Most market participants believed that Congress was going to raise the debt ceiling before the Aug. 2 deadline. However, it was largely expected that the U.S. long-term debt rating was going to be downgraded from its 'AAA' status by at least one of the two big rating agencies.

The choices presented in the debt ceiling debate prior to this date did suggest that a rating cut was imminent, most market participants agreed.

UBS analysts expected that the initial risk-off move caused by a U.S. rating downgrade announcement would be short-lived.

"U.S. obligations are not a pristine a credit as they use to be, but they are the 'best looking horse in the glue gactory,'" said Jeffrey Ho, an MBS strategist at UBS. "Investors with large amounts of investable funds do not really have a real alternative, in terms of a combination of established infrastructure, market size, liquidity and economic backing."

Mahesh Swaminathan, a managing director at Credit Suisse, suggested that there might be a situation where only one of the rating agencies decides to downgrade the U.S. sovereign rating and the country might end up with "a split rating situation. However, it is almost a non-issue if you have only one rating agency downgrade the U.S. rating."

Raising the Debt Ceiling

Prior to Aug. 2, many MBS analysts stated that not being able to raise the debt ceiling was a bigger issue in terms of agency MBS than a U.S. sovereign downgrade would be.

Citigroup Global Markets analysts said that downgrade-induced selling should affect the Treasury market more than agency MBS.

They expected small-scale selling in both these markets by households and nonprofits, retail-based mutual funds, REITs and foreign investors. "Combined, these investors hold a higher concentration of U.S. Treasurys than of agency MBS," Citigroup analysts said.

Analysts projected that households and nonprofit organizations own approximately $100 billion of agency MBS, while retail money managers have about $52 billion of agency MBS.

According to Credit Suisse analysts, government backing for agency MBS does not change regardless of the outcome of the debt ceiling talks or a U.S. sovereign rating downgrade. The only problem is, they said, is that the government might have to prioritize payments, which means placing other obligations ahead if there is no debt deal reached, which serves as the main risk to MBS buyers.

Even that is highly unlikely because capital draws by GSEs are likely to be small in contrast to severely negative consequences if they are pushed into receivership due to a lack of funds from the U.S. Treasury. If the U.S. rating is lowered inspite of a debt deal being reached, analysts said that investors should largely be unaffected since their cash flows would remain unchanged.

"Typically for agency MBS buyers, given the government backing and willingness to deliver, the actual rating is not that important," Swaminathan said. "Banks usually have specific risk weights for these investments and categorize agency MBS independent of their ratings, which are largely separate from their implicit triple-A nature. If there's selling, it's going to be a small number."

He added that the downgrade issue is a secondary issue, although it might exacerbate the weakness in MBS due to the uncertainty and cause incremental widening.

Ginnie Mae Advantage?

One question is whether GNMAs are in a better position versus other agency MBS to weather a scenario where the government cannot pay its bills.

Credit Suisse said this may be the case short-term but is not necessarily sustainable because even though the Federal Housing Administration (FHA) premiums have typically been enough to absorb losses, investor confidence might still be shaky without the government backing.

"GNMA at least at the outset has FHA insurance cash reserves that are enough capital to absorb losses on a fundamental basis," Swaminathan said. However, he said that this advantage might not be meaningful in a context where the government cannot meet its obligations. "If there's a lot of broad-based market disruption, this Ginnie Mae relative advantage will be overshadowed. Investors might not completely buy into the view that GNMAs benefit from a sufficient cash cushion," he said.

Will agency MBS have an advantage over Treasurys because of their collateralized nature, specifically GNMA securities?

Even though GNMAs have the same full faith and credit guarantee from the U.S. government as Treasurys, the two are different because GNMAs are collateralized while Treasurys are not, according to Barclays Capital analysts.

They said that principal and interest (P&I) payments from the underlying loans are passed to MBS holders either directly by the issuers or via a central paying and transfer agency. Analysts said that if the loans are still performing and the U.S. government is not trying to seize P&I payments, MBS cash flows should be not be affected.

Meanwhile, Credit Suisse also said that the collateralized nature of agency MBS does not give them an advantage over Treasurys since agency MBS yields are low because of government support. Minus the guarantee of timely principal and interest payments, they said that agency MBS would be like private-label MBS, the best of which trade around two to three points back or at 50 basis points to 75 basis points higher yield.

Additionally, agency MBS do not possess the benefit of structural protection from credit enhancement or subordination to make up for losses. Credit Suisse analysts, however, said that guarantee fees and insurance premiums make up for some of this lack.

"Without the government guarantee, agency MBS could just be a collection of whole loans - these are not prime bonds and they have no structure and no credit support," Swaminathan said. "They trade at tight spreads because of the government backing."

Investor Selling

One of the major questions that come up is whether a U.S. downgrade will trigger investor selling or inhibit levered investors' appetite for MBS.

Repo rates increasing is a factor that MBS analysts have brought up that could change investor views of MBS.

According to a July 22 report from Nomura Securities International, agency passthroughs are being funded in the three-month repo market at 0.24% with 3% to 5% haircut. They explained that if the U.S. sovereign debt rating is downgraded to 'AA', the haircut on agency MBS repos will likely rise to 4% to 6% and the funding rate will be slightly higher.

However, Nomura analysts do not believe that the rise in haircuts would cause the material selling of agency MBS by leveraged buyers such as hedge funds, REITs and dealers, although a ratings downgrade to below 'AA' could lead to negative demand-side technicals for agency MBS from the same investors, they said.

Meanwhile, Swaminathan said, "Price volatility would have to spike for repo haircuts to increase. Repo haircuts should not change materially as long as dollar prices are roughly in the range. If we end up in a situation where repo haircuts do go up, then that would be a broader problem for the overall market because of increased collateral requirements."

GSE portfolios might also be affected by a ratings downgrade. Nomura analysts do not anticipate that GSEs will be compelled to shed agency MBS due to a sovereign rating downgrade.

They explained that a significant part of assets on GSE retained portfolios are funded by short-term liabilities. This is why if spreads on GSE short-term liabilities do widen or if money market funds that are holding onto GSE short-term debt choose to sell, the GSEs can become agency MBS sellers.

Money market funds' ability to buy or hold a rated security, Nomura analysts noted, would rely on the issuer's short-term credit rating, and unless the major rating agencies also downgrade short-term debt issued by the Treasury and other federal agencies, money market funds would not be impacted by changes in the 'AAA' rating of the long-term debt.Deutsche Bank Securities analysts said that a likely initial reaction to a downgrade would be selling by Employee Retirement Income Security Act accounts that hold Treasury and agency debt and MBS. They added that other U.S. dollar investors worried about the unknown consequences of a downgrade, although with limited choices outside of the U.S. they would likely flee to liquidity, or the short end of the Treasury curve.

Domestic bank portfolio managers will most likely hold off increasing their security portfolios, added Morgan Stanley analysts. However, they will likely experience adverse impact to their capital position because of the knee-jerk price declines.

Meanwhile, they think overseas investors could be required to increase equity requirements, which in turn can impact their demand. Analysts also don't believe money managers will be forced to sell in a downgrade event, as most are benchmarked to specific indices that will not be affected by a U.S. ratings change.

Rating Agency Perspective

On July 15, Standard & Poors placed its ratings on 604 structured finance deals on CreditWatch negative. This came after the agency had placed on CreditWatch negative its 'AAA' long-term and 'A-1+' short-term sovereign rating of the U.S. The agency then followed this action on July 21 by placing an added 136 structured finance transactions on negative watch .

The rating agency said that the negative watch placement reflected its view on the ongoing failure to raise the U.S. government debt ceiling as well as the chances that Congress and the administration can in the foreseeable future agree on a credible, medium-term fiscal consolidation plan.

Separately, the rating agency said also that it might lower the long-term rating on the U.S. by one or more notches into the 'AA' level within the next three months if it concludes that Congress and the administration have not achieved a credible solution to the rising government debt burden within the foreseeable future.

The negative CreditWatch placement of the U.S. sovereign rating will impact the ratings of structured finance securities that typically include direct exposure to U.S.-backed securities.

However, the negative watch actions thus far have impacted only a small portion of structured finance securities that S&P rates. The agency said in a statement that most structured finance securities are supported by collateral whose credit quality is not directly linked to the U.S. government's sovereign rating.

"Even if there is a sovereign default, it does not prevent the issuance of triple-A securities," said Robert Chiriani, senior director in structured credit surveillance at S&P. "There is still the ability to do so throughout the securitization sector in auto and credit cards, for instance. The overall impact is under 4% - it's a very small portion of structured finance deals that we rate that are actually potentially affected."

There also might be some instances where the negative outlook on government-related securities can be mitigated. "There may be a situation where a note linked directly to the government will not be impacted by the change in the U.S. rating and can maintain its triple-A rating by excluding sovereign support," said Gary Kochubka, senior director in ABS surveillance at S&P. "We would have to see if there might be circumstances that this can happen."

Meanwhile, Fitch Ratings-rated U.S. structured finance deals have little direct linkage to the U.S. government's sovereign rating, according to the rating agency. So even if the U.S. sovereign rating were placed on Rating Watch Negative or even downgraded into the 'AA' category, Fitch does not expect that most U.S. structured finance ratings would be similarly downgraded. Fitch's criteria also allows structured finance transactions to be rated up to 'AAAsf' in cases where the sovereign rating is 'A' or higher.

However, analysts said that some of Fitch's structured finance ratings such as GSE-related securities can be impacted, and there also might be more negative and pervasive indirect effects of a U.S. downgrade that might affect the rating of Fitch-rated structured finance securities.

"If the U.S. is downgraded, it would precipitate a downgrade of the GSEs, which would in turn affect the guaranteed MBS," said Rui Pereira, head of U.S. RMBS for Fitch Ratings.

"A negative rating action on the U.S. may pressure ratings performance for some structured finance transactions in numerous ways," added Kevin Duignan, head of U.S. structured finance for Fitch. "Counterparty ratings may be affected, interest rates could become volatile, economic activity may be curtailed and liquidity could be constrained."

Moody's Investors Service placed the U.S. government's debt on review for possible downgrade on July 13. The rating agency said that the action has consequences for the ratings of structured finance securities that are directly linked to the U.S. government or that are otherwise vulnerable to U.S. sovereign credit risk.

As a result of its actions on the U.S. government ratings, Moody's has placed structured finance ratings that are directly linked to the U.S. government's ratings under review for possible downgrade. It said that ratings that are directly linked will move with any future rating action it takes on the U.S. government.

The agency is also looking into credits linked indirectly to the U.S. government's rating. It expects, however, that the exposure of structured finance transactions' eligible investments to the U.S. government rating "to be generally small" because of the short duration and diversification of investments.

The rating agency also does not expect that placing the U.S. government under review for downgrade to affect the large majority of structured ratings, citing their high credit enhancement levels, strong liquidity positions, and/or minimal dependence on the U.S. government credit.  


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