Have Moody’s and S & P Seen the Light? (Part 1)

Moody’s (MCO) and Standard and Poor’s (S&P), the nation’s largest Nationally Recognized Statistical Rating Organizations, have faced a barrage of recent criticism over their ratings of structured finance assets. Continued criticism over past rating mishaps and reduced structured finance revenues are likely to pose the most significant challenges over the next year. However, it is interesting to consider whether the recent criticism has motivated Moody’s and S&P to provide competent and honest ratings. This will be done in two separate articles focused on two areas that have revealed major problems – ratings for residential mortgage backed securities (RMBS) and financial guarantors.

This article (Part 1) deals with financial guarantor ratings, which remain more troublesome than RMBS ratings. It suggests that Moody’s recent ratings are not as unrealistic as Standard and Poor’s ratings, some of which appear to be based on incompetence, fraud, or some combination of the two.

The table below outlines current ratings for three financial guarantors, Financial Security Assurance (FSA), Assured Guaranty Corporation (AG Corp.) (AGO), and MBIA Insurance Corporation (MBIA Corp.) (MBI). FSA was purchased on July 1 of this year by Assured Guaranty Ltd., AG Corp’s parent. The Moody’s ratings for FSA and AG Corp. are under review for possible downgrade.

Rating Agency	FSA	AG Corp.	MBIA Corp.
S&P	AAA	AAA	BB+
Moody's	Aa3	Aa2	B3

FSA and AG Corp. will be discussed first. The following table, produced from the companies’ operating supplements, highlights the credit exposure by rating of each of these companies as of June 30, 2009. The ratings are internal, but they track closely with Moody’s and S&P ratings.

	Net Par Exposure (dollars in billions)
Rating	FSA	% of total	AG Corp.	% of total
AAA	71.6	17.2%	44.3	34.7%
AA	144.2	34.7%	17.2	13.5%
A	144.3	34.7%	43.7	34.2%
BBB	41.3	9.9%	16.2	12.7%
Below investment grade	14.48	3.5%	6.3	4.9%
Total	415.8	100.0%	127.7	100.0%

Net par exposure is the outstanding principal balance of amounts insured, less exposure ceded via reinsurance. The exposure transferred to reinsurers exposes FSA and AG Corp. exposure to reinsurer credit risk, but this is ignored for the purposes of this article.

Financial guarantors often refer to money available to absorb credit losses as “claims paying resources.” Claims paying resources are not quite as good as cash or risk free securities, because they include premium installments to be collected over a number of years, possibly after the funds are needed to pay losses. There is also a risk that future premiums turn out to be less than anticipated. For the purposes of this article, it will be assumed that claims paying resources are as good as cash.

The table below outlines claims paying resources for these two companies.

Claims paying	Billions of	% of net par
resources	dollars	exposure
FSA	7.28	1.7%
AG Corp.	2.72	2.1%

Under the assumption that future financial guaranty insurance writings will be adequate (but not more than adequate) to cover future operating expenses and credit risk on new policies, the tables above imply that $7.28 billion (1.7% of exposure) to fund losses is enough to boost the ratings of the $415.8 billion of credits insured by FSA to an S&P rating of AAA and a Moody’s rating of Aa3 Similarly, a $2.72 billion buffer (2.1% of exposure) is enough for a AAA S&P rating and a Aa2 Moody’s rating on the $127.7 billion of debt insured by AG Corp.

On the surface, this seems preposterous. Below investment grade exposure is twice claims paying resources for each company. Arguably, this might be enough to push the ratings below investment grade even if these credits were mostly rated BB (instead of CCC or lower), but the below investment grade credits are highly correlated and mostly at or near default.

Another way to evaluate the default risk on credits insured by the financial guarantors is to compare it with non-recourse debt issued by an investment fund that holds the assets insured by the financial guarantors. Assuming the fund holds equity capital equal to the financial guarantor’s claims paying resources and the average rate on the investment fund’s debt is the same as the rate earned on the fund’s assets, the risk of default on the fund’s borrowings should be very close to the risk that the financial guarantor defaults on insured obligations. The following table provides a simplified capital structure for two hypothetical investment funds that hold the bonds that FSA and AG Corp. insure, along with ratings that seem intuitively reasonable for different classes of debt issued by the funds.

Capital	Fund A	Fund B
structure	(FSA)	(AG Corp.)
AAA- rated debt	364.5	111.3
AA-rated debt	18.6	5.9
A-rated debt	12.9	4.0
BBB-rated debt	10.1	3.3
<BBB-rated debt	9.8	3.1
Equity	7.3	2.7
Total	423.1	130.4
AAA credit support	51.3	16.3
As % of total exposure	12.1%	12.5%
% of debt rated AAA	87.7%	87.2%
BBB credit support	17.1	5.9
As % of total exposure	4.0%	4.5%
Claims paying resources	7.28	2.72
As % of total exposure	1.7%	2.1%

Assuming these ratings are reasonably fair, this table implies that FSA and AG Corp. should be required to more than double their claims paying resources to justify BBB ratings. AAA ratings should require claims paying resources over six times as high as actual claims paying resources.

This oversimplified analysis does not consider the individual credits and the correlations between them. A more detailed analysis suggests more credit risk than this simplified analysis. Highly correlated mortgage-backed debt in or near default accounts for a high percentage of the below investment grade exposure for each company. In addition, a growing percentage of the remaining structured finance credits are facing increased stress, and insured municipal credits are facing budgetary challenges that are unprecedented in the past 70 years. Credit risk is highly correlated within each asset class, and is also correlated across asset classes. High mortgage defaults correlate with credit card defaults, and both correlate with municipal defaults, etc.

A strong case can be made that too much of the hypothetical investment funds’ debt is rated AAA (87.7% for FSA and 87.2% for AG Corp.), given the thin layer of equity capital (1.7% for FSA and 2.1% for AG Corp.) and relatively small percentage of AAA-rated assets. Some might also argue that more of the debt should be rated AAA. However, it is absurd that 98% should be rated AAA or AA, as implied by the S&P and Moody’s ratings.

MBIA Corp.’s ratings are amenable to a more rudimentary analysis than FSA and AG Corp. with the help of the table below, created from MBIA’s second quarter operating supplement.

Rating	MBIA Corp.
AAA	109.5
AA	16.4
A	25.8
BBB	38.8
Below investment grade	26.2
Total	216.6
Claims paying resources	7.78

Since June 30, additional insured credits have been downgraded, increasing the below investment grade exposure from $26.2 billion to over $30 billion. Of this $30 billion, over $20 billion is at or near default. Based on the below investment grade exposure alone, it is difficult to see how an investment grade rating can be justified without at least $20 billion of claims paying resources, or how a rating in the BB range is justifiable without at least $15 billion of claims paying resources. S&P rated MBIA Corp. BBB until last week, when the rating was downgraded to BB+.

If S&P’s ratings of the financial guarantors are as preposterous as they seem, then the agency is likely to face continued credibility damage, opening the door for other competitors to gain market share and push profit margins below the monopolistic levels where they have been for most of the past five years. Readers who believe that there is some reasonable basis for the S&P or Moody’s ratings of FSA or AG Corp. or the S&P ratings of MBIA Corp. are encouraged to present their arguments.

Disclosure: Short MHP, AGO, MBI

Comments

[Mad Hedge Fund Trader]

Terry McGraw, CEO of McGraw Hill, and owner of defendant Standard & Poor’s, says that at the peak in 2006, the industry was prepared for a worst case scenario of a 15% draw down in real estate prices over 18 months on the local level. Instead, it got a 50% national plunge that is now two years old and aging. It didn’t help that a Moody’s analyst wrote an e-mail saying he would rate paper issues by “cows.” In the race for market share, Moody’s, S & P, and Fitches’ competitively devalued the meaning of “AAA” so that even the most toxic subprime sludge came out highly rated. With their seals of approvals, the agencies became the facilitators-in-chief of the over lending and over borrowing that made the crash a mathematical certainty. The hedge funds that made billions wisely ran their own in-house ratings departments which thought otherwise. They fell down on their knees, thanking God that inflated “independent” ratings led to wild over valuation of debt securities and set up some of the greatest shorts of the century. There is no Hell hot enough to make ratings agencies adequately pay for their deliberate misdirection of trusting investors. As for the hedge funds, their new short play is the one rating agency that is still publicly traded, Moody’s (MCO).

2009 Oct 07 08:14 AM

[roadwarriors57]

Mark, your reasoning is sound and hope to see some arguments with additional analysis rather than most that are simply personal rants against the rating agencies with no basis in fact.

As for your first commenter - The mad hedge fund trader, while it notes he has made 3,066 comments apparently 3,000 of them has been this identical comment continuously cut and pasted to every article listed on Seeking Alpha.

2009 Oct 07 09:49 AM

[Mark Alexander]

MaxHedge, I have made a mental distinction between Moody’s and S&P for a couple reasons.

1. Moody’s has gotten its RMBS ratings in order, and ratings in other areas seem to have some analytical basis. Its ratings of financial guarantors are within a few degrees of being plausible.
2. S&P’s recent round-trip on CMBS (from AAA to BBB to AAA, or something like that) was particularly incompetent.

Realistically, these distinctions may have no impact on share prices in the intermediate term. For the time being, Moody’s will take at least as much heat as S&P, if not more, even though Moody’s taken very meaningful steps toward better practices. Meanwhile, there is no guarantee that S&P’s strategy of weaving bigger and more blatant lies to cover up past incompetence and fraud will backfire.

Roadwarriors, thanks for the kind words.

Overall, unless we experience a magical recovery, the outlook for investors in S&P and Moody’s seems very poor as they will face a triple whammy.

1. Reduced long-term size of the market as structured finance remains a fraction of its glory days, and we settle in to more reasonable levels of debt issuance
2. Lower market share driven by increased competition.
3. Lower margins driven by increased competition.

2009 Oct 07 10:51 AM

[M Smotth55]

While many of your points are valid on the surface, they lack sufficient depth. Lower and below investment grade securities are concerns, but the mistake that continues to made is assuming the securities have zero recovery value and nothing is more from the truth, also the insurers control most aspects of the restructuring. So it's not the default rate that should be the focus of attention, but rather the recovery rate. I am not a fan of the rating agencies, but they have information about an issuer that we don't, so the information playing field is not level and we cannot fully assess the risks. It's kind of like being a being a fan at a football game, sure you see the speed, but seeing it and being on the field to experience it are two different things. Many investors don't understand or can assess the risks and this inability to do so was fueled by fear and contribute to the fallout of 2008.

2009 Oct 07 11:27 AM

[Mark Alexander]

The basic thesis of the article is simple. Taking AG Corp. as an example, the idea that one can take a $128B portfolio made up of 35% AAA, 13% AA, 34% A, 13% BBB, and 5% below investment grade credits, throw in 2.3% to absorb losses, and call it all AAA is absurd on its surface.

The available information on most of the troublesome credits insured by Assured and FSA is good enough to get an idea about their loss potential (including default and recovery rates). The AAA rating looks even more ridiculous if one takes the time to examine individual credits.

Your comments “they have information about an issuer that we don't” and “we cannot fully assess the risks” are partly true. However, this mentality is what has enabled completely ridiculous ratings supported by fantasy world black boxes.

The reality is that the rating agencies have been extremely slow to downgrade structured finance credits when needed. Moody’s seems to be getting its act together, but S&P seems to have fallen into a deep funk.

Two securities that illustrate the insanity of S&P’s behavior are classes 1A-1B and 2A-1C of DSLA 2006-AR2, insured by Ambac. Year-end 2008 performance data suggested that that these two securities would default, and Moody’s downgraded them to Ca in February. Performance has steadily worsened since then making a default appear all but inevitable, but S&P did not downgrade to match Ambac’s BBB rating. S&P finally downgraded from AAA to CC in August, two weeks after Ambac was downgraded, and six months after Moody’s. Investors will be lucky to recover 50 cents on the dollar – 10 cents from pool cash flows and 40 cents from Ambac. S&P’s actions were not driven by superior analysis and information. S&P just dropped the ball. This security and some others that maintain ridiculous S&P ratings will be discussed in Part 2.

2009 Oct 07 09:15 PM