, as any downgrade would automatically transmit itself to the many bonds they insured, threatening a cascade of falling prices. By the end of 2007 it became clear that the insurers’ likely losses would bankrupt them unless they had a multi-billion infusion of new capital. The companies’ share prices reflected this, losing most of their value during the year. The cost of insuring against the bond insurers’ default (easily gauged from the credit derivatives market) at the same rose to levels consistent with a rating in the Cs or Ds – that is, the market had performed its own assessment of these companies’ creditworthiness, and classified them as junk.

Nevertheless, to date Moody’s and Standard and Poor’s have stubbornly refused to downgrade the bond insurers, and their AAA rating remains.   Although it is likely that they have come under heavy pressure from the banks and, behind the scenes, from regulators, to avoid a downgrade, the agencies’ unwillingness to recognise the insurers’ high risk of default flies in the face of reality, and is attracting increasing criticism.

It is also perhaps the culmination of the long process of loss of integrity that we have outlined. From acting in their first two decades as the investor’s friend, the credit rating agencies had become thoroughly corrupted by the peak of the bubble in 2007.

A lesson for investors: beware conflicts of interest

For them, the outlook is bleak. Their reputation indelibly tarnished, there must be a significant chance that they will in due course fall victim to lawsuits and bankruptcy themselves

However the credit bubble’s deflation will have much wider repercussions. The Basle-II accord, which sets bank capital adequacy requirements on the basis of credit ratings, and depends on discredited financial risk models such as value at risk (VaR), will probably have to be scrapped or rewritten. Many investment and insurance agreements that depend on credit ratings to allocate capital will also need to be amended. The discrediting of the existing ratings system has also seriously damaged secondary market liquidity: whole swathes of the bond market have simply stopped trading.

Recognising the gravity of the credit market seizure, the US central bank has already started an aggressive series of interest rate cuts. Whether this has more than a temporary effect in restoring confidence to an economic system overburdened by poor-quality debts remains to be seen. Yet it is unlikely that the cure for the economy can be more borrowing, which is the origin of the problem. The level of saving in all the Anglo-Saxon economies will have to increase, and this will come at the cost of economic growth, which over the last decade has depended on ever-greater levels of debt. Ironically, rate cuts may impede the return to normality by hurting savers and forcing them to save more for longer, thus dragging out the downturn.

For the investor, the lesson learned is an old one – to pay attention to conflicts of interest. Just as the internet bubble showed us that stock tips given by investment banks with a vested interest in selling new shares were worthless, the credit rating scandal has reminded us that we cannot trust a system where the raters are paid by the issuers.

Paul Amery is an independent financial analyst based in London, formerly a fund manager and bond trader







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