Get Set for Wave of Debt Downgrades

With Investors Frazzled, Real-Estate Softening,
Three Rating Firms Have Their Markers Out

AARON LUCCHETTI and SERENA NG / Wall Street Journal 9nov2007

The credit-rating downgrade deluge that's been rocking financial markets isn't over.

Surveying the Damage

Downgrades of mortgage-related
bonds* by S&P, 2005 through
3rd quarter '07

Original 
rating     Number       Percent
category   downgraded   downgraded
AAA           82           2.2%
AA           488           6.2
A           1,346         19.1
BBB         2,268         31.3
BB            977         34.9
B              95          8.5
Total       5,256

*Includes US residential 
 mortgage-backed securities,
 collateralized debt obligations 
 and some structured investment
 vehicles.

source: S&P

In the next few weeks, debt-rating services like Moody's Investors Service, Standard & Poor's and Fitch Ratings look poised to downgrade hundreds of mortgage-related investments worth tens of billions of dollars, creating the potential for more market unrest.

The three major rating firms — owned respectively by Moody's Corp., McGraw-Hill Cos. and Fimalac SA of Paris — have been maligned by critics for originally underestimating the danger of bonds backed by subprime mortgages and other investments tied to mortgages.

Now they're moving in the other direction, aggressively reassessing where they stand on a wide assortment of debt. Behind the about-face: a worsening real-estate backdrop and frazzled investors.

Credit-rating firms have lowered their credit ratings on more than $70 billion in mortgage-related bonds in the past few months, setting off waves of distress in the stock and bond markets. They've also expressed concerns about the outlook for a range of related industries from banking to bond insurance. Banks and Wall Street firms including Citigroup Inc. and Merrill Lynch & Co. took large charges when they were forced to reassess the value of even their highest-rated mortgage debt.

The latest turmoil to hit markets has been a reminder that the raters — despite all of the criticism about their approach — still have great sway. Many pensions and other institutional investors are bound to hold only investment-grade debt. A downgrade into junk territory can have an impact on demand for securities.

Moreover, because many mortgage instruments are so hard to value, some banks and hedge funds rely on credit ratings even when they know the ratings could be flawed.

"We are going to be seeing ratings actions coming for awhile" on mortgage-related debt, says Yuri Yoshizawa, a group managing director overseeing U.S. derivatives at Moody's.

Collateralized debt obligations, or CDOs, look primed for more distress. These are investments often backed by portfolios of mortgage-backed securities. They're sold in pieces, or tranches, with varying levels of risk and return. The CDO tranches — widely held by banks and investors — haven't been downgraded as quickly as the underlying mortgage securities they hold.

As of Nov. 1, S&P had lowered ratings on 381 tranches of residential mortgage-related CDOs. It still had a "Credit Watch negative" on 709 CDO tranches, meaning the bonds face a good chance of a downgrade.

Fitch has 609 CDO tranches on negative watch and plans to act on them by later this month. Through the end of October, Moody's said it had downgraded so far this year 338 CDO tranches worth $13 billion, backed primarily by mortgage-backed securities. It was still reviewing for downgrade another 734 tranches worth $48 billion.

Moody's says it hopes to finish its current crop of CDO downgrades in the next few months. Further downgrades could happen depending on the rating firm's assumptions about the underlying economy, where the outlook could be changing fast.

In October, when Moody's lowered ratings on thousands of subprime residential mortgage-backed securities, it said it didn't expect another big wave of downgrades on such bonds unless home prices declined by more than 10.4% from their peak in late 2005. That forecast of a fall in home prices was in contrast to the Moody's expectation last year of more-resilient home prices. Home prices were recently down around 4.4% from a year ago, as measured by the S&P/Case-Schiller index.

Last month, Moody's also changed its assessment of losses that would be suffered in pools of subprime loans from 2006, saying it could hit roughly 10%, on average, compared with a projection of around 6% early this year. Losses could hit 20% in some of the shakiest loan pools, Moody's added last month.

Adding to the confusion, there is little uniformity in the way ratings firms are acting as they scramble to downgrade CDOs and other bonds. For example, S&P has been giving investors comprehensive reviews lately whenever it takes big actions on CDOs, while Moody's has been providing data monthly. A Moody's spokesman says the firm also provides data on individual CDO ratings changes to investors.

In September, during hearings about ratings firms on Capitol Hill, at least one questioner raised the issue about whether the Securities and Exchange Commission could require more-uniform updates from the rating firms, which could also boost transparency about the state of the market.

While the rating downgrades of mortgage-backed securities were expected by many analysts, the speed and magnitude of the corresponding CDO downgrades caught many banks, brokerage firms and investors off guard. This past spring, even as mortgage delinquencies kept rising, some rating executives told investors that they didn't foresee CDO downgrades until 2008.

That's all changed as the rating companies have slashed their assessments of thousands of subprime mortgage-backed securities. That's had an especially severe impact on a class of CDOs backed by low-investment-grade securities. According to J.P. Morgan research, several CDOs had over 80% of their underlying collateral affected by the downgrades or reviews. The Aaa tranches on some of these CDOs were subsequently cut by multiple notches — some to junk — days after the mortgage-backed securities downgrades.

"There will be a lot of chain reactions," says David Yan, director and head of CDO research at Credit Suisse Group.

source: p.C1 9nov2007