Tuesday, July 10, 2007

Looks Like the Rating Agencies are Beginning to Move

Better buckle your seat belt, like I said in an earlier post this is going to be an interesting summer and fall. From the WSJ:

Standard & Poor's said it expects the majority of the 612 classes of mortgage-backed securities it put under review Tuesday to be downgraded "beginning in the next few days." . . . .

In a press release, the rating agency also said it is reviewing the credit ratings of collateralized debt obligations -- complex securities that have been under the spotlight since two
Bear Stearns Cos. hedge funds stumbled recently -- that contain any of the affected mortgage bonds facing downgrade.

The announcement about the potential downgrades sent shivers through the credit markets, as such action could spark broader selling of these mortgage bonds and a repricing of these assets that are difficult to trade.

The mortgage bonds under review for a downgrade total approximately $12 billion in rated securities, roughly 2.13% of the $565.3 billion in U.S. residential mortgage bonds rated by S&P between the fourth quarter of 2005 and fourth quarter of 2006.

Any deal that is expected to experience losses within 12 months, regardless of its current rating, will be downgraded to CCC, a highly speculative category, S&P said.

Deals facing losses within 13 to 24 months will be given a B-rating, five notches below investment-grade and deals facing losses within 25 to 30 months will be cut to BB, or two notches below investment-grade ratings.

A BBB status will be assigned to deals that are likely to face losses in the next 31 to 36 months.
The ratings agency also said it is going to change the methodology it has been using to rate these deals with immediate effect, but provided few details about revisions. In its release, S&P said that standard variables since FICO credit scores, loan-to-value rations and ownership status used to evaluate a borrower's risk for default "are proving less predictive" than in the past.

Subprime loans aren't the only problem, however. S&P said in the conference call that it will also review bonds backed by Alt-A loans - a type of mortgage that straddles the divide between prime and subprime.

Alt-A deals have "similar characteristics" as problem subprime loans, said S&P analysts in the call. "We expect to come out with performance information on those shortly," one analyst said.
As for the loans themselves, S&P said it expects "the losses will continue to increase, as borrowers experience rising loan payments due to resetting terms of their adjustable-rate loans."
When these loans were made, the assumption was that with home prices rising steadily, if a borrower was unable to pay the higher interest rate on his mortgage, he could sell his home or refinance. Now, with a slowing housing market, those options are not available to most borrowers.

Clearly, no risk analysis was completed by the borrower when these loans were made. Also none was completed by the lender either. This happens every time in lending when the profit motive supercedes risk considerations. Buying a home with debt is NOT like buying stock with your margin account. The home is not liquid.

S&P's warning that mortgage bonds face potential downgrades helped push the benchmark derivative ABX index that measures subprime credit risk to a new record low.

The riskiest, triple-B-minus tranche of the subprime-based index hit at 50 cents on the dollar in morning trade, according to Derrick Wulf of Dwight Asset Management. It later recovered slightly, trading at 52 cents on the dollar, he said. Yikes!!! (my emphasis).

The higher-rated double-A tranche is trading at 95.75 cents on the dollar, also slightly lower from Monday's close of 96.50 cents on the dollar, according to Alex Pritchartt, a trader at UBS.

"The expectation is that a lot of hedge funds that invested in this sector could blow up," Mr. Lahde said.

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