Have Moody’s and S&P (and Fitch) Seen the Light (Part 2)?

The original idea for this article, when it was conceived around the beginning of August, was to highlight a number of cases where S&P’s (MHP) ratings for residential mortgage-backed securities remained completely unrealistic, and make a side comment about financial guarantor ratings. In August, S&P downgraded some of the securities, so the order was reversed and financial guarantor ratings were discussed first (in Part 1). By October 1, S&P had slashed the ratings of all but one of the securities to be discussed (and many others like them) to deep junk.

The downgrades reveal just how far off the previous ratings were. They also make the ratings of financial guarantors like FSA, Assured Guaranty Corp. (AGO) and MBIA Insurance Corp. (MBI) seem outright bizarre and incongruous in relation to the RMBS ratings. FSA, Assured, and MBIA have direct (RMBS) and indirect (CDO) exposure to multiple securities from each of the pools discussed below, as well as many others that were downgraded along with them. Financial guarantor ratings will be revisited briefly after discussing the RMBS ratings.

RMBS RATINGS

The following table outlines Moody’s and S&P’s current ratings for four RMBS securities. S&P ratings as of the beginning of August are also shown for comparison purposes.

Pool	Class	Moody’s Rating	Moody’s Rating Date	Current S&P Rating	S&P Rating on August 1, 2009
DSLA 2006-AR2	2A-1C	Caa2	2/20/2009	CC	AAA
CWABS 2006-18	2A3	Caa2	3/25/2009	AA-	AA-
JP Morgan 2006-CH2	AV5	B3	6/12/2009	CCC	AAA
CSFB HEAT 2006-7	M1	C	10/28/2008	CC	B-

In the case of class 2A-1C of the Downey Savings and Loan transaction (DSLA 2006-AR2), S&P maintained a AAA rating for almost six months after Moody’s downgraded to Caa2. This security benefits from a financial guaranty policy provided by Ambac Assurance (ABK). S&P downgraded Ambac to CC from BBB on July 28, about a week before downgrading class 2A-1C to CC on August 4.

S&P downgraded class AV5 of JP Morgan (JPM) 2006-CH2 from AAA to CCC on October 1. Moody’s had maintained a B3 rating for almost four months prior to S&P’s downgrade.

The rating for class M1 of CSFB Home Equity Asset Trust (HEAT) 2006-7 is remarkable because S&P downgraded to CC on October 1, 2009, almost a year after Moody’s downgraded to C. This security is likely to default within six months and never receive a principal payment.

Some summary statistics for each of these securities are provided in the following two tables, which were created based on reports produced by Wells Fargo (WFC), Bank of New York Mellon (BK), and US Bank (USB). The first table shows pool data as of September 30, 2009.

Pool	Class	Pool balance (millions)	60+ day delinquencies FC/BK/REO	Subordination
DSLA 2006-AR2	2A-1C	699.7	43.3%	5.6%
CWABS 2006-18	2A3	1,027.7	55.8%	29.1%
JP Morgan 2006-CH2	AV5	996.2	44.9%	23.4%
CSFB HEAT 2006-7	M1	509.4	56.4%	5.6%

The table below provides similar statistics as of June 30. Performance has deteriorated slightly from June through September, but not enough to make a huge difference in ratings.

Pool	Class	Pool balance (millions)	60+ day delinquencies FC/BK/REO	Subordination
DSLA 2006-AR2	2A-1C	743.4	42.3%	7.7%
CWABS 2006-18	2A3	1,050.2	52.7%	28.8%
JP Morgan 2006-CH2	AV5	1,046.2	40.0%	23.9%
CSFB HEAT 2006-7	M1	555.4	55.9%	9.7%

Recent losses on liquidated loans have average around 70% for the past several months on the Countrywide transaction (CWABS 2006-18). If 90% of the delinquent loans (including those in the process of foreclosure, in bankruptcy, or already foreclosed) are liquidated at an average loss of 70%, then these loans will produce pool losses a little over 35%. Many of the current (non-delinquent) loans have been delinquent recently, and are likely to re-default. If losses on these loans are large enough to offset excess spread interest – the difference between the interest rate paid on class 2A3 and other securities from this pool – then class 2A3 will default because the 35% is larger than the 29.1% current subordination. The rate of net new delinquencies is much higher than the 4% or so per year spread income on the loans in this pool, so a default is likely. This explains Moody’s Caa2 rating. The rationale for S&P’s rating remains a mystery, yet the rating was affirmed in August. On the surface, the likelihood of default does not seem much different from the JP Morgan security that was downgraded to CCC.

Class 2A-1C of DSLA 2006-AR2 differs from many senior securities in that it does not benefit from pro rata loss sharing once the subordinate securities are wiped out. Instead, it absorbs losses for the other group 2 senior securities. Losses of around 20% on the group 2 securities would burn through 2A-1C, and begin to generate losses on the more senior group 2 securities. This security will continue to receive principal payments in the interim, so there will not be a complete principal loss (only 80%-90%). It has looked very likely for six months that losses would burn through class 2A-1C. It is remarkable that S&P maintained a AAA rating for so long on a security that was highly likely to default and recover only a very small percentage. At a minimum, S&P should have downgraded this security to Ambac’s rating, a ridiculously inflated BBB at the time. In addition to downgrading 2A-1C, S&P downgraded class 2A-1B3, which is senior to 2A-1C, to CCC on August 4. Moody’s has rated 2A-1B3 Ca since February.

To be fair, S&P’s ratings for most securities have been more reasonable than the ratings for the ones discussed here. However, these ratings are reasonably representative of a significant percentage (perhaps 20% or so) of S&P’s ratings.

FINANCIAL GUARANTOR RATINGS

S&P’s recent downgrades, many of which affect securities wrapped by the financial guarantors, reveal yet another level of ridiculousness to the AAA ratings for FSA and Assured Guaranty Corp. Recent downgrades increase junk rated exposure to well over $15 billion for FSA and $7 billion for Assured Guaranty Corp., around seven times Assured’s Statutory Capital

Recent single notch downgrades (to AA-) of Assured Guaranty Corp. and FSA show that Fitch does not want to be outdone in the inflated ratings game. On the surface, a AA- seems more realistic than S&P’s AAA, but the AA- is drastically inconsistent with Fitch’s RMBS Loss Metrics, which project severe losses. For example, Fitch projects lifetime principal losses of 71% on class A-2 of DBALT 2007-OA5. This equates to approximately $49 million on Assured’s $65 million of exposure. Fitch does not project losses for CWALT 2007-OA10, but analyzes two similar pools with similar performance, CWALT 2007-OA3 and 2007-OA4. Fitch’s projections imply principal losses of 70%-75%, or about $130 million, on the parts of CWALT 2007-OA10 that Assured wraps. Overall, Fitch’s projections imply ultimate RMBS principal losses of over $2.5 billion for Assured. Based on the ceded percentages from Assured’s recent Statutory financials, over $1.5 billion would be retained net. This is greater than Assured Guaranty Corp.’s Statutory Capital, and would leave Assured Guaranty Corp. with $1 billion of claims paying resources to cover $2 billion to $3 billion of other (non-RMBS) below investment grade exposure and $135 billion of investment grade exposure.

Fitch’s loss projections applied to FSA’s portfolio would leave an even more crippled balance sheet, with losses eroding all or almost all of FSA’s claims paying resources.

Fitch’s RMBS loss projections produce present value losses for MBIA Insurance Corp. of around $14, $7 billion each on CDOs and direct RMBS, almost double the company’s claims paying resources. It looks highly unlikely that MBIA will be able to meet its obligations.

CONCLUSION

After miserable failings on a massive scale in structured finance, a handful of remaining sham ratings are not all that significant from a practical standpoint. The fallout from past failures will cause serious reputational damage even if future ratings were perfect. However, the blatantly ridiculous ratings of the financial guarantors and a handful or RMBS securities reveal that the agency remains more concerned with damage control than restoring the integrity of its ratings. This is unfortunate, because S&P and the other rating agencies offer many valuable services to a wide variety of parties. It would be nice if honest and competent ratings were one of these services.

Disclosure: Short MBI, AGO, MHP

Comments

[notsosmart]

nobody should pay attention to these people in hopes they would go away.some of them should be with made-off.

2009 Oct 22 03:08 PM

[TFC]

For generations institutional credit investors have accepted ratings based on agency reputation, which in corporate debt has been mostly justified. In structured product most investors, including the rating agencies were out of their depth in understanding collateral quality. It seems all the checks and balances missed this one, the banks and Govt. watch dogs. Why would the rating agencies be different?

2009 Nov 10 09:23 AM