Ratings: Year of the downgrade

COPYING AND DISTRIBUTING ARE PROHIBITED WITHOUT PERMISSION OF THE PUBLISHER: SContreras@Euromoney.com

By:
Louise Bowman
Published on:

The record number of ratings downgrades in structured finance has fundamentally altered the market’s dynamic.

Shammi Malik, Henderson Global Investors

"There haven’t been many cases where downgrades haven’t been justified"
Shammi Malik, Henderson Global Investors

In 2007, the global structured finance market suffered more tumult than ever before. For the first time, structured finance issuance actually fell below the previous year’s level. Unsurprisingly, this decrease was driven by the US RMBS and CDO markets, which fell 45% and 17% respectively. For the ratings agencies, the number of downgrades on structured finance securities reached new highs. The 12-month downgrade rate (measured as the proportion of rated securities that are downgraded at any point over the past year) for securities rated by Moody’s in the global structured finance market was a record 7.4%, up from 1.2% the year before. That accounts for 8,725 ratings from 2,116 deals, with 98% of those downgrades coming from the home equity loans, RMBS and CDO markets. On a less holistic level, US structured finance CDOs, the source of much of the sub-prime grief, experienced a 12-month downgrade rate in excess of 20%, from just 3.2% last year.

It is a similar story at the other rating agencies, with widespread downgrades on predominantly 2006 and 2007 vintage securities backed by sub-prime assets. Fitch placed nearly $140 billion of RMBS on ratings watch negative, which covers nearly 3,000 rated classes. In January, following an overhaul of its ratings criteria, Standard & Poor’s announced that 6,389 rated classes from the US sub-prime sector, originally rated between January 2006 and June 2007, have been downgraded or placed on negative watch. Also, 1,953 ratings from 572 global CDOs of ABS and CDOs of CDOs are now on negative watch. That accounts for some $270.1 billion, or 46.6%, of sub-prime US RMBS deals and $263.9 billion, or 35.2%, of global CDOs of ABS and CDOs of CDO issuance rated by the agency.

With such increases in the volumes of downgraded securities, do rating actions carry as much weight any more? Before the credit crunch, any downgrade in the ABS market had a negative impact on the ABX indices. But now each successive round of downgrades is less surprising than the one before, and there has been a loss of confidence in the process. People are no longer relying on a deal’s rating to determine its price but are taking a more hands-on approach. "There is no doubt that given the volume of downgrades seen in the US sub-prime RMBS and securities referencing these, the value of ratings has been seriously damaged," says Shammi Malik, portfolio manager at Henderson Global Investors. "In the structured finance arena, people are questioning the value of a rating and looking more closely at the underlying stresses and methodology. The confidence level in the rating process from a year ago is simply not there today."

Reversal

As a result, the pricing dynamic has changed. It has become the practice of investors to see these downgrades as a foregone conclusion, and to act accordingly. Where before a deal’s pricing followed its rating, that is no longer the case. Rating actions now lag pricing movements that anticipate them.

Spread moves are largely driven on the asset class rather than the originator or rating. The market is assuming the worst and bunching issues together based on the sector, causing very wide spreads on some deals that are still fully performing. That many of these assets remain triple-A rated is seemingly not affecting the attitude of the market toward them. For example, the triple-A rated tranche of a prime, five-year RMBS issue from Alliance & Leicester last July had a spread at reoffer of five basis points. A similar issue from the same company in February this year had a pricing spread of nearer 60bp.

Global structured finance downgrade and upgrade rates

Cumulative downgrade rates by vintage

Source: Moody’s


Although it is true that most of the recent downgrades come from nearer the investment-grade cusp, with 75% coming from the single-A and Baa columns, the downgrades of formerly triple-A securities can be said to be having the biggest effect. Portfolio managers are understandably wary of holding bonds that are not triple A. Funds that exclusively invest in triple-A securities are forced to sell any downgraded assets, often at a heavy discount. But valuations prevailing in the market don’t properly reflect true value. In many cases, downgraded and thus cheaper assets are still performing well, and this has created opportunity. For example, issues wrapped by the monoline insurance firms that have recently been downgraded, such as Ambac or FGIC, have been downgraded with them. But many of those issues are from tenants whose underlying credit strength puts them very near a triple-A rating anyway. "There haven’t been many cases where downgrades haven’t been justified," says Malik. "But some downgraded assets I still look upon as triple-A."

But while some ratings actions may well be unjustified on an individual basis, the overarching degradation of sub-prime assets will ensure that the trend persists as sentiment in the market continues to sour. Fitch expects to see a 25% loss in US sub-prime RMBS backed predominantly by first-lien mortgages originated in 2006 and the first half of 2007, with a near 50% default rate on the remaining balance of 2006 and 2007 vintage mortgages. Delinquency and foreclosure rates in sub-prime mortgages are not slowing, nor are there any signs that they will do so over the coming months. Although the ABS and sub-prime markets are still operating, even those triple-A securities that have not yet been downgraded are now in the realm of distressed and high-yield investors, rather than the investment-grade people as before. "There are still plenty of triple-A rated securities that have significant value," says Ron Thompson, head of securitization research at RBS. "But the question is where will the next downgrades come from, and when will they stop?"