Moody's, S&P defer cuts on AAA sub-prime, hiding loss

Even after downgrading almost 10,000 subprime-mortgage bonds, Standard & Poor's and Moody's Investors Service haven't cut the ones that matter most: AAA securities that are the mainstays of bank and insurance company investments.

None of the 80 AAA securities in ABX indexes that track sub-prime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg.

A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 per cent of the underlying mortgages are delinquent.

Sticking to the rules would strip at least $120 billion in bonds of their AAA status, extending the pain of a mortgage crisis that's triggered $188 billion in writedowns for the world's largest financial firms.

AAA debt fell as low as 61 cents on the dollar after record home foreclosures and a decline to AA may push the value of the debt to 26 cents, according to Credit Suisse Group.

"The fact that they've kept those ratings where they are is laughable," said Kyle Bass, chief executive officer of Hayman Capital Partners, a Dallas-based hedge fund that made $500 million last year betting lower-rated subprime-mortgage bonds would decline in value. "Downgrades of AAA and AA bonds are imminent, and they're going to be significant."

Holding capital
Bass estimates most of AAA subprime bonds in the ABX indexes will be cut by an average of six or seven levels within six weeks.

The 20 ABX indexes are the only public source of prices on debt tied to home loans that were made to subprime borrowers with poor credit histories. About $650 billion of subprime bonds are still outstanding, according to Deutsche Bank. About 75 per cent were rated AAA at issuance.

Regulators require banks to hold more capital against lower- rated securities to protect against losses; a downgrade would force them either to sell the securities or bolster reserves.

While most banks haven't disclosed the ratings of their subprime holdings, S&P estimated in January that losses on the debt may exceed $265 billion.

American International Group Inc, the world's largest insurer, has $20.8 billion invested in AAA rated subprime-mortgage debt, not including asset-backed securities that caused the company's biggest-ever quarterly loss last period, according to the New York-based company's disclosures.

Credit support
S&P and Moody's, the two biggest rating companies, are lagging behind Fitch Ratings, their smaller competitor. S&P, owned by McGraw-Hill Cos, and Moody's, a unit of Moody's Corp, have cut a combined 112 AAA ratings since July, about a quarter of Fitch's 390, according to Bloomberg data. S&P lowered one AAA bond in an ABX index, Moody's refrained altogether, and Fitch cut 19.

"We have built in 20 per cent more home price declines from the end of '07," said Glenn Costello, managing director for residential mortgage-backed securities at Fitch.

"When you build in that much home price decline, I feel good when I pick up the paper and I see that home prices are only down another 3 per cent. My ratings are still good."

The ratings methods balance estimated losses against so- called credit support, a measure of how likely it is that owners of each piece of the bond will incur losses.

For AAA rated debt, credit support needs to be five times the expected losses, according to Sylvain Raynes, author of The Analysis of Structured Securities, a college textbook.

Performance testing
All but six of the 80 AAA ABX bonds failed an S&P test for investment-grade status, which requires credit support to be twice the percentage of troubled collateral.

The guideline was one of four tests used by S&P used until last year, and a failure to meet the standard wouldn't have automatically resulted in a downgrade. The other companies used similar metrics to grade bonds, Raynes said.

Investment grade refers to all bonds rated BBB- and above by S&P and Baa3 by Moody's.

S&P and Moody's, both based in New York, failed to anticipate the record foreclosures on home loans and slumping house prices. New foreclosures jumped to 0.83 percent of all home loans in the fourth quarter, up from 0.54 percent a year earlier, the Mortgage Bankers Association said March 6.

Home prices fell 9 percent, the biggest decline in 20 years of record-keeping, according to the S&P/Case-Shiller home-price index.

As defaults on subprime loans increased, the three ratings companies increased their assumptions in the past six months for losses on the mortgages within the bonds and changed the computer models that predict declines in credit quality.