A symbiote’s life is not a happy one: Part 4, look around you
[Continued from yesterday’s Part 3 and the previous Part 1 and Part 2.]
Hubris, the Greeks knew, was always followed by nemesis.
In the subprime residential lending sector, the Wall Street Journal’s lengthy article has documented how the rating agencies’ looser credit standards proved both popular (volume boomed) and successful (few defaults). Everyone was happy, and residential home prices rose rapidly, absorbing the value boost of the low interest rates and friendly, flexible new instruments:
At first, underwriters creating mortgage securities made sure the loan pools they based them on didn’t have more than 20% with piggybacks. But by 2006, some were willing to accept a ratings penalty. They created securities like those structured from a pool of 14,500 loans from Washington Mutual Inc.’s mortgage arm. About 52% of the pool’s value consisted of loans with piggybacks, a prospectus showed.
From one in five to more than one in two. That’s really flexible.
It takes all the flexibility you’ve got just to keep market share
The agencies — or at least one of them, S&P — kept studying the phenomenon, wondering if the good times would continue:
By 2006, S&P was making its own study of such loans’ performance. It singled out 639,981 loans made in 2002 to see if its benign assumptions had held up. They hadn’t. Loans with piggybacks were 43% more likely to default than other loans, S&P found.
Good move, very responsible. So S&P blew its own whistle:
Heroic?
In April 2006, S&P said it would raise by July the amount of collateral underwriters must include in many new mortgage portfolios. For instance, S&P could require that mortgage pools have extra loans in them, since it now expected a larger number to go bad.
Still, S&P didn’t lower its ratings on existing securities, saying it had to further monitor the performance of loans backing them.
We’ve all been there; allowing to go unchecked something we thought was faintly questionable, our discomfort gradually rising. But when we change our minds, from Yes to No, we flinch from rescinding previous approvals. All right, no more of that, we tell ourselves, and the rest of the problem will just work itself out.
Rating agencies aren’t supposed to be doing favors, though; they’re supposed to be calling them as they see them.
“No more rating fees for you!”
It thus helped the market for these loans hold up through the end of 2006.
Some investors, however, grew concerned, as newer mortgage securities appeared that were based not just on piggyback loans but on loans with other risky attributes as well. One money manager, James Kragenbring, says he had five to 10 conversations with S&P and Moody’s in late 2005 and 2006, discussing whether they should be tougher because of looser lending standards.
That’s plausible, since it was in late 2005 that I called the market top (not that anybody noticed!). Here’s what I wrote:
Enter the miner’s canary — the sensitive universal leading indicator. And mine has just started wobbling, as this article from the Washington Post reveals:
Mortgage delinquencies among homeowners with high-cost loans will rise by 10% to 15% in 2006, as borrowers struggle with higher interest rates, high debt levels and higher energy costs amid flattening home prices, a new report from investment analyst Fitch Ratings predicts.
Consequently, overall mortgage delinquencies are likely to rise next year, as well, according to the report’s authors.
Why is subprime lending a leading indicator? Because by definition, subprime borrowers are at the edge of the bankable frontier (as my AHI colleague David Porteous has discussed on his blog), and as such, they are the most sensitive to changing economic circumstances.
About 19% of home loans nationwide are subprime, up from about 5% a decade ago, as homeowners take on heavy debt burdens.
This is another longer-wave clue: the much higher percentage of loans being subprime means more folks closer to the economic edge have elected to buy homes. Observant herds can turn into stampedes and in so doing can drive prices up above ‘normal’ (whatever that is).
[…]
Up to now, I’ve read innumerable frothy insubstantial Chicken-Little-market top articles, and found all of them utterly unpersuasive. But this modest story — the newspaper equivalent of a green salad! — is different; this feels like a leading indicator.
“I don’t like my role in this ecosystem“
So here it is, folks. I’m calling the market top.
Evidently I wasn’t alone in thinking that:
“I’d think there would be more protection to guard against defaults,” Mr. Kragenbring, from Advantus Capital Management, says he said to the rating companies.
He says he was told that for much of 2005 and 2006, subprime loans were performing about the same as in previous years.
They probably were, a combination of newness, rising prices, and a torrent of buy-now newspaper stories.
Other analysts recall being told that ratings could also be revised if the market deteriorated. Said an S&P spokesman: “The market can go with its gut; we have to go with the facts.”
There are facts and there are facts.
In the second half of 2006, Mr. Kornfeld at Moody’s noticed a troubling trend. In an unusually large number of subprime loans, borrowers weren’t making even their first payments.
I’m not making my first payment
That’s just not good.
A long, long time ago, during the dark days of the Seventies (recession, not platform shoes!), when I worked at Boston Financial, the developer of a property in Portland, Maine got it to final endorsement (permanent mortgage takeout; conversion from construction loan to permanent), only to default on the very first payment after the closing. Another property sat in interim-loan status for five years for failure to fulfill the conditions for a permanent takeout. Eventually that one went perm because its interim clock ran out, and had to fix its rate 300 basis points higher than the original underwriting.
The market’s great strength “could not continue,” Mr. Kornfeld recalls thinking at the time. He called staff meetings to discuss his concern, and in November Moody’s said publicly it saw signs of deterioration.
By now, S&P’s reversed course:
In March 2007, S&P said it expected home prices to be stagnant this year but grow 3% to 4% in 2008. By early July, S&P had lowered this forecast.
Once faith is shaken, everything is re-examined.
It said its chief economist projected that home prices would fall 8% from the 2006 peak to a trough expected in the first quarter of 2008.
Due to the interaction between perception, capital availability, and borrower commitment:
Defaults and delinquencies rose. Hard-pressed borrowers found it harder to get a new loan to bail them out or to sell their homes and pay off the loan that way.
Credit is faith. Loss of faith means loss of credit.
By July, almost a third of the loans in Washington Mutual’s subprime pool were delinquent or in foreclosure. This performance, much worse than what credit-rating firms had expected, forced Moody’s and S&P to slash their ratings on several securities backed by those loans. On some, S&P cut an initial A-minus investment-grade rating by five notches, to a below-investment-grade BB.
Only five notches down!
Marking to market is a first step; only when the securities have been repriced to their current value can the market clear, and people come in who can restructure the loans.
The downgrading, begun late last year, became an avalanche this summer. On July 10, Moody’s cut ratings on more than 400 securities that were based on subprime loans. S&P put 612 on review, and downgraded most two days later. The moves jolted financial markets and prompted some investors to criticize the ratings firms for misjudging the market.
Certainly looks that way; but would you have them compound the error?
The firms said that the soaring market of 2005-06 had reduced the relevance of their statistical models and historical data.
Money mangers unloaded on a July 12 conference call with Moody’s analysts. “You had reams upon reams of data,” said Steve Eisman, a managing director of hedge fund Frontpoint Partners, which had made bets against the subprime market. “Despite all that data, your original predictions of the performance of 2006 loan pools have proven to be completely and utterly wrong.” He asked why the rating firms waited to take major steps.
We’ll respond temperately
The chief credit officer at Moody’s, Nicholas Weill, replied that some of the original subprime data provided to rating firms weren’t “as reliable as expected.”
When I worked in Citibank Amsterdam a really long time ago, the then-head of the corporate bank explained the large losses his division ran with the wonderful phrase, “the market turned against us.” I thought this so delightful; that for the next week, if anything bad happened in my area, I had my answer ready: “the photocopier turned against me,” “the typewriter turned against me,” “the coffee-maker turned against me.”
He also said Moody’s put out “early warnings” of downgrades as far back as November 2006. Instead of cutting ratings right away, he added, Moody’s needed time to see whether the loans would start to recover.
Fair point; you don’t want to shout crash in a crowded Wall Street.
“What we do is assess information available at the time,” Mr. Weill said.
S&P, Moody’s and Fitch Ratings have reacted by repeatedly toughening their ratings methodology for new subprime bonds, requiring significantly bigger cushions. They now assume more and quicker defaults among pools of loans, especially those with piggybacks.
One has the feeling that the rating agencies, feeling themselves having been used, are chagrined at the state of affairs, and hastening to correct their laxness:
The changes have had an effect. About 27% of loans made in the first quarter of this year had piggybacks attached, down from 35% a year earlier, according to S&P research.
That’s still a very high percentage.
Overall, issuance of subprime-mortgage bonds is down 32.5% this year through June, according to Inside Mortgage Finance. That is resulting in lower Wall Street profits and tighter lending standards for consumers.
Committees in the U.S. House and Senate are broadly examining the mortgage market, as are various state and federal agencies.
Quick, let’s summon Congress — they’ll find somebody to blame! Yeah, yeah, that’ll solve the problem!
What? You say you’re not guilty?
It’s not clear whether ratings firms will become a focus of the inquiries.
I really, really, really wouldn’t want to be a rating agency right now.
You know the old saw about the freshman in their first law school lecture? “Look to your right, gentlemen; look to your left. One of you will be gone in three years.” If S&P, Moody’s and Fitch were sitting on a bench together, I’d advise them:
Prediction: within five years, one of the three agencies will be out of business.
Possibly bankrupt, possibly taken over by a consortium of irate investors who’ve lost sums and need to re-establish credibility of the ratings function.
It’s a given they’re going to get sued. (This is
It doesn’t matter if they’re culpable. What matters is if the markets lose confidence in them. For the agencies, their reputation is critical. What is a rating agency if no one trusts it?
Worse than a crooked referee
[Concluded tomorrow in Part 5.]
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