Ratings migration is a term that few outside the structured finance world are aware of or particularly interested in; this is about to change. Although the history of US RMBS since its inception in the mid 1980s has been relatively straightforward – very few defaults and until recently no major crisis – its status as one of the safest and most stable of investments at the triple-A level is under threat.
The savage downgrades that Moody’s and Standard & Poor’s have inflicted on second-lien sub-prime RMBS, and margin calls at Bear Stearns hedge funds that were long of CDOs backed by sub-prime, have caused turmoil on the wider markets and are set to have serious ramifications for the wider credit market.
In the middle of June credit spreads on MBIA five-year credit default swaps widened from 37 basis points to 44bp. This indicates that traders believe sub-prime woes could be bad news for the insurers of investment-grade paper. The possibility of widespread downgrades of highly rated paper to the cusp of junk is a strong possibility and the capital charge for a monoline insurance company increases by multiples in such an event. This would not be a positive for their P&L, to say the least. It is unfortunate for the monolines that the rating agencies are savagely revising their rating opinions on sub-prime paper because the monolines have big exposures to the sector.
In and around March, when sub-prime woes first came to the wider market’s attention – many supposedly informed observers (including the rating agencies) stated that problems were contained or even overdone. The BBB– sub-prime tranche was trading technically, they said, and did not accurately reflect the underlying asset class. Contagion is not likely, they all argued – there is little reason for sub-prime woes to spill over, and to some extent markets stabilized as bottom fishers appeared and appeared to make a quiet killing.
But the sub-prime crisis was always going to take a long time to play out. Foreclosures take time to work their way through the system but the fact that already triple-B-rated paper backed by second liens is being downgraded to single B and even triple C is just a taste of things to come. Already S&P is warning that Alt A performance is deteriorating fast – remember this asset class is supposedly composed of obligors that are self-employed, for instance.
Observers are rightly focused on the potential losses that ABS CDOs will likely face because of their being largely backed by subordinated tranches of sub-prime risk. But what happens when triple-A, double-A and single-A rated sub prime is downgraded to triple B? One of the arguments that the rating agencies made in response to the charge that their methodologies failed because so much weak collateral was securitized is that the vast majority of rated paper is not triple B and therefore highly unlikely to suffer losses.
This might be true but it does not take into account what happens when lots of triple-A-rated paper is downgraded to single A or even, heaven forbid, triple B. Older heads will remember that when triple-A paper suffers from dramatic transition rates a credit crunch is assured. Manufactured housing suffered a crisis way back in 1999-2001 and while the performance of the underlying assets has recovered – investors have long memories. And the recollection that some 47% of triple As were downgraded is not easily forgotten.
