Rating agencies again seen as scapegoat

NEW YORK (Reuters) - Credit rating agencies are being blamed for failing to warn investors quickly enough of problems in the subprime mortgage market, but there may be more chapters to be written before the end is known for sure in this credit cycle.

With a wave of borrowers defaulting on subprime home loans, and two hedge funds managed by Bear Stearns BSC.N suffering losses on bad bets on subprime-related securities, some on Wall Street and on Washington's Capitol Hill are criticizing rating firms Moody's Investors Service and Standard & Poor's for retaining top grade ratings on many affected securities.

The mood in the credit markets reminds some of earlier debacles in the past decade when major U.S. corporations like Enron and Worldcom went bankrupt and investors also blamed credit rating agencies for not sounding the alarm soon enough.

Bill Gross, manager of the world's largest bond fund at Pacific Investment Management Co., or PIMCO, lambasted the agencies this week for failing to warn investors, saying "what was chaste and 'AAA' years ago" -- referring to the highest credit rating for bonds -- "may no longer be the case today."

U.S. House Financial Services Committee Chairman Barney Frank said on Thursday lawmakers may examine the role of rating agencies if more hedge funds melt down.

"If some highly rated packages fall steeply in price, then there's going to be some looking into what credit rating agencies were doing," he told Reuters.

FULL STORY NOT YET TOLD

However, the criticism may reflect a failure to distinguish between credit risk, or the risk of default on loan payments, and market or price risk which may just reflect rising interest rates in general or extra supply from debt issuers.

In addition, the structure of popular new funding vehicles such as collateralized debt obligations (CDOs) may provide some protection that did not exist a few years ago.

But the extra complexity in the terms of some mortgages held by CDOs, and the opaque nature of the CDOs themselves, means the story may not yet have been told in full.

"To say because a triple-A (security) has been volatile, that therefore the rating agencies are wrong, is a misstatement," said Andrew Harding, chief investment officer of fixed-income at Allegiant Asset Management in Cleveland.

Losses suffered by two Bear Stearns hedge funds have spooked some investors, who fear a "firesale" of subprime-related assets could force investors holding similar securities to mark down the value of their portfolios, prompting re-pricing of subprime collateralized debt obligations or CDOs.

CDOs are bonds backed by a variety of types of debt in order to diversify risk, but the repackaging process and the illiquid nature of the market makes it hard to know their value, especially in a crisis.

But such market risks have nothing to do with credit ratings, investors and rating agencies say.

"There seems to be a lot of confusion in the market between credit risk and other types of risk," said Yuri Yoshizawa, group managing director at Moody's Investors Service.

Agencies base their ratings solely on credit risk or the likelihood that borrowers will default on the debt bundled into the CDOs.

"Whether that CDO tranche is liquid or illiquid or how it prices, is not something the rating addresses," Yoshizawa said.

Yoshizawa and Moody's managing director Jonathan Polansky told Reuters on Wednesday they expect to downgrade more subprime-linked CDOs this year and next than they did in 2006.

S&P said in April it expected to downgrade some riskier CDOs later this year. Fitch Ratings issued warnings on a few CDOs backed by subprime loans last Friday.

The difficulty with marking CDOs to market, the way stock investors do, may not matter much anyway, said Dan Castro, managing director of GSC Group in New York.

"You can have mark to market loss, it doesn't matter as long as there's still cash flowing" from the loans to the subprime bonds to the CDO, he said.

"And if there's firesale prices, (a CDO manager is) going to be inclined not to sell," riding out the price weakness and protecting his investors.

Indeed, the illiquidity of CDOs is actually why they're so attractive to risk-averse buyers like pension funds, many of whom can only buy higher-rated securities.

CDOs offer pension funds relatively high interest rates because of the low credit ratings on some of the tranches of debt in the bundle of securities.

But the CDOs themselves also have high credit ratings since the CDO structure effectively provides pension funds with a guarantor for the risky debt in the form of hedge funds who bought riskier tranches of the debt and pledged to take losses on those tranches ahead of other creditors.

END GAME STILL TO COME

The real question is what the end-game is for risky home loans made in late 2005 and 2006, when loan underwriting standards plummeted.

Rating agency critics like Josh Rosner, managing director at investment research firm Graham Fisher & Co., believe the firms have enough information to act immediately.

But other market players are less sure of that.

"I don't have a way to tell whether we're heading toward six, seven, eight percent, or 13, 14, 15 percent, in terms of losses (on risky slices of subprime mortgage bonds), and the difference is critical," said Mark Adelson, head of structured finance research at Nomura Securities International. Most subprime CDOs are packed with risky investment-grade subprime securities, he said.

"The reason I can't tell - why nobody can tell - is that the loans that matter, the late 2005 and 2006 vintage, don't reach their moment of crisis until they hit their reset," he said.

Approximately $500 billion of adjustable rate mortgages are scheduled to reset higher this year, according to a report by Bank of America cited recently by PIMCO's Gross. In 2008, nearly $700 billion in ARMs are subject to reset.

"It is the resets that are the climax of the story," Adelson said, making it hard for anyone to know the exact outcome for subprime CDOs.