Rating Agencies Target Guarantors to Deflect Subprime Blame

Includes: AMBC, MBI, MCO, SPGI
by: Tom Brown

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 (NYSE: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 (NYSE: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.