http://www.princeofwallstreet.com/2008/02/04/for-…
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.
http://www.princeofwallstreet.com/2008/02/04/for-…
The Prince
http://www.princeofwallstreet.com
