Subprime Mortgage Revisited

Recently, Bloomberg News reported (8/31/11) that Standard & Poor's, the New York based rating agency, was "poised" to provide a AAA grade (it's highest) to a mortgage trust comprising bonds totaling $497 million dollars lent to homeowners with "below average credit scores and almost no equity in their properties." The mortgage trust was put together by a lender who specializes in lending to borrowers with risky credit, and who also pays S&P to evaluate the deal for creditworthiness. This is the same S&P rating agency that recently downgraded the United States to AA+ (its second highest rating) because US politicians are becoming "less stable, less effective, and less predictable." As the Bloomberg article pointed out, debt issued by the United States is now comparable in risk of default to that of Belgium.

Deven Sharma, who has been S&P's president since 2007 and who is reportedly stepping down this month, defended the company's practice. He suggested its methodologies are "completely comparable" and consistent across all assets it reviews. These attempts to be consistent have seemingly met some snags. S&P apparently continues to assign its top grades to pieces of home-loan bonds which are packaged into securities called re-remics. Bloomberg reports that in May 2010, S&P was forced to lower the ratings on 308 classes of such deals. One deal worth a reported $10 million, created only nine months prior to the downgrade, went from a AAA rating to CCC, a slide of six ratings in one day! The reason was a higher-than-forecast number of mortgage defaults. In December 2010, S&P said it would need to review 1196 such re-remic securities because it had apparently "incorrectly analyzed" the debt structure of the underlying deals. Bloomberg also cited S&P's admission of mistakes in structured finance, ranging from misunderstanding of cash flows to inconsistent and sometimes conflicting methods of analysis.

Is S&P in this alone? Apparently not. According to Bloomberg, a former analyst from Moody's Investors Service, in a letter to the SEC, said that his group faced management pressure to issue higher grades in an effort to win business for the firm by implementing "a market friendly methodology." You might be tempted, as we are, to ask "Friendly to whom?" Enough people are asking that question to prompt the Justice Department, the Senate Banking Committee, and the Securities and Exchange Commission to investigate the role of the rating agencies in the original crisis of 2008 and in the downgrade of US Treasury debt last month. I would submit that you don't get that kind of broad-based attention unless things are seriously out of alignment.

Credibility for Sale?

The credibility of S&P and its brethren is clearly on the wane. The Bloomberg article cites a number of money managers with significant doubts on rating agency reporting. This is quite understandable, given the capital they have at risk and the experience they have been through in the last three years. More importantly, the markets seem to be the ultimate voice of sanity. Rates on 10-year US treasuries have been consistently far lower than on comparable mortgage-backed offerings of similar maturity, even after the August 5 downgrade. This suggests that investors demand a far higher yield on the mortgage offerings, given the perceived risk involved. And the risk is considerable. It only takes a slight downturn in the economy to further depress home prices, which will encourage another wave of borrowers to walk away from their underwater homes and leave investors with a sea of worthless debt. Treasuries are still the safe haven for capital, no matter what S&P says. And why shouldn't it be? Unlike the mortgage deals mentioned, the US Government has the authority to adjust tax rates (and thus its income to repay the debt) as well as to print more money (despite the accompanying inflation). Just who is S&P trying to kid?

The casualty in all this, once again, is the individual investor who at one time came to rely on the three major credit rating agencies (S&P, Moody's, and Fitch) for reliable credit reporting. Their reliability has seemingly been sold to the highest bidder in the name of corporate profits. In order to please Wall Street securities firms, the reporting agencies are slathering lipstick on so many pigs and selling them off as stallions. And apparently it is working. That $497 million in bonds for sale in the mortgage trust? According to the Bloomberg article, roughly half had been sold. Some lessons are just too difficult to learn, and some people never get it.