Rating Agencies Target Guarantors to Deflect Subprime Blame

Wall Street loves sports analogies, so allow me to offer one: the credit-rating agencies are to the financial guarantors what Tim Donaghy is to NBA officiating.

You think I’m overstating things? I’m not. Both the agencies and Donaghy can be relied on to make up random rules, then apply them only to the players they’ve decided to punish. Donaghy sold out for money, while the agencies did so to evade responsibility for the subprime mess. In particular, the agencies want to shift the blame to the guarantors, by coming up with rules the companies find it more difficult to operate under. The only other difference is that the people who run the agencies aren’t being forced to pay a price for their dishonesty. Too bad.

If you want evidence of the corruption that now pervades the agencies’ work, look no further than the “rationale” they offered last week when they downgraded the debt of MBIA (MBI) and Ambac (ABK). It is the picture of unfair, self-interested rulemaking. Here are the reasons the agencies gave for the downgrades:

Continued deterioration in the mortgage market has led to an increase in “stress case” loss estimates. I can understand how the agencies’ base case loss estimates could have (and should have) risen sharply in recent quarters. But the stress case? Those are supposed to be the losses the agencies believe will in the most extreme, 1-in-10,000-year set of circumstances. You don’t define a stress case by looking at recent headlines; you set it by stepping back, defining the worst-possible outcome to a number of variables, and then assuming they all correlate.

Which is to say, a stress-case loss estimate is not the kind of number one would expect to change every other month. And yet the agencies seem to be changing theirs regularly. From what I can tell, S&P (MHP) and Moody’s (MCO) have changed their stress-loss estimates at least three times over the past nine months. It’s not as if Ambac and MBIA have added meaningfully to their insured portfolios over that time. But that doesn’t matter: like a couple of crooked refs, the agencies are going to make the call they want to make, regardless of the facts.





(Especially mystifying is the decision by Moody’s and S&P to cite recent deterioration in subprime mortgage credit quality as a reason for their downgrades. The deterioration in subprime credit quality since the beginning of the year has largely been driven by already-bad loans moving through the delinquency buckets. As we’ve pointed out here since the start of the year, the inflow of newly delinquent loans has slowed, while the rate at which early-stage delinquent loans roll into later stage buckets has fallen. These two factors, inflow rates and roll rates, are the most important numbers the agencies should be watching to gauge the ultimate losses. Both have improved for the past several months.  Not deteriorated--improved! But to the agencies, that doesn’t matter. They are determined to stick it to the guarantors, and so are not reluctant to cite “facts” that are manifestly false.)

The companies are seeing a lack of new business. This isn’t just nonsensical; it’s dangerous. Can we take a moment and review the basics of how insurance is supposed to work? If I’m an insurer who agrees to cover a given risk, the revenues I expect to generate when I enter into the contract should be enough to pay any future claims I expect to make. I shouldn’t have to depend on revenue from unrelated new contracts I enter into with other parties, somewhere down the road. There is a name for that latter model. It’s called a “Ponzi scheme.”  

An insurer’s prospective business is beside the point. Notably (and sensibly) Moody’s and S&P used to understand that; they have historically rated the bond insurers based on their ability to pay claims, not on their ability to grow their books of business. If anything, the agencies should view new growth with suspicion. If new business were so important a factor in setting ratings, why didn’t Moody’s and S&P have higher ratings on the faster-growing (and now nearly defunct) guarantors (FGIC, SCA, ACA, and CIFG) back in 2006 and 2007 when those companies were growing their RMBS and CDO insured exposures much faster than Ambac and MBIA?  For that matter, how can Moody’s and S&P say any tranche of any securitization is triple-A? New business there is clearly not forthcoming, and won’t be any time soon.

Simlarly, how can Moody’s (20% owned by Berkshire Hathaway) rely on new business in setting ratings and then turn around and rate Berkshire’s new bond insurance subsidiary AAA before the unit had even written a dime’s worth of business, and had no experience in this long-term underwriting business? The only possible explanation: the “new business” standard is a red herring, selectively applied, in order to stick it to MBIA and Ambac.

The companies have reduced financial flexibility. No, they don’t. Neither Moody’s nor S&P dispute that Ambac and MBIA have sufficient capital to pay all future claims even assuming what I believe are excessively high loss forecasts. For example, S&P is assuming 40% cumulative losses on the loans included in insured securitizations backed by closed-end second mortgages and home equity lines of credit. But the agency makes no distinction—none—between a subprime loan securitization and a prime loan securitization! That’s not just incompetent—it’s crazy and reckless.

And as long as Ambac and MBIA are adequately capitalized, why in the world should Moody’s and S&P care where their stocks are trading? Or how high their credit default swap spreads are?  Irrelevant. The agencies’ ratings are supposed to be cold, rational evaluations of the capital and claims-paying ability of the companies they rate.

The agencies are being particularly disingenuous, in my view, when they suggest MBIA does not have sufficient financial flexibility when it has $1.5 billion in cash at the holding company level and Warburg Pincus as a financial partner.  I’m sure Warburg could find a sufficient number of co-investors to take MBIA private within 24 hours if things come to that.  Given all this, for the agencies to cite “reduced financial flexibility” as a reason to downgrade the guarantors strikes me as being beyond not fair.

So the agencies are spouting a lot of nonsense. The truth is both Moody’s and S&P are running scared. I can’t say as I blame them. They were central players in hatching the greatest financial crisis in our lifetimes. Other key players who made misjudgments have paid the price: a raft of originators are out of business, investment banks have taken hundreds of billions in writedowns, the guarantors have raised new capital on highly dilutive terms. It’s only the rating agencies, cowed by the possibility of litigation, who refuse to step up and take responsibility for their earlier decisions. Instead, they make up random new rules, and apply them arbitrarily, in a disgraceful attempt to shift the blame to others. They should be ashamed of themselves.

In the end, Tim Donaghy was called to account. The agencies should be, as well. As referees of the financial guarantors, they have intentionally changed the rules under which they want these companies to operate, solely to protect their own corporate interests. That’s not incompetent. It’s corrupt.  I, for one, believe Congress and the S.E.C. should delve into the matter.

Tom Brown is head of BankStocks.com.

Comments

[Ishortyou]

In respect to AMBAC and MBIA, they need to keep and save all the cash possible including stop paying dividends, deleverage from all their risky liabilities specially those CDS, CDO's, RMBS-ABS of uncertain value, in order to remediate their book values, once their book values are sound they need to reinstate their triple A rating again to write new low risk public bond insurance business. They can also open or extend a line of credit to make sure to continue operations and dissipate doubts.

They are already doing these, so it will take some time to deleverage their books from uncertainties and rewrite new business again. This coming back will be the best advertisement to recruit new clients.

[apppro]

Now go read the Whitman article on the site. 1+1 does equal 2 in this case.

seekingalpha.com/artic...

And why do the same comments made by some bloggers appear under different stories?

[valuemanager03]

With all due respect to Tom... but his article is just blame shifting from the insurance companies TO the ratings agencies. The insurers took crazy risks at very low premiums... and thus ruined their reputations themselves (while all the while being rated AAA). Those poor underwriting decisions are NOT the rating agencies faults. Even while being rated AAA early this year, the market (investors and clients) already treated them as insolvent. Look at the yields they had to offer to raise capital. Look at municipalities reinsuring their already wrapped bonds. And Moodys or S&P keeping a AAA now wouldn't change that.

[crashof2008]

Some of you have heard about MBI and ABK attempting to cancel 125 billion in credit default swaps in intense negotiations with Citibank, Merrill and UBS. Most accounts put MBI's share at 80 billion of this.

Any negotiations to cancel the 80 billion in insurance contracts that MBI wrote will be extraordinarily problematic, especially in this environment of collapsing bank profits.

To understand why, you need to master the difference between a CDO and a CDS. The difference between these two is an absolutely VITAL distinction that so many overlook.

I'll keep it short and sweet. But you need to master this distinction. Read carefully for just 30 seconds and it will serve you well.

Think of a CDS (credit default swap) as an insurance policy. MBI insured 80 billion of largely worthless paper to various banks. They are, after all, an insurance company and thought this would be a logical extension of their insurance business.

Now MBI wants the banks such as Merrill and Citi and UBS to cancel the insurance policies. MBI is basically offering to simply refund the premiums paid.

This would leave the banks holding 80 billion dollars of collateralized debt obligations (CDOs) that had been insured and guaranteed by MBI.

It's like if your house is destroyed in a fire. The insurance company, instead of reimbursing you for the value of the home (say $400,000) offers instead to rebate you the $1200 you have paid in premiums.

Would you take it?

This is what MBI is offering.

[Ishortyou]

well there is a catch to it, everytime the insurers get downgraded, the CDO's (which is a form of a bond) get downgraded as well, so we are getting into a vicious cycle of downgrades in ratings for almost all the bond industry, the only way to stop this is to give some stabilization to the insurance industry, unfortunately this cannot be done unless deleverage from those CDS and CDO's is taken into effect, no one wants those CDO's not even the bank themselves which originate them, but if the banks leave it to the already hurt insurers to take care of them the only thing they are doing is to hurt themselves.

[oldlures1]

Mr. Brown, I hear your frustration, and for what it's worth, I feel it as well! It is astonishing that no one is questioning the rating agencies actions, no one of authority that is. Their capricious and subjective decision-making seems so obvious, so blatant, and yet they're allowed to continue unchecked. It is maddening!

valuemanager03 - I strongly disagree. If MBI and ABK were allowed to keep their AAA; as they should pursuant to their capital adequancy and financial performance, they could continue writing business (as they were doing, albeit at far less volume, depsite what you read in the headlines), the mkt turmoil would eventually dissipate in time and the reputation of both companies would recover, again...in time. They don't need the new business to protect current policyholders, so there is no...I repeat, no...reason for them to have been downgraded in the first place.

With regard to the rating agencies, I've got say, it must be to operate with impunity, completely unaccountable for your actions...even if doing so ruins otherwise viable going concerns.

I'm a firm believer in free-market capitalism, but this is NOT what I had in mind. This is just plain wrong!

[JKirk]

Really, what ABK/MBI suffer from is that they don't control their business model. It relies on a AAA rating from the rating agencies and they didn't have a contractual goal post for maintaining that rating. They thought they just had to have reserves that fulfilled the Moodys/S&P models, but have found out those models... however long they've been in effect previously, can be changed 3 times in a six-month period due to fear. I don't know if ABK/MBI will remain going concerns, but in run-off they seem to be worth multiples of their current stock price... and there are of course lots of talented/experienced people there available to start new financial guarantor companies.

[Reclined]

Tom,
You have a point regarding the short-sightedness of the agencies' evaluation game. Unfortunately being right here does not help MBIA/ABK since they have too much leverage to gain back credibility in these confusing times. As always in the short term it does not matter whether you will be able to pay and survive but only whether people believe you'll be able to. Might be a big difference!

I wish I had the ability to correctly analyse today's exposure of financial players. I believe I would become exceedingly rich :-)

[mythoughts]

For those of you that like MBIA stock I have some housing stocks I would like to sell you at a special price.

[XORCIST]

The rating agencies (should) have lost their credibility, while the bond guarantors have already paid the consequential price in enormous losses. It's time for a paradigm shift. Who can trust what Moody's says for longer than a week? The rating labels (e.g., Ab2, Bb3) sound absurdly archaic and the MCO name suggests capriciousness and despondency. The Silly Exchange Commission should initiate the transition away from institutionalized dependence on these charlatans. Otherwise, too many gullible "money managers" will get confused, not to mention the bond assurance equity holders. Less than 12 months ago Morningstar rated ABK and RDN 5 stars! Enough!