According to an article on Bloomberg today:
Moody’s Investors Service has created a new unit that surprises even its own director.
The team from Moody’s Analytics, which operates separately from Moody’s ratings division, uses credit-default swap prices as an alternative system of grading debt. These so-called implied ratings often differ significantly from Moody’s official grades.
The implied ratings frequently show that swap traders think debt is in more danger of defaulting than Moody’s credit ratings signify. And here’s the kicker: The swaps traders are usually right.
In fact, by their own admission, the track record of Moody’s is downright abysmal:
[The new unit’s managing director, David] Munves says that over one year, the implied ratings have been a more accurate predictor of defaults than Moody’s ratings. The Moody’s unit reports that implied ratings for one year have a 91 percent accuracy ratio compared with an 82 percent ratio for Moody’s official ratings.
In other words, the failure rate of the Moody’s rating service (which generated $2.3 billion in revenue last year and justified the building of a new headquarters in lower Manhattan) was 18% vs. 9% for the market. As noted short seller Jim Chanos remarked last July:
It’s a great business model as long as you can get people to pay for it. If they have no predictive power over that which they’re rating, then why bother?
Of course, the credit ratings business is no product of the free market, but a government sanctioned and protected oligopoly. In fact the valuable “NRSRO” status (Nationally Recognized Statistical Rating Organization) is conferred by none other than the SEC, another worthless gatekeeper and brainchild of the state.
As Chanos noted in a WSJ op-ed exactly two years ago, these lessons could have been learned by anyone paying close attention to the Enron implosion:
Time and again, when confronted with negative financial “surprises” by corporate issuers during the last decade, the “independent” ratings agencies fell down on the job. This kept slow-on-the-uptake investors dancing on the decks of numerous financial Titanics, while those heeding other signals (such as the burgeoning market for credit-default derivatives) prepared to man the lifeboats.
Whether it was the hubris of not wanting to precipitate a run on the bank (as if it wasn’t happening already!), or the incompetence of one ratings agency analyst admitting to not having read the company’s SEC filings, the shortcomings of an analyst-based ratings agency system became apparent in the Enron fiasco. Market-based price-discovery agents, such as short sellers in the equity market and purchasers of credit-default insurance in the bond/derivative markets, supplanted the Big Three ratings agencies as accurate predictors of Enron’s financial distress.
As philosopher George Santayana famously wrote in 1905, “Those who cannot remember the past are condemned to repeat it.”
It seems the Moody’s (MCO) organization has disclosed to the public a problem with one of their proprietary ratings models. Evidently a bug was discovered in the ratings model for CPDO, constant proportion debt obligations. According to the report which a senior staff member uncovered in early 2007, the securities should have been rated four notches lower at inception.
The products were designed for institutional investors. In the recent credit market turmoil, those who still hold the products will have suffered some paper losses while others who have bailed out have lost up to 60 per cent of their investment.
On discovering the error early in 2007, Moody’s corrected the coding glitch and instituted methodology changes. One document seen by the FT says “the impact of our code issue after those improvements in the model is then reduced”. The products remained triple A until January this year when, amid general market declines, they were downgraded several notches.
My Comments: Yet one more fraud is uncovered from the monetary madness hatched years ago. Once again we believe most of the structured finance world was rated using the classic “garbage in , garbage out” model.
When placing blame on the latest bubble without a doubt the rating agencies are near the top of the list. Ongoing denial seems to permeate the credit landscape and after further review we know why.
Even after downgrading almost 10,000 subprime-mortgage bonds, Standard & Poor’s and Moody’s Investors Service haven’t cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments.
None of the 80 AAA securities in ABX indexes that track subprime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg. A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.
Sticking to the rules would strip at least $120 billion in bonds of their AAA status, extending the pain of a mortgage crisis that’s triggered $188 billion in writedowns for the world’s largest financial firms. AAA debt fell as low as 61 cents on the dollar after record home foreclosures and a decline to AA may push the value of the debt to 26 cents, according to Credit Suisse Group.
The 20 ABX indexes are the only public source of prices on debt tied to home loans that were made to subprime borrowers with poor credit histories. About $650 billion of subprime bonds are still outstanding, according to Deutsche Bank. About 75
percent were rated AAA at issuance.
Regulators require banks to hold more capital against lower- rated securities to protect against losses; a downgrade would force them either to sell the securities or bolster reserves. While most banks haven’t disclosed the ratings of their subprime holdings, S&P estimated in January that losses on the debt may exceed $265 billion. American International Group Inc., the world’s largest insurer, has $20.8 billion invested in AAA rated subprime-mortgage debt, not including asset-backed securities that caused the company’s biggest-ever quarterly loss last period, according to the New
York-based company’s disclosures.
Further analysis of the AAA rated structured paper market clearly illustrates significant downgrades are on the way over the next few months.
My Comments: When 74 of 80 “AAA” bonds fail the investment grade test one should realize the Wall Street machine is beyond broken. Of course that same machine actually owns this paper with leverage beyond belief. Is the US taxpayer the buyer of last resort? Or are US and foreign savers the patsies of last resort?
Last week the people at Institutional Risk Analytics hosted “Subprime Crisis: Scofflaws & Scapegoats”. Here are some of the comments from several panelists.
Josh Rosner, managing director of independent investment firm Graham Fisher & Co., spoke about two decades of “home ownership” hysteria:
Regarding the origins of the subprime disaster, Rosner provided a fascinating history of the policy roots in Washington. “The reason for the boom in housing in the past decade [was] the result of structural changes in the housing industry over a decade before. I would argue that most of these changes were a result of the 1980s recession. We came out of the 1980s recession and a lot of the industry players had lost their shirts in the S&L crisis. We saw Fannie Mae (NYSE:FNM) insolvent on a mark-to-market basis in 1986 and that was largely because of the OREO portfolio. We saw housing in 1993 and 1994 with home ownership rates stagnant, exactly where they were at the beginning of the 1980s.
Home ownership rates have consistently ranged in this country between 62 and 64 percent during the post-WWII period, and yet affordability had actually locked people out.” “So what we saw actually was the largest public-private partnership to date, started as the National Partners in Home Ownership in 1994. It was signed onto by the realtors, the home builders, Fannie, Freddie, the mortgage bankers, HUD. It was a massive effort, with more than 1,500 public and private participants, and the state goal was to reach all time home ownership levels by the end of the century. And the stated strategy proposal to reach that goal was, quote: “to increase creative financing methods for mortgage origination.” Those seeds were sown in 1994. Those policies were put in place in 1994.”
…the role of the GSEs:
Rosner continued: “By 1995 we saw home prices start to rise and home ownership levels also start to rise. How did we do that? There was no private label [mortgage] market at that point. We were really dealing in a world of enterprise [GSE] paper. We saw most of the features [of CDOs and structured assets] that we are now looking at as having been atrocious or irresponsible or poor risk management having started in the enterprise markets. We saw changes in the LTV, changes from manual underwriting to automated underwriting. The approval models used were easy to game. We saw reductions in documentation requirements. We saw changes for mortgage insurance requirements. We saw the perversion of the appraisal process and a move to automated appraisals. All of these features which we now look at and point our fingers at the subprime originators and say ‘you bad boys,’ all started in the enterprise market. This, by the way, is why I believe there is still significant risk [in the GSEs].
…the trouble with forbearance:
“Rosner argues that besides low interest rates c/o of Alan Greenspan and the FOMC, mortgage lenders “began to see loss mitigation as a very valuable tool. So whereas in 1998, about 77 percent of 90-day plus borrowers ended up loosing their homes, by 2002 the measure had dropped to only 16 percent did. There is very little disclosure. Most investors don’t know [when a default has actually been] cured because when you modify you go from ‘delinquency risk’ to ‘current’ without putting out a penny. And this [example] actually suggests where we are going because there is still no transparency, still no standards for disclosure. Loss mitigation is becoming the next biggest predatory lending problem out there. When you speak to servicers, they tell you that the first thing they consider when entering into a loss mitigation is how much more capital they can drain out of the borrower before he blows up again. You have to wonder. When re-default rates on modified loans are 20-25 percent within two years, you have to ask if there is a social benefit of saving those remaining 80 percent of borrowers or not?”
…and speculators looking to front-run the home ownership drive:
“The structural change [put in place in the 1990s] drove housing to be a speculative asset,” continues Rosner. “Historically, investor share in the housing market was only about 8-9 percent. In the past three years, roughly 40 percent of sales have been for investment purposes. That creates what I call phantom inventory, usually in the fastest appreciating markets. These homes were purchased for speculative purposes with the most risky loan structures which required the least documentation… There is a lot of inventory that is not showing in the official numbers. At some point, that [inventory] gets thrown into the market.”
My Comments: 1500 public/private entities financed with below market interest rates generating tens of billions of dollars annually for the Wall Street structured finance crowd-priceless! According to a fellow credit bear I was wrong about the third inning so please stand for the national anthem.
Recently, the negative news impacting structured finance seems to hit the news wires sometime after 5:00 PM EST when most of the Wall Street gang has departed for the local tavern. Today was no different as the illustrious TCW came clean on some of their CDO investments.
Terms of the CDO created a forced sale:
A decline in the price of securities in the market-value CDO, formally called Westways Funding X, managed by TCW triggered a clause that demands assets be sold so holders of the highest- rated pieces don’t incur losses, TCW said today in an e-mailed statement. TCW was unable to amend the clause, according to Moody’s Investors Service, which cut the credit ratings on six classes of the Westway CDO.
Most CDOs can hold assets until they mature. Others such as Westways have tests based on the price of their holdings that are designed to protect investors who buy higher-rated portions of the securities from losses in lower-rated classes.
“Westways X did not experience any delinquencies or credit performance issues, but did experience widening spreads consistent with all non-Treasury fixed income sectors,” TCW said in the statement. “The resulting pricing declines, while modest by most financial market standards, have been sufficient to cause the structure’s net asset value to fall below a critical threshold.”
Rating agencies reluctantly continue the downgrade process:
Moody’s downgraded $40 million of notes from the Westways Funding X CDO that were rated A2, four levels above investment- grade, to Caa2, eight levels below. Moody’s is continuing to review those securities for further downgrades, as well as the CDO’s AAA securities. Bonds rated below Baa3 by Moody’s are considered high-yield, high-risk, or junk. Fitch Ratings last week said another five Westways Funding CDOs might have to sell assets under the CDOs’ rules.
My Comments: Fitch, S&P and Moodys have downgraded approximately 1% of the outstanding structured finance world. Any doubt about much more in the near term?
“Going forward … many more weak companies will be unable to obtain new financing and will default either when debt maturities come due or when they run out of cash,” the agency said.
The default rate among U.S. speculative-grade companies will more than double to 4% during the next year, Moody’s predicted.
Homebuilders, auto makers, retailers and consumer durable companies may be most affected, Moody’s said. Many companies in these industries have been acquired in leveraged buyouts in recent years and have borrowed a lot of money in the process, the agency said.
“The bumper crop of highly leveraged new issuance in 2006 and 2007 expanded the number of these low-rated, highly leveraged issuers to a record level,” Moody’s said. “We expect defaults to rise substantially among the large population of companies that have been aggressively financed with less than two times EBITDA/interest coverage and little or no free cash flow.”
My comment: Perhaps Moody’s has learned from the mortgage bubble and decided to get ahead of the curve on the private equity bubble.
From today’s Bloomberg: “Moody’s Cuts Outlook on $14 Billion of Commercial Paper Funds.”
Moody’s Investors Service said it had downgraded or placed on review for downgrade $14 billion of bonds sold by funds known as structured investment vehicles.
The credit rating firm also changed the way it rates the funds, citing ”unprecedented market volatility”.
This is the equivalent of shutting the barn door in Idaho when the horse is already in Montana.
The litany of woes for our beloved government-sanctioned oligopoly – the rating agencies – keeps stacking up.
According to a report
from Reuters this morning:
U.S. Senate Banking Committee Chairman Christopher Dodd on Friday called for an examination of the credit rating agencies’ role in valuing the subprime mortgage securities market.
This came one day after the European Commission announced a similar probe into the raters’ activities.
Just last Tuesday, Bloomberg
penned a piece
about the rating agencies losing their mojo
in structured finance land:
The legacy built by John Moody and Henry Varnum Poor a century or more ago is being tarnished by losses on securities linked to everything from subprime mortgages that the firms failed to downgrade before it was too late to high-yield, high- risk loans. Bonds backed by mortgages to people with poor credit fell by more than 50 cents on the dollar in June before the companies started to slash their ratings.
Perhaps the carrot of easy money dangled by the investment banks (who helped the raters design these structured products) had some influence:
Moody’s earned $884 million last year, or 43 percent of total revenue, from rating so-called structured notes, according to Neil Godsey, an equity analyst at Friedman, Billings, Ramsey Group Inc. in Arlington, Virginia. That’s more than triple the $274 million generated in 2001.
One of our favorite authorities on the subject weighed in:
Ratings firms “used to be seen as good, objective folks dressed in white, who you could count on to give reliable opinions,” said Christopher Whalen, an analyst at Institutional Risk Analytics, a research firm in Hawthorne, California, that writes software for auditors to determine if banks are accurately valuing their assets. “But when they got involved in structuring and pricing these deals, I think they crossed the line. They have lost a lot of credibility.”
Moody’s, the only pure-play publicly traded rating agency, looks no better at valuing its own stock than evaluating structured debt. During the first two quarters of this year, the company took on $519 million in debt and spent $901 million to buy back its shares, which at the time traded in a range of $60-$75 (currently $45 and change). Perhaps their same investment banking friends advised them on how to maximize shareholder value.
Meanwhile, the boilerplate from their press releases doesn’t give the impression that Moody’s will be early in the dot-connecting line:
Moody’s Investors Service is a leading provider of credit ratings, research, and risk analysis. Moody’s commitment and expertise contributes to stable, transparent and integrated financial markets, protecting the integrity of credit.