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Subprime Mortgage Bonds Get AAA Rating From SP

Scott Eells/Bloomberg

Pedestrians pass in front of Standard Poor’s Financial Services LLC in New York, U.S.

Pedestrians pass in front of Standard Poor’s Financial Services LLC in New York, U.S. Photographer: Scott Eells/Bloomberg

Aug. 30 (Bloomberg) — Karl Case, professor emeritus of economics at Wellesley College and co-creator of the SP/Case-Shiller index of U.S. property values, talks about the U.S. housing market and the outlook for government policy to boost home purchases and economic growth.
Residential real estate prices in in the U.S. decreased in the year ended in June at a slower pace than in the prior month, according to the latest Case-Shiller report. Case speaks with Lisa Murphy and Matt Miller on Bloomberg Television’s “Street Smart.” (Source: Bloomberg)

Standard Poor’s is giving a higher
rating to securities backed by subprime home loans, the same
type of investments that led to the worst financial crisis since
the Great Depression, than it assigns the U.S. government.

SP is poised to provide AAA grades to 59 percent of
Springleaf Mortgage Loan Trust 2011-1, a set of bonds tied to
$497 million lent to homeowners with below-average credit scores
and almost no equity in their properties. New York-based SP
stripped the U.S. of its top rank on Aug. 5, saying Washington
politics were making the country less creditworthy.

Treasuries gained about 1.95 percent and U.S. borrowing
costs have fallen to record lows as investors repudiated the
downgrade, according to Bank of America Merrill Lynch indexes.
SP has awarded AAAs to more than $36 billion of securities in
the U.S. this year that were created by bankers who continue to
gather thousands of loans, bundle them into bonds of varying
risk and pay ratings firms a fee to assign credit rankings.

“Everybody has been led to believe over the years that AAA
means AAA means AAA across the board,” Gregory W. Smith, the
general counsel for the $41 billion Public Employees’ Retirement
Association of Colorado, said in a telephone interview on Aug.
24. “Anybody that didn’t learn in the 2008 crisis that doesn’t
apply should find another line of work.”

Inflated Grades

Money managers are lending to the government at rates that,
in some cases, are about a third of what they demand to hold
top-rated mortgage notes, four months after Congressional
investigators said SP helped spur the longest economic
contraction since the 1930s by assigning inflated grades to the
bonds from 2005 through 2008.

More than 14,000 securitized bonds in the U.S. are rated
AAA by SP, backed by everything from houses and malls to auto-
dealer loans and farm-equipment leases, according to data
compiled by Bloomberg.

SP has said it made mistakes in structured finance since
the crisis including misunderstanding cash flows and using
conflicting methods to analyze the securities. Its owner, New
York-based McGraw-Hill Cos., depended on credit ratings for 27
percent of its $6.19 billion of revenue last year, down from 33
percent of $6.77 billion in 2007, Bloomberg data show.

“These are errors that could cause airplanes to crash if
this was aerospace engineering,” said Sylvain Raynes, a
principal at RR Consulting in New York and a former analyst at
Moody’s Investors Service.

Senate Report

Securitization enabled by SP contributed to more than $2
trillion in losses and writedowns at the world’s largest
financial institutions and the collapse of Lehman Brothers
Holdings Inc. three years ago, causing credit markets to seize
up and leading to the global recession.

A report by the Senate’s Permanent Subcommittee on
Investigations said that SP, Moody’s and Fitch Ratings helped
trigger the financial crisis when they cut thousands of mortgage
securities they rated AAA to junk status. The raters had engaged
in a “race to the bottom” to win business, lawmakers said.

Bank of America Corp. is marketing $292.4 million of
mortgage bonds that are set to get AAA ratings from SP,
according to people familiar with the matter, who declined to be
identified because the terms haven’t been set. The transaction
was reworked to give $242.7 million of the bonds more protection
against losses than SP required, the people said, a sign
investors may not have trusted the grades.

Springleaf Bonds

The underlying mortgages represent 96.6 percent of the
current value of the homes, the issuer estimates. Borrowers may
have an incentive to walk away from the debt and leave investors
with sizable foreclosure losses should the economy slow further
and house prices continue to decline.

The securities were created by Springleaf Finance Corp., a
lender to borrowers with risky credit that’s majority owned by
private-equity firm Fortress Investment Group LLC and partly by
former parent American International Group Inc., according to
the people familiar with the offering.

“We didn’t even start to look at the deal,” Paul Norris,
a senior money manager at Dwight Asset Management Co. in
Burlington, Vermont, which manages and advises on about $54
billion of assets, said on Aug. 25. “For the funds we would buy
this in, we need a AAA rating and we don’t have any confidence
SP would hold this rating for any period of time.”

Underlying loans for the bonds are on average five years
old, according to a document sent to investors. Credit scores of
the borrowers, none of whom has missed a payment over the past
two years, average 651. The U.S. median is 711, according to
Fair Isaac Corp., which creates the formulas behind FICO scores.

Better Record

The transaction may get investment-grade ratings on 79
percent of the debt, meaning losses on the underlying loans can
reach 21 percent before portions rated BBB or better lose
principal, according to the term sheet. Springleaf plans to
retain all but the most-senior debt, said two of the people.

Of the $12.8 billion of loans made by the firm over the
past decade that are still outstanding, 11.5 percent are 60 days
or more delinquent, the term sheet shows. That’s a better track
record than rivals, with the rate on subprime mortgages packaged
into bonds averaging almost 37 percent, Bloomberg data show.

Ed Sweeney, an SP spokesman, declined to comment on the
Springleaf transaction. “We believe our ultimate success will
be driven by the value investors derive from our ratings and
analysis,” he said.

SP says structured finance securities can deserve the top
grades if they’re backed by enough collateral to weather a U.S.
default. The company said it downgraded the U.S., which, unlike
corporations, has the authority to set tax rates and print
money, because politicians are becoming “less stable, less
effective and less predictable.” Government debt of the world’s
largest economy is now rated AA+, the same as Belgium.

Losing Trust

“I’m trying to sort out why debt backed by the ability to
tax in the United States is rated lower than securities that are
backed by no particular ability to have additional revenue,”
said John Milne, who oversees about $1.8 billion as chief
executive officer of JKMilne Asset Management in Fort Myers,
Florida, in a telephone interview on Aug. 23.

Treasuries have rallied since Aug. 5, even though the
downgrade showed SP considers the securities to be less
reliable. Investor demand for 10-year government notes, the
benchmark for everything from corporate borrowing to mortgage
rates, drove yields as low as 1.9735 percent on Aug. 18.

Investors lost trust that ratings are consistent across
asset classes after the crisis, Milne said. Top-rated slices of
commercial-mortgage-backed securities created since the market
revived, known as CMBS 2.0, offer yields of 3.66 percent, or
2.31 percentage points more than Treasuries ranked one step
lower by SP, according to Barclays Capital index data.

‘Many Lessons’

“The pricing in the market suggests that really it does
not believe the ratings anymore,” said Satyajit Das, author of
“Extreme Money: Masters of the Universe and the Cult of Risk”
(FT Press, 2011), in a telephone interview on Aug. 23. “If the
sovereign goes down the tubes, it’s very difficult to see how
these structures will be unaffected.”

Deven Sharma, the president of SP who’s stepping down in
September, has defended the company since taking over in 2007.
It said on Aug. 22 that Sharma, 55, will be replaced by Citibank
NA Chief Operating Officer Douglas Peterson, 53.

“Clearly, there were many lessons we learned out of the
U.S. residential mortgage-backed securities,” Sharma told
Congress last month. SP reviewed its methodologies and added
checks to make sure ratings are “completely comparable” across
asset classes and regions, he said.

Even after Congress included rules in the Dodd-Frank Act
last year designed to cut reliance on ratings, SP and its
competitors remain a key part of the financial markets. Pension
and mutual funds often require minimum ratings to buy debt
securities. Banks are generally required to hold less capital to
back higher rated bonds as regulators including the Federal
Reserve have yet to find an alternative.

Justice Probe

The Justice Department is probing SP and Moody’s over
mortgage-bond ratings between 2005 and 2008, according to three
former analysts who said they were interviewed by investigators.
The Senate Banking Committee and the Securities and Exchange
Commission are scrutinizing the decision to downgrade the U.S.
rating, according to people with knowledge of the inquiries.

SP downgraded the U.S. even after Treasury Department
officials told the firm it had overestimated future national
debt by $2 trillion. The company said the mistake didn’t affect
its decision, which was based on Congress’s failure to pass
enough budget cuts during the standoff over the debt ceiling
with President Barack Obama. SP’s move conflicted with Moody’s
and Fitch, which kept their top ratings on America’s debt.

No Cap

“The point is the debt is still rising,” Sharma said in a
Bloomberg Television interview on Aug. 9. “That’s why the
sovereigns team and ratings committee came to that conclusion.”

SP generally doesn’t cap the rankings of companies or
structured-finance securities at their country’s level. Along
with the 14,000 securitized bonds, four non-financial companies
including Johnson Johnson and Microsoft Corp. (MSFT) have AAA
rankings, Bloomberg data shows.

Granting top grades to securitized debt can be appropriate
as long as the AAA rated portion is small enough that the
collateral is sure to be worth enough to pay it off even in
extreme circumstances, said Ron D’Vari, the chief executive
officer of the advisory and asset management firm NewOak Capital
LLC in New York. He used the example of $100 of bonds backed by
$500 million of car loans.

The U.S.’s lower grade may make sense when taking into
account the government’s “willingness to repay rather than
ability,” said D’Vari, a former head of structured finance at
BlackRock Inc., which manages more than $1.14 trillion in fixed-
income assets.

‘Decent Job’

Pacific Investment Management Co., which runs the world’s
largest bond fund, says the quality of structured-finance
ratings has improved since the run-up to the financial crisis.

“They are doing a decent job — far better than the glory
days,” said Scott Simon, the head of mortgage- and asset-backed
debt at Newport Beach, California-based Pimco, which runs the
$245.5 billion Total Return Fund.

SP says it has made mistakes in structured finance, where
the top grade is now printed as AAA.sf following European rules
in 2010 meant to warn investors that securitized-debt grades may
be less reliable.

The company said in July that it allowed a discrepancy to
develop in how it rates commercial-mortgage securities. The
issue came to light after investors objected to how much of a
$1.5 billion deal planned by Goldman Sachs Group Inc. and
Citigroup Inc. was set to get top grades.

Two Approaches

After the banks restructured the deal to provide some AAA
bonds with a loss buffer of 20 percent, rather than 14.5
percent, Goldman and Citigroup were forced to pull the offering
when SP withdrew its ratings.

SP said it had been using the easiest of two approaches to
calculate borrowers’ income relative to required debt payments
when rating new deals, while continuing to apply an average for
outstanding bonds. The firm said it needed to review the
“potentially conflicting methods.”

The largest underlying loan was to be debt on the Park
Place Mall in Tucson, Arizona, according to a document sent to
investors. Borders Group Inc., the bankrupt book retailer that
won court approval last month to liquidate its remaining 399
stores, occupies 5.6 percent of its rental space.

“Our pursuit of quality and comparability means that when
we discover a material error in our ratings, we promptly review
it and address the matter transparently,” SP’s Sweeney said
last week.

Wrong Downgrades

Not all inaccurate ratings are too high, according to
Amherst Securities Group LP’s Laurie Goodman, a member of the
Fixed Income Analysts Society’s Hall of Fame.

Of 156 home-loan bonds deemed unlikely to suffer any losses
by Pimco in its reviews for insurance regulators that now rely
on its assessments rather than those of the raters, only 94
retain investment grades from the firms that assigned them, she
wrote in an Aug. 17 report.

SP wrongly downgraded 32 mortgage bonds in April 2010
because it used “incorrect” estimates for the size of losses
per foreclosure, the company said July 29. On Aug. 11, SP said
it wrongly withdrew ratings on almost $250 million of securities
backed by home-equity credit lines a month earlier. Those were
reinstated to AA+ because that is the rating on the debt’s
guarantor, a unit of Assured Guaranty Ltd.

That’s also the same grade on the U.S. even though credit-
default swaps show traders are pricing the insurer’s odds of
default over the next five years at more than 50 percent,
according to Bloomberg data.

‘Incorrectly Analyzed’

Even after losses from subprime mortgages infected the
global economy, SP continued assigning top grades to pieces of
home-loan bonds that were repackaged into new securities called
re-remics.

The firm lowered the ratings on 308 classes of such deals
in May 2010, cutting to CCC from AAA a $10 million bond created
by Credit Suisse Group AG nine months earlier, saying mortgage
defaults were turning out to be worse than it forecast. SP said
in December it would need to review 1,196 re-remic securities
because it had “incorrectly analyzed” the debt in light of the
structure of the underlying deals.

Wyndham Worldwide Corp.’s finance unit may have won higher
grades on two of three deals backed by timeshare loans in 2010
and 2011 that SP said this month it ranked using an “incorrect
priority of payments sequence in our analysis.” Among the
ratings affected were those on $249.7 million of A+ notes.
Wyndham added “funds to newly created reserve accounts” to
skirt downgrades, SP said in an Aug. 12 statement.

Fitch’s Refusal

Billionaire Wilbur Ross’s American Home Mortgage Servicing
Inc. said in May that it went with SP and DBRS Inc. to rate a
securitization of its advances on homeowners’ missed payments
and loan-management expenses after Fitch refused to grant AAA
grades to $650 million of the deal because of concern that
foreclosures are taking longer to complete.

While Fitch criticized that deal, SP has pointed out flaws
in some rated by Moody’s. William Harrington, who worked in
Moody’s derivatives group from 1999 until last year, said in an
Aug. 8 letter to the SEC its analysts face management pressure
to win business and noted it recently moved to “a market-
friendlier methodology” for bonds backed by high-risk company
loans.

Moody’s said in June that it stopped using a tougher
“temporary” approach to looking at the collateralized loan
obligations, which it introduced in 2009, because credit
conditions are “relatively more stable now and default rates
low.” Michael Adler, a spokesman, declined to comment.

To contact the reporters on this story:
Zeke Faux in New York at
zfaux@bloomberg.net;
Jody Shenn in New York at
jshenn@bloomberg.net

To contact the editor responsible for this story:
Alan Goldstein at
agoldstein5@bloomberg.net