We did so well the last time around
These days’ financial pages and credit updates are full of Emily Litella moments:
Emily Litella: I’m here tonight to speak out against busting schoolchildren. Busting schoolchildren is a terrible, terrible thing. I hear this is going on all over the country. Mean policemen arrest little children and put them in jail in the wrong neighborhood, so they can’t even play with their little friends. Imagine, busting schoolchildren! The food in jail isn’t good, and even though they get bread, I don’t believe they can get toast. Or nice cake. Now, who will tuck them in? Where will they hang their leggings? Where will they set up their little lemonade stands? Well, they don’t have toys in jail, except maybe –
Emily Litella: Yes?
Emily Litella: Oh! I’m sorry. Never mind.
Scarcely were the electrons aglow with the stock price collapses following the unexpected explosions of asset writedowns in companies not hitherto suspected of having a large position in subprime securities (see the share histories of AMBAC and E*Trade, to name two) than the news has broken that the rating agencies, whose AAA seals of approval led so many of these institutions in the first place to buy securities they did not understand, are now thinking of offering the Emily Litella Weekend Update explanation: “never mind!”
“Never mind!”
As The Wall Street Journal reported it, with a fascination that borders on bedazzlement:
The credit-rating downgrade deluge that’s been rocking financial markets isn’t over.
In the next few weeks [that is, late November -- Ed.], debt-rating services like Moody’s Investors Service, Standard & Poor’s and Fitch Ratings look poised to downgrade hundreds of mortgage-related investments worth tens of billions of dollars, creating the potential for more market unrest.
I’ve already speculated that before the subprime mess sorts itself out, its casualties will include one of the rating agencies. I have no insider knowledge and no candidate in mind, but the revenge to be taken against the Pied Piper
The three major rating firms — owned respectively by Moody’s Corp., McGraw-Hill Cos. and Fimalac SA of
Having been criticized for underestimating the risks, the rating agencies appear ready to lurch in the other direction.
No, we’re totally steady here!
Now they’re moving in the other direction, aggressively reassessing where they stand on a wide assortment of debt. Behind the about-face: a worsening real-estate backdrop and frazzled investors.
This is always the analyst’s defense: We used the information available at the time.
Did you rely on my ratings, dearie?
Credit-rating firms have lowered their credit ratings on more than $70 billion in mortgage-related bonds in the past few months, setting off waves of distress in the stock and bond markets.
The impact of such massive downgrades is not confined even to the $70 billion touched.
As of Nov. 1, S&P had lowered ratings on 381 tranches of residential mortgage-related CDOs. It still had a “Credit Watch negative” on 709 CDO tranches, meaning the bonds face a good chance of a downgrade.
Fitch has 609 CDO tranches on negative watch and plans to act on them by later this month. Through the end of October, Moody’s said it had downgraded so far this year 338 CDO tranches worth $13 billion, backed primarily by mortgage-backed securities. It was still reviewing for downgrade another 734 tranches worth $48 billion.
The downgrades signal a comprehensive, end-to-end revaluation of risk, not just in subprime loans, not just in real estate, but in all forms of credit and capital.
They’ve also expressed concerns about the outlook for a range of related industries from banking to bond insurance. Banks and Wall Street firms including Citigroup Inc. and Merrill Lynch & Co. took large charges when they were forced to reassess the value of even their highest-rated mortgage debt.
The market has woken up from its previous complacency and is now anti-complacent (what the economists call a Minsky Moment).
The latest turmoil to hit markets has been a reminder that the raters — despite all of the criticism about their approach — still have great sway. Many pensions and other institutional investors are bound to hold only investment-grade debt.
Be careful what mast you lash yourself to, for it may sail you onto the rocks.
We’re all triple-A rated, big boy, all of us!
A downgrade into junk territory can have an impact on demand for securities.
Moreover, because many mortgage instruments are so hard to value, some banks and hedge funds rely on credit ratings even when they know the ratings could be flawed.
That’s the trap of using a single indicator as a rule of thumb to stand for the whole organism: if the indicator is mis-measured, so are all your conclusions.
“And the rest of me is in proportion to my thumbs”
“We are going to be seeing ratings actions coming for awhile” on mortgage-related debt, says Yuri Yoshizawa, a group managing director overseeing
Collateralized debt obligations, or CDOs, look primed for more distress. These are investments often backed by portfolios of mortgage-backed securities. They’re sold in pieces, or tranches, with varying levels of risk and return. The CDO tranches — widely held by banks and investors — haven’t been downgraded as quickly as the underlying mortgage securities they hold.
Making this even more infuriating for those who used the ratings as the basis for investment decisions is that the agencies are making up a whole new risk paradigm in real time, with no indication that they are ahead of the curve:
In October, when Moody’s lowered ratings on thousands of subprime residential mortgage-backed securities, it said it didn’t expect another big wave of downgrades on such bonds unless home prices declined by more than 10.4% from their peak in late 2005.
That prediction has lasted all of six weeks.
Last month, Moody’s also changed its assessment of losses that would be suffered in pools of subprime loans from 2006, saying it could hit roughly 10%, on average, compared with a projection of around 6% early this year. Losses could hit 20% in some of the shakiest loan pools, Moody’s added last month.
‘Could’ is such an unhelpful word.
Adding to the confusion, there is little uniformity in the way ratings firms are acting as they scramble to downgrade CDOs and other bonds.
Ratings dropping? We’re ready for it!
For example, S&P has been giving investors comprehensive reviews lately whenever it takes big actions on CDOs, while Moody’s has been providing data monthly. A Moody’s spokesman says the firm also provides data on individual CDO ratings changes to investors.
Yes, markets of money thrive on an active marketplace of ideas. Rratings agencies are supposed to be accurate and consistent measurers of information. They’re not referees, they’re linesmen, and their yardage chains are all supposed to be the same length. When three different linesmen, who knows how far you have to go?
Depends on which linesman you use
In September, during hearings about ratings firms on Capitol Hill, at least one questioner raised the issue about whether the Securities and Exchange Commission could require more-uniform updates from the rating firms, which could also boost transparency about the state of the market.
Rating-agency credibility appears to be dropping as fast as some stock prices.
While the rating downgrades of mortgage-backed securities were expected by many analysts, the speed and magnitude of the corresponding CDO downgrades caught many banks, brokerage firms and investors off guard. This past spring, even as mortgage delinquencies kept rising, some rating executives told investors that they didn’t foresee CDO downgrades until 2008.
“I see no downgrades until 2008.”
In short, the agencies posture appears to be, “You can trust us. We did so well the first time.”
According to J.P. Morgan research, several CDOs had over 80% of their underlying collateral affected by the downgrades or reviews. The Aaa tranches on some of these CDOs were subsequently cut by multiple notches — some to junk — days after the mortgage-backed securities downgrades.
“I’m an institution, dearie.”
“There will be a lot of chain reactions,” says David Yan, director and head of CDO research at Credit Suisse Group.
“Now remember, you can absolutely rely on my devaluations.”
“That’s evaluations, Miss Litella, not devaluations.”
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