|Insufficient understanding of the ratings of subprime securities have been a problem for the rating agencies and the investment community, according to a managing director at one of the agencies who noted, “The whole subprime thing is going to get a lot more messy.” The comments contrast recent claims that suggest ratings provide little value for investors.
Rating agencies could have better communicated their reasoning behind ratings to mortgage-backed securities investors, but too many investors have shown a lack of interest in details about bond ratings and their basis, said Glenn Costello, co-head of the RMBS Ratings Group at Fitch Ratings.
“I definitely think there were some problems that rating agencies could have better addressed,” he said at Andrew Davidson & Co.’s 15th annual conference held recently in New York. “Maybe there were really problems of just communicating what we do, how we do it, what to invest in and the places to invest. Then maybe investors would better know how to judge what level of comfort they can get from a credit rating and what things the credit raters are doing themselves to help them.”
But despite this need to provide more information, Costello lamented, “investors aren’t listening” when critical information is available to them.
“My frustrations have been that I haven’t really had a lot of calls prior to the last several months from people who invest in subprime mortgages,” he complained. “We had calls from investors who bought CDOs backed by subprime mortgages but CDO asset managers themselves were not calling too much to see what we thought about things.”
But some investors don’t ascribe much value to the ratings process, according to one recent study.
The report, authored by Joseph R. Mason, associate professor of finance at Drexel University’s LeBow College of Business and a visiting scholar at the FDIC, and Graham Fisher & Co. Managing Director Joshua Rosner, questioned the value of the assessments provided by the agencies.
The study slammed the three major credit ratings agencies, noting their evaluation of risk in RMBS and collateralized debt obligations has been skewed because of conflicts of interest and the misapplication of inappropriate bond rating methods. Among the criticisms outlined in the report was the primary reliance on issuers for data, the low frequency with which tranches are re-rated and inadequate prepayment modeling.
Fitch’s Costello told of one originator that was going to provide the representations and warrantees for a deal that Fitch had been asked to rate. But the originator could not provide reps and warrants because it was a REIT and thus Fitch did not rate it, Costello explained.
“When I told investors about that,” he said, rather than express shock, “they asked, “When are they coming to market again?'”
He cited one wholesaler who used an originator’s underwriting guidelines for the loans it purchased rather than its own guidelines. When the wholesaler was asked if it had any exceptions to those guidelines, Costello said he was told that they had exceptions — though they were the originator’s own exceptions.
But the situation may be changing as a result of all the current problems, Costello indicated.
“The crisis we’re going through now is painful,” he admitted, “but it’s a somewhat healthy thing in terms of being conducive to introducing discipline into the markets.”
And the current environment, he argued, is “a more healthy environment,” partly because Fitch and the other rating agencies have been responding in a number of areas.
“We can provide more information and talk about our [rating] tools for looking at loan level credit risk,” Costello explained.
Fitch now pays “a lot of attention” to the providers of representations and warrantees and won’t rate those without the necessary “where-with-all.”
“Another thing that we’ve done for new subprime issues is to start providing resale reports,” he said, pointing out that this increases transparency by making more comparisons possible.
“And we are generating more research, talking about what we think is happening in the market and where we think it’s going,” Costello reported. “Particularly we’re doing a lot more with home price scenarios and what we think that means in terms of losses and means in terms of potential rating actions.”
But he was less optimistic about the subprime market itself.
“We are expecting subprime losses to be probably 8 percent or more,” he said. “If we get double digit losses on deals, but if the prepay slows enough, the Triple B bonds will be able to withstand that. While we think Double Bs will have some very significant problems, we do think the payment level of Triple B may be somewhat contained if conditions don’t worsen.”
But uncertainty characterizes Fitch’s outlook regarding loan modifications and their impact on the secondary market, he cautioned.
“Servicers may modify loans, and maybe aggressively modify loans, and that makes it very hard to foresee what’s going to happen,” he said. “Modifications in general are a good thing. They tend to keep borrowers in the home. However, they [servicers] may take loans that are in a nonperformance status and report them as current under their modified payment terms. The problem with that is we know a large percentage of those loans will re-default after modification. So those loan modifications could result in potential bond downgrades.”
But it is not known how much and how many times loans will be modified and what kind of modifications will be made and what the subsequent default rates will be, Costello warned, saying this creates uncertainty about performance.
“We’ll need more information on this,” he said, and added, “The whole subprime thing is going to get a lot more messy.”
Fitch also is “very concerned” that geographical areas that experienced the highest growth in subprime lending “could have the biggest corrections,” he reported.
“We could be in for a long time where home prices don’t rise very much at all,” he concluded. “That has a lot of implications for losses — an 8 percent loss, maybe 10 percent, or worse. If there’s a double-digit decline in California that would be a whole new ball game. And you’d be talking about rating corrections that could go up to mezzanine bonds.”
Ratings Quality Questioned
Jerry DeMuth is an award winning journalist who has been reporting for four decades.
e-mail Jerry at email@example.com