Agencies at odds over rating new mortgage bonds

Fri Dec 21, 2012 3:19pm EST

Dec 21 (IFR) - Just four years after the financial crisis, the slipping credit quality of privately-sponsored residential mortgage bonds is setting off unusually public disputes between rating agencies.

The agencies, seen by many as central villains in the crisis, have been squabbling over each other's ratings, as the kinds of bonds that fuelled the crisis make a slow, tentative comeback.

The spats usually erupt over "credit enhancement", a way of protecting investors against risk in bond structures - and an issue that was at the heart of the subprime mortgage crisis.

And while the overall credit quality of loans underlying such mortgage bonds has improved substantially since then, just the hint of slipping credit standards could be cause for concern.

The most recent bickering emerged last month, when S&P rated an almost US$330m mortgage bond from Credit Suisse.

It assigned the highest triple-A rating to one tranche of the bond that had only 5.85% credit enhancement - meaning only 5.85% of underlying loans would have to default before the investors in the triple-A slice of the deal would suffer losses.

It was the lowest triple-A credit enhancement of any such residential mortgage-backed bond since the financial crisis, and was almost three percentage points lower than the enhancement it required on a Credit Suisse deal in June that carried similar collateral. It had required a 8.25% level on that deal's triple-A bond.

Almost immediately, rival agency Fitch spoke up publicly against S&P's decision, saying it would not have accorded the deal the highest triple-A ranking.

"The credit enhancement available to the 'AAA' rated A-2 class is more than 15% lower than any Fitch-rated prime RMBS transaction issued since 2008," it said.

The S&P rating raised eyebrows as it came just two weeks after watering down the importance of so-called geographic concentration risk - when a large percentage of such loans are centered in an overpriced region, for example, or a disaster-prone area - in assigning credit ratings.

This was exactly the risk that Fitch said required more protection for investors, not less, when it evaluated the Credit Suisse deal, officially known as CSMC 2012-CIM3.

WHERE IT'S AT

Fitch said that the geographic concentration of the otherwise high-quality residential-mortgage portfolio underlying the CIM3 deal was of concern.

A large swathe of the properties are located in the Washington DC area, an area the agency believes may be overvalued in price.

Fitch said that much concentration of collateral in one area was a cause for concern, and insisted that it took a more conservative approach than S&P in rating such deals.

Because the high number of wildly inflated decisions on the creditworthiness of such residential mortgage-backed securities (RMBS) helped bring on the worst financial crisis since the Great Depression, the agencies have rarely spared an opportunity to paint themselves conservative - and their rivals as risky.

Earlier in November, Fitch said Moody's and S&P had overrated a commercial-mortgage deal; the previous month, Moody's accused S&P of the very same thing.

In early 2011, Moody's was kicked off a deal - and Fitch was hired for it - after the former said it contained too many properties in quake-prone San Francisco.

For its part, S&P said it welcomed the divergence of opinion on the rating of the Credit Suisse deal.

"We believe the market benefits from a diversity of opinions on credit risk," said an S&P spokeswoman.

KEY FACTOR AHEAD

The market in privately-sponsored RMBS - that is, those not backed by mortgages guaranteed by the US government - seized up in 2008 in the wake of the crisis.

Since then only two issuers - Credit Suisse and Redwood Trust, a California-based REIT - have come to market with new RMBS deals.

Yet while the market is still a far cry from the peak of RMBS issuance in 2005 and 2006, private RMBS is expected to increase next year to more than $10 billion from about $5 billion this year, according to Deutsche Bank.

As the sector makes its slow return, the dispute over credit enhancement takes on added importance - as the issue was crucial in helping bring about the financial crisis in the first place.

According to a 2011 US Senate report on the financial crisis, rating agencies failed to demand enough credit enhancement to adequately protect investors from expected losses.

Requiring increased loss protection means that rating agency analysts demand more revenues to be set aside in each pool by issuers to provide triple-A rated bonds greater protection.

It also means that RMBS pools would have a smaller bit of triple-A securities to sell to investors. Higher credit enhancement, in turn, would mean RMBS pools would produce less profit for issuers and arrangers.

Investors and regulators are paying closer attention than ever to how rating agencies adjust credit enhancement level requirements in their ratings methodologies.

This will become even more important in 2013, as new non-agency RMBS issuance will feature riskier collateral, aggregated pools from multiple originators, and weaker representation and warranty providers, according to a new report by Moody's.

"Pools will have higher compositions of loans with riskier attributes, such as those secured by investment properties," said the report.

"While lender guidelines have not materially loosened recently, increasing investor appetite for prime jumbo RMBS and limited supply of 'super-prime' borrowers has incentivized lenders to originate more loans near the fringes of their underwriting criteria."

Given current conforming loan limits, prime jumbo mortgages these days will naturally be limited to areas with very high home values, such as California. However, as the housing market continues to pick up and expand next year, mortgage-collateral metrics will migrate to marginally worse loan-to-value and debt-to-income levels, experts say.

"If the starting point is pristine credit, then as you expand the universe of borrowers, the credit quality would move down," said Paul Jablansky, head of structured products at Western Asset Management.

"Perversely, we're in a strange place where we now know a lot more about the credit quality of the legacy RMBS transactions that have longer data series. It's much harder to forecast the credit of the new deals, although they generally have very high credit quality."

Regarding the recent Credit Suisse deal, S&P said the collateral underlying it was much stronger than that in other RMBS issued since the crisis.

It said the FICO consumer credit scores on the loans averaged around 774, while previous post-crisis RMBS were underpinned by mortgage loans in the 725 range. It also said the recent deal had a lower average LTV of about 70%.

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