Standard & Poor's placed about $7.3 billion worth of subprime bonds on CreditWatch with negative implications last Tuesday, a dose of consolation to a market that originally thought the rating agency would downgrade $12 billion of bonds.
Still, the subprime RMBS market had plenty to worry about last week. The rating agency subsequently downgraded 498 classes, leaving 26 classes on CreditWatch, and removing 74 from watch for a downgrade late Thursday afternoon. Adding fuel to the fire, Moody's Investors Service on Tuesday afternoon downgraded $5.2 billion in 399 2006 subprime RMBS and placed an additional 32 RMBS under review for possible downgrade. If this were not enough, late Thursday, Fitch Ratings placed 33 classes from 19 structured finance CDOs on rating watch negative as well as kept on review for downgrade eight classes of four structured finance CDOs, affecting a total of $803 million. The rating agency also put 170 U.S. subprime transactions on review for rating actions.
These moves are what some market players have been dreading for months as the troubled 2006 vintage loans approach their reset date. What is worrisome about the downgrades beyond the timing, since investors have claimed they should have been done sooner, is their ultimate effect on the ABS CDOs the loans were used to collaterize.
Indeed, 558 of the mortgage bonds Moody's downgraded in 2007 were in ABS CDO collateral portfolios, distributed among 294 CDOs, according to a report from UBS released on Wednesday. And 258 of the bonds put on watch for a downgrade affect 235 CDOs. Of the mortgage bonds S&P has on watch for downgrade, 448 are distributed among 244 CDOs, UBS said.
On a conference call Tuesday morning, S&P said that it typically assumes a one-notch downgrade on a CDO tranche with an underlying asset put on CreditWatch. The agency also noted that, based on the speed of the expected downgrades, it normally waits until the underlying collateral is hit. The sudden RMBS downgrades are an unusual move for a rating agency, the UBS report said, noting that typically the downgrade process is done in "baby steps."
However, pressure from holders of senior CDO tranches may have pushed the gas pedal down further. It should be noted that overcollateralization tests within the ABS CDOs provide for par haircuts if collateral bonds have been downgraded. These haircuts make it more likely that the CDO will violate its overcollateralization tests, deny cash flow to subordinate CDO tranches and amortize senior tranches, UBS said.
CDO downgrades are expected as the underlying mortgage collateral continues to experience delinquencies and defaults. On a follow-up conference call, S&P estimated that 100% of the synthetic CDO transactions with exposure to the affected RMBS are expected to be downgraded. On the cash CDO side, eight to 10 out of the 60 CDOs exposed to the collateral under question could see negative rating actions, the agency said. CDO squared exposure had not yet been determined, with S&P attributing the lack of ratings response to its opaque and hard-to-analyze nature.
In its own conference call, Moody's added that it, too, would need additional time to review CDO squared vehicles. It was, however, a bit more aggressive on its more traditional CDOs, putting the ratings on 184 tranches of 91 CDOs backed by RMBS on review for possible downgrade, affecting $5 billion in securities including 15 Aa' and eight Aaa' rated tranches - though the rating agency noted that Aaa' tranches would be pretty remote from downgrades. The CDO tranches that were not affected by the downgrades will be monitored, Moody's said, and while no further actions were expected at the time, the agency did not rule out future changes.
Some of the CDOs hit the hardest by the negative rating actions of Moody's and S&P, according to the UBS report, were ARCA Funding 2006-I, which closed on Oct. 11, 2006, with 25.4% of its collateral downgraded and 11.3% put on downgrade review. ACA ABS 2006-2, managed by ACA Management, also took a hit when 21.7% of its collateral was downgraded and 11.9% put on downgrade review, along with seven other transactions. Tricadia CDO Management was also affected on several fronts when its TABS 2006-5 deal had 28.6% of its collateral downgraded and 6.4% put on watch for a downgrade. Its TABS 2006-6 transaction had 20% of its collateral downgraded and 4.8% put on downgrade review. The firm also had three other affected funds.
Tricadia and ACA were not the only managers to have multiple funds on the CDO sick list. Deerfield Capital Management had seven injured funds, Goldman Sachs Capital Partners had nine affected issuances and TCW Asset Management had a whopping 22 funds affected, according to UBS.
As if the downgrades on subprime RMBS were not enough to torture these CDOs, S&P also said the rating actions may impact transactions where excess spread is utilized in the deal, such as Alt-A and closed-end seconds. This acknowledges a concern that some of the characteristics in the subprime sector are also prevalent in the Alt-A sector, which is currently under surveillance. This specifically includes deals on the lower end of the Alt-A spectrum, some considered Alt-B, which are performing worse than historical averages, S&P said.
Some of the major issuers to get hit by rating downgrades included Fremont Investment & Loan, New Century Financial Corp., Long Beach Mortgage Co. and WMC Mortgage Corp., which contributed to 31% of the subprime issuance volume in 2006 and 63% of the 2006 subprime downgrade volume, Moody's said, noting that the 2006 vintage was not as homogenous as it was expected to be, and it was much more concentrated among weaker issuers. Divided up, Fremont made up 19% of the 2006 vintage downgrades, New Century made up 17%, Long Beach made up 14% and WMC made up 13% of the 2006 subprime downgrades.
Who Is To Blame?
Criticism of the rating agencies also made headlines last week as many market players balked at Moody's and S&P's delayed responses. On S&P's lengthy follow-up conference call, Steve Eisman, managing director at hedge fund FrontPoint Partners, quipped, "The news has been out on subprime for many many months, delinquencies have been a disaster for many many months, the rating agencies have been called into question for many many months; I would like to understand why you are making this move today and why didn't you do this many months ago?" Separately, another investor not on S&P's call accused the rating agencies of withholding information, claiming that as the price discovery issue has hit a large portion of the market. "There might be a slight disconnect between what you said you knew and what you actually knew."
Indeed, total aggregate losses on all subprime transactions issued since the fourth quarter of 2005 is 29 basis points, according to S&P, compared with seven basis points for similar transactions issued in 2000, the worst-performing vintage of this decade up until now.
And on a quarterly basis for the fourth quarter of 2005 through the fourth quarter of 2006, S&P also noted that mean losses and standard deviations were worse than the 2000 book.
Whether these actions should have occurred at the initial onset of the subprime debacle or several months into the maturity of the cycle is a constant debate, though rating agencies have adamantly stuck by their methodology despite harsh investor remarks.
The rating agencies defended their delayed response on the grounds of the time needed to monitor true performance, examining them on a deal-by-deal and pool-by-pool basis instead of a change on market prices and headlines. "We felt that there was an appropriate level of seasoning at this time where the actual performance showed itself as opposed to just speculating where the performance would go, which causes us to take action at this time," S&P said.
Meanwhile, Richard Cantor, team managing director in the credit policy research group at Moody's defended the timing of the agency's downgrades, explaining that correlation in performance is imperfect across different sponsors, issuance dates and structures and that the ABX indices have been "painting all mortgage-related securities with the same broad and negative brush."
A more pressing concern, according to Brian McManus, head of CDO research at Wachovia Capital Markets, was not how quickly [the rating agencies] are moving but why the notes that were downgraded within the first year of issuance received their initial ratings. "Normally, we would expect a grace period of rating stability of a product after an initial rating."
The Dunk Tank
The rating agencies took yet another hit on their rating methodologies, as investors called into question just how so much weak and vulnerable collateral was able to make its way into ABS CDOs.
Countering the attack, both agencies unveiled lengthy alteration plans to their methodologies, as S&P said it will be increasing the level of severity to 40% from 33% in order to reflect the average severity that subprime servicers are currently experiencing. In addition, the agency modified its approach to ratings on senior classes in a transaction in which subordinate classes have been downgraded, adding a higher degree of correlation between the rating actions on classes located sequentially in the capital structure. "A class will have to demonstrate a higher level of relative protection to maintain its rating when the class immediately subordinate to it is being downgraded," the rating agency said.
For transactions that close on or after July 10, 2007, S&P said its cash-flow methodology assumptions will include a simultaneous combination of faster voluntary and involuntary prepayments that will result in less credit to excess spread. Its default expectations have also changed, increasing by 21% for 2/28 hybrid ARM loans.
Some market pundits have speculated that the shift in model, or the "move in the goal post," which they expected to be somewhat destabilizing for the market, is a way of rating agencies shielding themselves against previous financial debacles like the Asian financial crisis, where they were forced to testify regarding their rating methodologies.
Moody's said it will increase its loss expectations for newly originated loans by 10% and for other existing loans by up to 25%, expecting property values to drop by a 10% median price decline. Moody's also said it will increase its original loss expectations for non delinquent loans by 20%, taking into account the weak housing market and homeowners' lack of ability to refinance. The agency said it is not changing its CDO rating methodology at this time, despite questions regarding systemic risk problems in which the correlation risk can be very high in the vehicles' underlying assets.
And the market expects to see more downgrades, and has priced in more downgrades, McManus said, explaining that rating agencies have to be careful about the breadth of their ratings actions. "Based on where investors could recently buy issues, if this is all the pain they suffer, they will have gotten a good deal."
Triple-A rated RMBS holders are not expected to suffer, however, even in the ugliest of transactions, one banker said. The vast majority of Moody's downgraded bonds affected transactions rated Baa' or lower, though the agency did hit seven securities originally rated A'. S&P downgraded bonds rated AA' and lower and 80% of the classes affected by the ratings actions were BBB' or below.
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