Investors faced with rush of downgrades
Investors faced with rush of downgrades
By Saskia Scholtes in New York
Published: October 31 2007 20:05 | Last updated: October 31 2007 20:05
As the subprime mortgage debacle claimed another boardroom scalp this week – Merrill Lynch chief Stan O’Neal – investors were counting the cost of a string of downgrades on complex mortgage securities issued by investment banks such as Merrill and others.
In October alone, rating agencies Moody’s, Standard & Poor’s and Fitch Ratings delivered a heavy drip-feed of downgrades or reviews for downgrade that affected more than $100bn in so-called collateralised debt obligations (CDOs) and the mortgage securities they contain.
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Many of the downgrades took the CDO securities from investment grade directly to high-yield. In one case, Moody’s cut the Aaa-rated slice of a CDO deal called Vertical CDO 07-1 by 14 ratings notches to B2, and still left it on watch for further downgrades.
Domenico Picone, analyst at Dresdner Kleinwort, said: “What is astonishing, and at the same time particularly worrying, is that Moody’s gave a AAA rating to this security only back in April this year.”
This has potentially serious consequences for market prices, which have already suffered precipitous drops this year. Some investors are constrained by rules that force them to sell securities rated below investment grade.
The cuts come as the major rating agencies have been criticised for granting high ratings to complex mortgage securitisations that failed to take account of signs of looser lending standards and slowing house price appreciation in 2005 and 2006. Late payments and defaults on the underlying mortgages have far exceeded the agencies’ initial expectations, and investors and analysts say this month’s rating actions lag far behind where prices have already fallen.
“The rating agencies’ ability to accurately assess the risks have been in question since the beginning of the year, so downgrades do not really tell us whether the securities are worth more or less,” said Don Brownstein, chief executive of Structured Portfolio Management, a hedge fund. “But they are important because they can trigger forced selling for some investors and some structures.”
Widespread sales of such securities could cause further acute losses for banks and investors, even if they are not subject to forced selling rules, by providing dismal market prices for portfolios of mortgage-backed securities and CDOs. Losses for such securities forced Merrill Lynch to take a $7.9bn writedown in the third quarter alone, raising serious concerns about the outlook for the fourth.
Mr Brownstein said this complicated the rating agencies’ work because, while the existing ratings were not an accurate reflection of the likelihood of default for subprime-linked securities, wholesale downgrades could also destabilise the market.
“From a purely intellectual perspective, since the truth will come out, then the sooner the better,” he said. “But from a macro-economic standpoint, the question is how much shock is too much, given that we don’t know who owns what.”
The problem is particularly acute, given the ratings cuts are affecting not just the riskiest tier of securities, but also those with the highest AAA ratings. These are typically held by investors with low risk appetite, who could be forced to sell in large numbers, or may have leveraged their holdings based on the “safety” of the AAA rating.
According to a Bank of America analysis of recent Moody’s and S&P downgrades, while most affected classes were rated A or below, still about one quarter of affected ratings were AA or AAA.
In one set of rating actions earlier this week, Fitch placed $24bn of AAA-rated CDO securities linked to subprime mortgages under review for downgrade.
Meanwhile, the rating agencies are already trying to catch up with the scale of late mortgage payments and defaults on securities issued in 2007, when problems in the subprime mortgage market were already evident. S&P this month downgraded $23.35bn of US residential mortgage-backed securities issued in 2007.
But while the rating agencies admit that losses in the subprime mortgage market have eclipsed their initial assumptions, they say it is not unusual for rating actions on such structured finance securities to occur in such a wholesale manner.
“When structured finance [ratings] move . . . they move in groups more than company ratings do,” said Ray McDaniel, chief executive of Moody’s, in a recent video interview with the Financial Times. “It’s not surprising that they do, because they are packages of assets that are quite homogenous – a pool of mortgages, for example – and they are often originated at a very similar point in time.”
As a result, said Mr McDaniel: “It is reasonable to anticipate they are going to experience more correlated behaviour, and so in times of strength more of those securities will be upgraded across the board and in times of weakness more of those securities will be downgraded across the board.”
The rating agencies have announced reviews of their structured finance ratings for the coming weeks and months, all while conditions in the housing and mortgage market continue to deteriorate, leaving investors steeled for further losses in an already stricken market.
Additional reporting by Stacy-Marie Ishmael
Copyright The Financial Times Limited 2007