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Rating transitions start to bite

The storm clouds that were once on the horizon are now overhead.

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.

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