Anatomy Of A Ratings Downgrade

How S&P and Moody's miscalculated risk on two top-rated pools of mortgage-backed bonds

The big credit-rating agencies, Standard & Poor's (MHP ) and Moody's Investors Service (MCO ), aren't known for making rash moves when changing their grades on bonds and other securities. The odds are only about 1 in 10,000 that a bond will go from the highest grade, AAA, to the low-quality CCC level during a calendar year. So imagine investors' surprise on Aug. 21 when, in a single day, S&P slashed its ratings on two sets of AAA bonds backed by residential mortgage securities to CCC+ and CCC, instantly changing their status from top quality to pure junk.

S&P, like BusinessWeek a unit of The McGraw-Hill Companies (MHP ), considers the episode a fluke, chalking it up to events no one could have seen coming. But a closer look shows that the very structure of the vehicles that issued the bonds heightened the risk of dramatic downgrades--and that the ratings agencies were aware of this risk, however remote, from the start.

The agencies have long contended that they shouldn't be blamed for the subprime meltdown, even though they gave high grades to most of the mortgage-backed bonds whose values have since plunged. Investors consider two main variables when assessing a bond: its price and the interest payments it generates. The agencies say their ratings reflect only the latter. Ratings are judgments about whether a bond will pay interest on schedule until it matures--not indicators of how market forces might affect its price. "Unlike market prices, [bond ratings] do not fluctuate on the basis of market sentiment," wrote S&P Executive Vice-President Vickie A. Tillman in an Aug. 31 Wall Street Journal commentary.

But the downgrades made 10 days earlier were indeed driven by market forces. Because of the particular way the vehicles were structured, the credit market plunge that began in June hindered their ability to pay interest on time. The bonds were issued by Europe-based collateralized debt obligations, or CDOs, called Mainsail II and Golden Key, that were run by money-management firms.

The financiers who create CDOs buy securities, pool them together, and sell pieces of the pool as bonds to wealthy investors and institutions such as pension funds and university endowments. But the Mainsail II and Golden Key pools, which were chock full of mortgage-backed securities, were set up differently from most CDOs. Instead of buying up securities with cash raised by issuing long-term bonds, they borrowed most of the cash by issuing short-term commercial paper that was highly rated. When the credit crunch shut down the commercial paper market, these CDOs had to start selling their mortgage securities to stay afloat. And because the market for subprime-backed securities had dried up, they often fetched only a fraction of their original value.

S&P acknowledged in a written statement to BusinessWeek that the market rout led it to cut the ratings on the bonds. Moody's, which along with S&P also drastically downgraded in late August some $9 billion worth of commercial paper issued by Mainsail II and Golden Key, acknowledged the same in interviews.

The ratings agencies stress that the CDOs were victims of a market storm that resulted in prices for mortgage-backed securities falling by a magnitude 10 to 15 times greater than any time on record. "We've never seen anything like it in structured finance," says Paul Kerlogue, senior credit officer at Moody's in London. "Things just behaved in a way that we were not able to predict." Says S&P's statement: "Our original ratings were based on the best available data at the time." It adds that the credit quality of the CDOs' underlying investments is still strong.


The question is how many other similarly structured CDOs are out there. S&P Managing Director Nik Khakee says very few vehicles it rates are so dependent on market prices. Moody's says fewer than 5% of its structured finance ratings face this risk.

That's of little comfort to those who bought AAA bonds that have turned to junk. Now Mainsail II and Golden Key investors are hoping for at least a partial bailout by Barclays Bank PLC (BCS ), which helped set up the structures. A Barclays spokesman confirmed the bank's interest. Europe-based banks have been shoring up other commercial paper borrowers, too.

The CDO bond investors weren't the only ones hurt. King County (Wash.) officials bought $53 million in Mainsail commercial paper when it boasted the highest possible grade, with an extra plus sign, from S&P. Now S&P rates that paper B, a junk grade. Quoting from an S&P document, county finance director Ken Guy says the plus sign on the rating indicates that the company's "capacity to meet its financial extremely strong." He adds: "We rely heavily on that." At least, they did. The county has since halted purchases of commercial paper, one of the thousands of reversals that together are driving the global credit contraction.

S&P's original rating reports on the CDO pools warn that if the portfolios' market values were to fall below certain thresholds, the pools would be required to start selling. Given that the agencies were aware of that possibility, some investors are now skeptical of how closely the agencies were watching over the CDOs, says Alex Roever, a credit market strategist at JPMorgan Securities (JPM ). Mortgage bond prices had fallen steeply in July and early August, yet the agencies issued no warnings that market value triggers might be tripped, he says. Moody's says the plunge was most severe in August. "You have to wonder," says Roever, "were these guys looking at what was going on? How do you get from investment-grade to near-default so quickly?"

In retrospect it's clear that the agencies misread the market risk when they issued their ratings on Mainsail II and Golden Key. Roever says that's forgivable because no one could have known how extraordinary and precipitous the plunge might be. But some others say the agencies should have been more cautious. Recent mortgage bonds included many more adjustable-rate and subprime loans, which carry higher risk and which were backed by homes whose prices had run up sharply--an unsustainable trend. "They were looking at historical data in a brand new ball game with brand new products," says Janet Tavakoli, president of Tavakoli Structured Finance Inc., a Chicago-based consulting firm and longtime critic of the agencies. "You have to understand what you're modeling. That is Statistics 101, and they failed." S&P and Moody's say they did significant stress testing on their models to account for the risk.

Another suspected problem: The agencies may have been focusing too narrowly on the price history of mortgage-backed securities, says Christian Stracke, a senior analyst at CreditSights Ltd., a rival bond research firm. In the last few years the volatility of mortgage bonds was low because money was gushing into the sector, and financiers were developing all sorts of new vehicles. "New technology can breed dynamics that artificially depress price volatility, which in turn gives false confidence," says Stracke.

Given all of this, the drastic credit downgrades in August "should not have seemed all that implausible," says Stracke. "We know, over and over, that markets get into crises like this. Price volatility on even very safe assets can be high."

By David Henry

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