Moody’s Investors Service is proposing changes to ratings and rating methodologies for public finance bonds secured by mortgages guaranteed or insured by third parties such as states, the federal government, or government sponsored entities.

The changes could result in the downgrade of up to 453 existing 'Aaa'-rated bonds to 'Aa1', and lead to lower ratings for other current and future public finance MBS.

Moody’s request for comment, released Monday, has four proposed changes.

First, “cap at 'Aa1' the ratings of stand-alone housing transactions with semiannual debt service payments secured by Ginnie Mae-Fannie Mae-Freddie Mac mortgage-backed securities or Fannie Mae-Freddie Mac standby credit enhancement instruments.”

This change would result in a downgrade of up to 453 existing Aaa bonds to Aa1.

The lower rating reflects the possibility of trustee or servicer errors and losses after possible defaults.

“Examples of these mistakes include failure to properly redeem bonds with excess revenue, redeem bonds correctly with prepayments of mortgage principal, pay fees correctly, and properly invest fund used to pay debt service,” Moody’s stated.

Bonds secured by loans from government-sponsored enterprises that are monthly pay pass-throughs will not be affected by the methodology change.

In a second proposed change, for new and existing stand-alone single-family bonds, Moody’s is proposing an additional cash-flow analysis for what it called the most “severe prepayment scenario,” where there is an immediate prepayment.

“During the housing crisis, some of Moody’s rated bonds experienced prepayment speeds in excess of our most rapid prepayment stress scenario,” Moody’s wrote.

The new methodology could downgrade additional existing bonds beyond the 453 already affected by the first methodology change, according to Gregory Lipitz, Moody’s senior analyst and co-author of the report.

A third methodology change that Moody’s is proposing would alter the way it assigns ratings of housing bonds that utilize acquisition-fund guaranteed investment contracts.

The new methodology would treat acquisition-fund GICs and float fund GICs differently.

For the latter, Moody’s will continue to use its existing methodology.

For acquisition-fund GICs Moody’s would rate the bonds no higher than the rating of the GIC provider during construction or acquisition of the mortgage-backed security.

After the construction and acquisition period, Moody’s would review the bonds using a broader methodology.

The fourth proposed change would incorporate a more pessimistic assumption about investment return rates.

The Federal Reserve recently announced it would keep interest rates at their current low rates at least until 2014.

“We believe that as a result of this policy, many [bonds] with projected default dates assuming low interest rates in the mid- to long term have a greater risk of actual default, as they would need higher interest rates to ensure cash-flow sufficiency,” Moody’s wrote.

Accordingly, for bonds not supported by a GIC, Moody’s is adjusting the anticipated date of cash-flow insufficiency associated with different rating levels.

Mortgages guaranteed by the U.S. government or GSE such as Fannie Mae or Freddie Mac secure many housing bonds. Moody’s is asking for comments to cpc@moodys.com by April 20.

The agency expects to publish an updated methodology shortly thereafter.

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