Moody’s Investors Service said it won’t assign its top ratings to certain residential mortgage-bond deals with issuer-friendly terms, signaling a potentially tougher stance than competitors as the market revives.
Home-loan securities without government backing probably will be able to get rankings only as high as Moody’s Aa tier if “significant” limits are placed on when and how repurchases can be forced of mortgages that fail to match their stated quality, the New York-based firm said today in a report.
Ratings companies, after fueling the U.S. mortgage-credit bubble that caused a global financial crisis, are now confronting lenders and bond sponsors such as Credit Suisse Group AG and JPMorgan Chase & Co. that seek safer contracts for themselves. Moody’s competitors have said investors may get enough protection with weaker so-called representations and warranties if the deals have bigger loss buffers or offsetting features, such as upfront third-party reviews of all loans.
“Fraudulent loans are extremely hard to detect,” Kathryn Kelbaugh, a senior analyst at Moody’s, said today in a telephone interview. “The due diligence, no matter how good it is, isn’t going to catch every rep and warranty breach. Should the investor eat that loan?”
Moody’s views may do little to impair issuance because bond creators are free to choose which firm to hire for grades, a practice known as ratings shopping. During the housing bubble that began to burst in 2006, that flexibility pushed graders to engage in “a race to the bottom” to avoid losing market share, a Senate panel said in a 2011 report.
Credit Suisse issued mortgage bonds in November with contract clauses that voided some repurchase requirements after 36 months or if a borrower defaulted because life events such as a job loss, illness or divorce. Those types of concessions in combination would probably be enough to cap Moody’s ratings, Yehudah Forster, a senior credit officer, said, without commenting on the particular deal.
Fitch Ratings criticized the AAA ratings assigned by Standard & Poor’s to $306 million of the Credit Suisse securities, citing the size of their so-called credit enhancement, or loss buffer provided by items such as some bonds taking losses first.
S&P ratings reflected the “super prime” quality of the loans and 100 percent due diligence performed on them, Sharif Mahdavian, an S&P director in structured finance, said at a securitization conference last month in Las Vegas. The firm’s grades on the deal were “not a broad endorsement of the practice” of allowing loan warranties to sunset, he said.
Credit Suisse and JPMorgan have been working on deals this month that may offer themselves or lenders more protections than found in the initial transactions by Redwood Trust Inc. after the market revived in 2010. JPMorgan’s transaction may include 36 month to 60 month sunsets, according to person familiar with it who asked not to be named because the terms weren’t set. Credit Suisse’s latest deal doesn’t include sunsets for lenders, though it does include them for the bank’s backstops of their promises, Dow Jones Newswires reported.
April Kabahar, a S&P spokeswoman, declined last week to comment on its approach, while Drew Benson, a Credit Suisse spokesman, and Jennifer Zuccarelli, a JPMorgan spokeswoman, declined to comment on their deals.
Moody’s also said in its report today its ratings could be limited to its third-highest A tier amid a combination of weaknesses on items such as rep-and-warranty protocols, the amount and quality of upfront diligence, and potential conflicts of interest such as loan files being held by the firms that would be required to take back the mortgages.
While changing rep-and-warranty paradigms can increase investors’ exposure to “defective” mortgages, the complexity of the issue and details of the variations that issuers are considering will prevent Fitch from using a “one-size-fits-all approach,” the firm said in a Feb. 20 report.
The company said it would generally assign grades assuming higher expected losses with more issuer-friendly terms. Still, it said it some changes in covenants, depending on their nature, could be offset with other deal features being stronger. At the same time, other types of provisions could make it impossible to get “high investment-grade ratings,” Fitch said.
Kroll Bond Rating Agency analyst Glenn Costello and DBRS Ltd. analyst Quincy Tang also said in interviews this month their firms will generally demand more credit enhancement when the terms are weaker. Costello said that “nothing is mandatory,” though Kroll may be more troubled by certain items, such as expirations of putback rights for fraud.
DBRS prefers sunset provisions that are conditioned on loans not going delinquent, Tang said. While it has encountered covenants in securitization deals that caused it to cap its ratings in the past, it generally prefers to avoid that approach because “as rating agencies, we can’t structure deals” and instead try to assess their risks, Tang said.