Subprime Mortgage Bonds Rated Higher Than US Treasuries
By Zeke Faux and Jody Shenn, Bloomberg, 04 September 11
Subprime mortgage bonds getting AAA rating S&P denies to US Treasuries.
Standard & Poor’s is giving a higher rating to securities backed by subprime home loans, the same type of investments that led to the worst financial crisis since the Great Depression, than it assigns the US government.
S&P is poised to provide AAA grades to 59 percent of Springleaf Mortgage Loan Trust 2011-1, a set of bonds tied to $497 million lent to homeowners with below-average credit scores and almost no equity in their properties. New York-based S&P stripped the US of its top rank on Aug. 5, saying Washington politics were making the country less creditworthy.
Treasuries gained about 1.95 percent and US borrowing costs have fallen to record lows as investors repudiated the downgrade, according to Bank of America Merrill Lynch indexes. S&P has awarded AAAs to more than $36 billion of securities in the US this year that were created by bankers who continue to gather thousands of loans, bundle them into bonds of varying risk and pay ratings firms a fee to assign credit rankings.
“Everybody has been led to believe over the years that AAA means AAA means AAA across the board,” Gregory W. Smith, the general counsel for the $41 billion Public Employees’ Retirement Association of Colorado, said in a telephone interview on Aug. 24. “Anybody that didn’t learn in the 2008 crisis that doesn’t apply should find another line of work.”
Money managers are lending to the government at rates that, in some cases, are about a third of what they demand to hold top-rated mortgage notes, four months after Congressional investigators said S&P helped spur the longest economic contraction since the 1930s by assigning inflated grades to the bonds from 2005 through 2008.
More than 14,000 securitized bonds in the US are rated AAA by S&P, backed by everything from houses and malls to auto-dealer loans and farm-equipment leases, according to data compiled by Bloomberg.
S&P has said it made mistakes in structured finance since the crisis including misunderstanding cash flows and using conflicting methods to analyze the securities. Its owner, New York-based McGraw-Hill Cos., depended on credit ratings for 27 percent of its $6.19 billion of revenue last year, down from 33 percent of $6.77 billion in 2007, Bloomberg data show.
“These are errors that could cause airplanes to crash if this was aerospace engineering,” said Sylvain Raynes, a principal at R&R Consulting in New York and a former analyst at Moody’s Investors Service.
Securitization enabled by S&P contributed to more than $2 trillion in losses and writedowns at the world’s largest financial institutions and the collapse of Lehman Brothers Holdings Inc. three years ago, causing credit markets to seize up and leading to the global recession.
A report by the Senate’s Permanent Subcommittee on Investigations said that S&P, Moody’s and Fitch Ratings helped trigger the financial crisis when they cut thousands of mortgage securities they rated AAA to junk status. The raters had engaged in a “race to the bottom” to win business, lawmakers said.
Bank of America Corp. and Royal Bank of Scotland Group Plc sold $242.7 million of the Springleaf mortgage bonds today that are set to get S&P’s top ratings, according to people familiar with the matter, who declined to be identified because the terms haven’t been set.
The transaction was reworked after marketing began to give those securities more protection against losses than S&P required, a sign investors may not have trusted the grades. An additional $49.7 million of the deal ranked AAA that will suffer losses first was split from the rest and not sold.
The safer debt was sold at a yield of 4 percent and has a projected average life of 2.44 years, one of the people said. That’s about 20 times the rate demanded on two-year Treasuries.
The underlying mortgages represent 96.6 percent of the current value of the homes, the issuer estimates. Borrowers may have an incentive to walk away from the debt and leave investors with sizable foreclosure losses should the economy slow further and house prices continue to decline.
The securities were created by Springleaf Finance Corp., a lender to borrowers with risky credit that’s majority owned by private-equity firm Fortress Investment Group LLC and partly by former parent American International Group Inc., according to the people familiar with the offering.
“We didn’t even start to look at the deal,” Paul Norris, a senior money manager at Dwight Asset Management Co. in Burlington, Vermont, which manages and advises on about $54 billion of assets, said on Aug. 25. “For the funds we would buy this in, we need a AAA rating and we don’t have any confidence S&P would hold this rating for any period of time.”
Underlying loans for the bonds are on average five years old, according to a document sent to investors. Credit scores of the borrowers, none of whom has missed a payment over the past two years, average 651. The US median is 711, according to Fair Isaac Corp., which creates the formulas behind FICO scores.
The transaction may get investment-grade ratings on 79 percent of the debt, meaning losses on the underlying loans can reach 21 percent before portions rated BBB or better lose principal, according to the term sheet. Springleaf plans to retain all but the most-senior debt, said two of the people.
Of the $12.8 billion of loans made by the firm over the past decade that are still outstanding, 11.5 percent are 60 days or more delinquent, the term sheet shows. That’s a better track record than rivals, with the rate on subprime mortgages packaged into bonds averaging almost 37 percent, Bloomberg data show.
Ed Sweeney, an S&P spokesman, declined to comment on the Springleaf transaction. “We believe our ultimate success will be driven by the value investors derive from our ratings and analysis,” he said.
Ability to Tax
S&P says structured finance securities can deserve the top grades if they’re backed by enough collateral to weather a US default. The company said it downgraded the US, which, unlike corporations, has the authority to set tax rates and print money, because politicians are becoming “less stable, less effective and less predictable.” Government debt of the world’s largest economy is now rated AA+, the same as Belgium.
“I’m trying to sort out why debt backed by the ability to tax in the United States is rated lower than securities that are backed by no particular ability to have additional revenue,” said John Milne, who oversees about $1.8 billion as chief executive officer of JKMilne Asset Management in Fort Myers, Florida, in a telephone interview on Aug. 23.
Treasuries have rallied since Aug. 5, even though the downgrade showed S&P considers the securities to be less reliable. Investor demand for 10-year government notes, the benchmark for everything from corporate borrowing to mortgage rates, drove yields as low as 1.9735 percent on Aug. 18.
Investors lost trust that ratings are consistent across asset classes after the crisis, Milne said. Top-rated slices of commercial-mortgage-backed securities created since the market revived, known as CMBS 2.0, offer yields of 3.66 percent, or 2.31 percentage points more than Treasuries ranked one step lower by S&P, according to Barclays Capital index data.
“The pricing in the market suggests that really it does not believe the ratings anymore,” said Satyajit Das, author of “Extreme Money: Masters of the Universe and the Cult of Risk” (FT Press, 2011), in a telephone interview on Aug. 23. “If the sovereign goes down the tubes, it’s very difficult to see how these structures will be unaffected.”
Deven Sharma, the president of S&P who’s stepping down in September, has defended the company since taking over in 2007. It said on Aug. 22 that Sharma, 55, will be replaced by Citibank NA Chief Operating Officer Douglas Peterson, 53.
“Clearly, there were many lessons we learned out of the US residential mortgage-backed securities,” Sharma told Congress last month. S&P reviewed its methodologies and added checks to make sure ratings are “completely comparable” across asset classes and regions, he said.
Even after Congress included rules in the Dodd-Frank Act last year designed to cut reliance on ratings, S&P and its competitors remain a key part of the financial markets. Pension and mutual funds often require minimum ratings to buy debt securities. Banks are generally required to hold less capital to back higher rated bonds as regulators including the Federal Reserve have yet to find an alternative.
The Justice Department is probing S&P and Moody’s over mortgage-bond ratings between 2005 and 2008, according to three former analysts who said they were interviewed by investigators. The Senate Banking Committee and the Securities and Exchange Commission are scrutinizing the decision to downgrade the US rating, according to people with knowledge of the inquiries.
S&P downgraded the US even after Treasury Department officials told the firm it had overestimated future national debt by $2 trillion. The company said the mistake didn’t affect its decision, which was based on Congress’s failure to pass enough budget cuts during the standoff over the debt ceiling with President Barack Obama. S&P’s move conflicted with Moody’s and Fitch, which kept their top ratings on America’s debt.
“The point is the debt is still rising,” Sharma said in a Bloomberg Television interview on Aug. 9. “That’s why the sovereigns team and ratings committee came to that conclusion.”
S&P generally doesn’t cap the rankings of companies or structured-finance securities at their country’s level. Along with the 14,000 securitized bonds, four non-financial companies including Johnson & Johnson and Microsoft Corp. (MSFT) have AAA rankings, Bloomberg data shows.
Granting top grades to securitized debt can be appropriate as long as the AAA rated portion is small enough that the collateral is sure to be worth enough to pay it off even in extreme circumstances, said Ron D’Vari, the chief executive officer of the advisory and asset management firm NewOak Capital LLC in New York. He used the example of $100 of bonds backed by $500 million of car loans.
The US’s lower grade may make sense when taking into account the government’s “willingness to repay rather than ability,” said D’Vari, a former head of structured finance at BlackRock Inc., which manages more than $1.14 trillion in fixed-income assets.
Pacific Investment Management Co., which runs the world’s largest bond fund, says the quality of structured-finance ratings has improved since the run-up to the financial crisis.
“They are doing a decent job – far better than the glory days,” said Scott Simon, the head of mortgage- and asset-backed debt at Newport Beach, California-based Pimco, which runs the $245.5 billion Total Return Fund.
S&P says it has made mistakes in structured finance, where the top grade is now printed as AAA.sf following European rules in 2010 meant to warn investors that securitized-debt grades may be less reliable.
The company said in July that it allowed a discrepancy to develop in how it rates commercial-mortgage securities. The issue came to light after investors objected to how much of a $1.5 billion deal planned by Goldman Sachs Group Inc. and Citigroup Inc. was set to get top grades.
After the banks restructured the deal to provide some AAA bonds with a loss buffer of 20 percent, rather than 14.5 percent, Goldman and Citigroup were forced to pull the offering when S&P withdrew its ratings.
S&P said it had been using the easiest of two approaches to calculate borrowers’ income relative to required debt payments when rating new deals, while continuing to apply an average for outstanding bonds. The firm said it needed to review the “potentially conflicting methods.”
The largest underlying loan was to be debt on the Park Place Mall in Tucson, Arizona, according to a document sent to investors. Borders Group Inc., the bankrupt book retailer that won court approval last month to liquidate its remaining 399 stores, occupies 5.6 percent of its rental space.
“Our pursuit of quality and comparability means that when we discover a material error in our ratings, we promptly review it and address the matter transparently,” S&P’s Sweeney said last week.
Not all inaccurate ratings are too high, according to Amherst Securities Group LP’s Laurie Goodman, a member of the Fixed Income Analysts Society’s Hall of Fame.
Of 156 home-loan bonds deemed unlikely to suffer any losses by Pimco in its reviews for insurance regulators that now rely on its assessments rather than those of the raters, only 94 retain investment grades from the firms that assigned them, she wrote in an Aug. 17 report.
S&P wrongly downgraded 32 mortgage bonds in April 2010 because it used “incorrect” estimates for the size of losses per foreclosure, the company said July 29. On Aug. 11, S&P said it wrongly withdrew ratings on almost $250 million of securities backed by home-equity credit lines a month earlier. Those were reinstated to AA+ because that is the rating on the debt’s guarantor, a unit of Assured Guaranty Ltd.
That’s also the same grade on the US even though credit-default swaps show traders are pricing the insurer’s odds of default over the next five years at more than 50 percent, according to Bloomberg data.
Even after losses from subprime mortgages infected the global economy, S&P continued assigning top grades to pieces of home-loan bonds that were repackaged into new securities called re-remics.
The firm lowered the ratings on 308 classes of such deals in May 2010, cutting to CCC from AAA a $10 million bond created by Credit Suisse Group AG nine months earlier, saying mortgage defaults were turning out to be worse than it forecast. S&P said in December it would need to review 1,196 re-remic securities because it had “incorrectly analyzed” the debt in light of the structure of the underlying deals.
Wyndham Worldwide Corp.’s finance unit may have won higher grades on two of three deals backed by timeshare loans in 2010 and 2011 that S&P said this month it ranked using an “incorrect priority of payments sequence in our analysis.” Among the ratings affected were those on $249.7 million of A+ notes. Wyndham added “funds to newly created reserve accounts” to skirt downgrades, S&P said in an Aug. 12 statement.
Billionaire Wilbur Ross’s American Home Mortgage Servicing Inc. said in May that it went with S&P and DBRS Inc. to rate a securitization of its advances on homeowners’ missed payments and loan-management expenses after Fitch refused to grant AAA grades to $650 million of the deal because of concern that foreclosures are taking longer to complete.
While Fitch criticized that deal, S&P has pointed out flaws in some rated by Moody’s. William Harrington, who worked in Moody’s derivatives group from 1999 until last year, said in an Aug. 8 letter to the SEC its analysts face management pressure to win business and noted it recently moved to “a market-friendlier methodology” for bonds backed by high-risk company loans.
Moody’s said in June that it stopped using a tougher “temporary” approach to looking at the collateralized loan obligations, which it introduced in 2009, because credit conditions are “relatively more stable now and default rates low.” Michael Adler, a spokesman, declined to comment.