Moody's joins S&P in downgrading mortgage-based securities - 11-Jul-07 - Generational Dynamics

Generational Dynamics Web Log for 11-Jul-07

Moody's joins S&P in downgrading mortgage-based securities

Stocks fell sharply in Europe, North America and Asia, following the moves on Tuesday morning by ratings agencies Standard & Poor's and Moody's Investors Service to downgrade the ratings of mortgage-based securities based on CDOs (credit derivatives). Mutual funds, investment trusts, hedge funds, savings banks, pension funds, college endowments, money market funds, insurance companies, and so forth, hold nominally tens or hundreds of trillions of dollars of these securities in their portfolios, and a fall in the values of credit derivatives will have a domino effect that causing huge losses in these portfolios.

Index price of low-quality ABX-HE-BBB- 07-1 credit derivatives and high-quality ABX-HE-AAA 07-1 credit derivatives from Jan 19 to Jul 10, 2007 <font face=Arial size=-2>(Source: Markit.com)</font>

Index price of low-quality ABX-HE-BBB- 07-1 credit derivatives and high-quality ABX-HE-AAA 07-1 credit derivatives from Jan 19 to Jul 10, 2007 (Source: Markit.com)

The ABX-HE-BBB- 07-1 securities index, which is a proxy for the values of the lowest quality of these CDOs, fell from 55 to 49 early in the day, just after S&P made its announcement, but recovered slightly to close just above 51, resulting in a net fall of 7.4%.

Even more startling, though, is that the ABX-HE-AAA 07-1 index, which is a proxy for the HIGHEST quality of these CDOs fell even more sharply -- from about 99.5 to 98.2. (The "value" of a security based on this index is computed from the (100 - the value of the index), and so a fall from 99.5 to 98.2 is a fall by a factor of 2.6.)

This means that the the mortgage crisis is now spreading rapidly from low-quality subprime mortgages to the highest quality mortgage-based securities.

After S&P announced its lowering of the ratings, Moody's followed suit.

Here are some excerpts from the actual S&P report (PDF):

"The CreditWatch actions are being taken at this time because of poor collateral performance, our expectation of increasing losses on the underlying collateral pools, the consequent reduction of credit support, and changes that will be implemented with respect to the methodology for rating new transactions. Many of the classes issued in late 2005 and much of 2006 now have sufficient seasoning to evidence delinquency, default, and loss trend lines that are indicative of weak future credit performance. The levels of loss continue to exceed historical precedents and our initial expectations.

We are also conducting a review of CDO ratings where the underlying portfolio contains any of the affected securities subject to these rating actions. ...

We have been surveilling these transactions on a regular basis and have been monitoring market trends. At this time, we do not foresee the poor performance abating. Loss rates, which are being fueled by shifting patterns in loss behavior and further evidence of lower underwriting standards and misrepresentations in the mortgage market, remain in excess of historical precedents and our initial assumptions.

[[Note the phrase, "misrepresentations in the mortgage market." - JX]]

New data reveals that delinquencies and foreclosures continue to accumulate at an increasing rate for the 2006 vintage. We see poor performance of loans, early payment defaults, and increasing levels of delinquencies and losses. ...

On a macroeconomic level, we expect that the U.S. housing market, especially the subprime sector, will continue to decline before it improves, and home prices will continue to come under stress. Weakness in the property markets continues to exacerbate losses, with little prospect for improvement in the near term. Furthermore, we expect losses will continue to increase, as borrowers experience rising loan payments due to the resetting terms of their adjustable-rate loans and principal amortization that occurs after the interest-only period ends for both adjustable-rate and fixed-rate loans. ...

Although property values have decreased slightly, additional declines are expected. David Wyss, Standard & Poor's chief economist, projects that property values will decline 8% on average between 2006 and 2008, and will bottom out in the first quarter of 2008. ...

[[Catch the note of optimism in the last sentence. - JX]]

The Mortgage Asset Research Institute (MARI) reports that alleged misrepresentations on credit reports were up significantly as a percentage of total submissions received in 2006. MARI, which was recently commissioned by the Mortgage Bankers Assoc. (MBA) to conduct a mortgage fraud study, reported that the current findings of fraud were in excess of previous industry highs. Data quality concerning some of the borrower and loan characteristics provided during the rating process has also come under question. ...

Data quality is fundamental to our rating analysis. The loan performance associated with the data to date has been anomalous in a way that calls into question the accuracy of some of the initial data provided to us regarding the loan and borrower characteristics."

S&P's statement does several things that it has to do:

It provides an explanation for the ratings changes. It's worth noting that the language used by S&P is exceptionally pessimistic. You will not find such pessimistic language virtually anywhere prior to last month or so (except on this web site, of course).

It blames someone else for the delay. Investors have been accusing ratings agencies of purposely covering up, by failing to lower their ratings on CDOs (mortgage-based credit derivatives) on a timely basis. You can be fairly certain that there will be lawsuits and possibly criminal proceedings against the ratings agencies for having delayed. By saying that other firms had provided S&P with inaccurate data, S&P is laying down its legal defense.

It provides a tiny note of unrealistic optimism, by saying that "David Wyss, Standard & Poor's chief economist, projects that property values will ... bottom out in the first quarter of 2008." S&P doesn't want to make this an official position, so it's worded as the opinion of one man, their chief economist. S&P knows what's really coming, but doesn't want to be responsible for triggering a stock market crash.

Stocks fell about 1% in Europe, North America and Asia, following the release of the ratings changes. Tuesday's speech by Fed Chairman Ben Bernanke had no apparent effect on the stock market except to cause them to go lower.

As I've been saying now for five years, from the point of view of Generational Dynamics we're headed for a new 1930s style Great Depression. (11-Jul-07) Permanent Link
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Generational Dynamics Web Log for 11-Jul-07 Moody's joins S&P in downgrading mortgage-based securities

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Generational Dynamics Web Log for 11-Jul-07
Moody's joins S&P in downgrading mortgage-based securities