The Ratings Game

From Bloomberg:

S&P, Moody’s Hide Rising Risk on $200 Billion of Mortgage Bonds

Standard & Poor’s, Moody’s Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans.

The highest default rates on home loans in a decade have reduced prices of some bonds backed by mortgages to people with poor or limited credit by more than 50 cents on the dollar and forced New York-based Bear Stearns Cos. to offer $3.2 billion to bail out a money-losing hedge fund. Almost 65 percent of the bonds in indexes that track subprime mortgage debt don’t meet the ratings criteria in place when they were sold, according to data compiled by Bloomberg.

That may just be the beginning. Downgrades by S&P, Moody’s and Fitch would force hundreds of investors to sell holdings, roiling the $800 billion market for securities backed by subprime mortgages and $1 trillion of collateralized debt obligations, the fastest growing part of the financial markets.

“You’ll see massive losses from banks, insurance companies and pension managers,” said Joshua Rosner, a managing director at investment research firm Graham Fisher & Co. in New York and co-author of a study last month that said S&P, Moody’s and Fitch understate the risks of subprime mortgage bonds. “The longer they wait, the worse it’s going to be.”
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Rosner estimates that collateralized debt obligations, which have packaged thousands of bonds and derivatives into new securities, will lose $125 billion. Institutional Risk Analytics, a Hawthorne, California-based company that writes computer programs for the four biggest accounting firms, says 25 percent of the face value of CDOs is in jeopardy, or $250 billion.

Losses may rival the savings and loan crisis of the 1980s and 1990s. The Resolution Trust Corp., formed by the U.S. government to resolve the thrift crisis, sold $452 billion of assets at a cost to taxpayers of about $140 billion.

The current debacle threatens the growth of asset-backed bonds, securities that use consumer, commercial and other loans and receivables as collateral. That market, which includes mortgage securities, has doubled to about $10 trillion since 2000, according to the Securities Industry Financial Markets Association, a New York-based trade group.

Executives at New York-based S&P, Moody’s and Fitch say they are waiting until foreclosure sales show that the collateral backing the bonds has declined enough to create losses before lowering ratings on some of the $6.65 trillion in outstanding mortgage-backed debt.
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“Don’t misunderstand me: I’m not saying these others are performing great,” Robert Pollsen, a director in S&P’s residential mortgage surveillance in New York, said in an interview last month. “And they certainly might warrant our attention several months from now, which obviously we’re going to do.”

Some investors say the ratings companies are waiting too long before downgrading the mortgage bonds and the CDOs that contain them. They noted that S&P and Moody’s maintained their investment-grade ranking on Enron Corp. until days before the Houston-based energy trader filed for bankruptcy.
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“A lot of these should be downgraded sooner rather than later,” said Jeff Given at John Hancock Advisors LLC in Boston, who oversees $3.5 billion of mortgage bonds. The ratings companies may be embarrassed to downgrade the bonds, he said. “It’s easier to say two years from now that you were wrong on a rating than it is to say you were wrong five months after you rated it.”
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The ratings companies point out they have downgraded bonds less than a year after they were sold, the first time that has ever happened. S&P has lowered a total of 15 subprime bonds sold in 2005, or 0.31 percent of the total, and 32 sold in 2006, or 0.68 percent.

“People are surprised there haven’t been more downgrades,” Claire Robinson, a managing director at Moody’s, said during an investor conference sponsored by the firm in New York on June 5. “What they don’t understand about the rating process is that we don’t change our ratings on speculation about what’s going to happen.”
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“That’s like saying these trees are just fine as there’s a forest fire on the other side of the hill,” said James Melcher, president of money-management firm Balestra Capital Ltd. in New York, who runs a $105 million hedge fund.