Split ratings in ABS are not entirely unheard of. The hyper-tranching trend in mortgage ABS, however, has magnified the differences in methodologies, as enhancement is spread thinly out over the entire deal. In some cases, tranches are exhibiting rating variances up to four notches.
"The presence of a split rating on a very thin tranche is arguably the least alarming thing in the world - it is exactly where you would expect the philosophical or ideological difference between probability of default and frequency and severity paradigms to clash," said Nomura Securities researcher Mark Adelson.
This has been limited to the home-equity sector thus far, and is still a somewhat rare occurrence, seen primarily in larger transactions, where tranche amounts remain sizable. Hyper-tranching, or structuring down the entire ratings spectrum, leads to relatively small amounts of enhancement separating each class throughout the capital structure. Its proliferation seemingly correlates directly to the current heavy demand for sub bonds.
While both Moody's Investors Service and Standard & Poor's defend their respective methodologies, investors are wondering if this represents an opportunity for future upgrades - or downgrades - as well as a place to pick up additional spread. Empirical evidence suggests that the buyside is viewing the bonds at the lowest rating, but as the majority of mezzanine and sub bonds end up in CDOs, it remains to be seen which rating buckets the bonds would fall into.
S&P, which has assigned higher ratings than its competitors in these offerings, said that in its stressing of deals, it has not seen a uniform increased probability of default when moving down the waterfall.
Internal stress tests
"S&P methodology is based on probability of default, meaning loss of principal and interest. Based on our internal stress tests, we view the probability of default for the M2 and M3 bonds, for example, to be exactly the same as for the M1 [class]," said S&P Managing Director Frank Raiter. "It is possible that other [rating agencies] couldn't get their arms around the concept of a bond rated the same as another that is higher or lower in the cash waterfall. This highlights that [S&P] has a rigorous stress-testing model, instead of a rule of thumb," he added.
Moody's, meanwhile, has taken a more predictable approach, dropping a notch in each class down the structure. Moody's Pramila Gupta counters: "In Moody's approach, severity of loss is always a concern. If one class is subordinate to another, and it is smaller in size, isn't the risk of a loss higher? And wouldn't this loss be more severe?
"Because of this view, Moody's requires a minimum tranche size, so if a loss occurs it is within the loss severity assumptions for the rating of that class," said Gupta.
But given such disparate ratings, can investors take advantage of a ratings arbitrage by buying down in the credit curve and awaiting upgrades from the other rating agencies? These bonds do price in line with the lowest rating on the bond, according to traders and syndicate officials.
The recent $3.15 billion offering from Countrywide Home Loans, which showed the most pronounced ratings disparity to date, showed an M7 class that was rated Baa1' by Moody's, and A' and A-' by S&P and Fitch Ratings, respectively. After being initially offered at 145 basis points over one-month Libor, a single-A level, it cleared at 160 basis points over.
The net benefits down the line remain to be seen, but views differ, depending on whom you ask.
"It depends on what [investors] are using the rating for," said Nomura's Adelson. "If they are using a rating as a real measure of credit quality and they're sophisticated enough, and they understand what the different rating agencies mean when they say different things, it's not a big deal."
However, a split rating could complicate things for those bound by portfolio management constraints that mandate a rating range.
"If one of the ratings is below [the threshold] you could have to sell a bond that you don't want to sell and sell it for less money than you think you should get for it," he added.
Barclays Capital portfolio manager Bob Ferguson said that it is not unusual to have split ratings on individual classes. Moreover, ratings are not the only way to view credit, he said.
"We run stress scenarios to determine breakpoints on each bond and then determine if a bond at the triple-B level has appropriate loss coverage. Therefore, we don't buy solely based on ratings, although they can be the motivating factor for some CDO managers," Ferguson said.
CDO managers - the primary buyer of mezz and sub bonds - will base their decisions on which agency is rating their deal. "If Moody's is rating my [CDO], I need to buy what qualifies for my Baa2' bucket," a syndicate source said. "But, in general, they are trading faster than ever at the lowest common denominator."
Issuers - at least those bringing multi-billion dollar transactions - are enjoying it while it lasts. One trader called this trend positive as issuers get efficient funding and investors get the appropriate yield for the risk they take. "This incremental pickup in spread, for essentially the same rating, is viewed as free money," he said.
"What's next, a triple-A minus bond?" he asked.