Bloomberg Plays Gotcha with S&P

Bloomberg's Mark Pittman isn't hedging his bets in a story headlined "S&P, Moody's Mask $200 Billion of Subprime Bond Risk":

Standard & Poor's, Moody's Investors Service and Fitch Ratings are masking burgeoning losses in the market for subprime mortgage bonds by failing to cut the credit ratings on about $200 billion of securities backed by home loans.

There's no attribution to anybody else – these are Pittman's own numbers, it would seem.

Almost 65 percent of the bonds in indexes that track subprime mortgage debt don't meet the ratings criteria in place when they were sold, according to data compiled by Bloomberg.

But rather than immediately explain what he means, Pittman then embarks upon 2,000 words of throat-clearing before explaining how he got his numbers. Eventually he does tell us: he's basing everything on an old S&P criterion for determining how well insulated a bond is against default.

S&P abandoned seven-year-old criteria for determining a bond's protection against default in February.
Under the old guidelines, S&P said a bond's ``credit support'' must be twice the rolling 90-day average of the sum of value of mortgages delinquent by three months or in foreclosure plus real estate that has been seized by the lender.
Credit support for a bond is determined by looking at the number of lower-rated securities that would have to go bust before it suffered losses, the dollar amount of mortgages available to pay back the interest and the annualized interest the mortgages generate in excess of what needs to be paid to bondholders.
The measure was one of four tests used by S&P, said Chris Atkins, a spokesman for the company, a unit of New York-based McGraw-Hill Cos. A failure to meet the credit support standard wouldn't have automatically resulted in a downgrade, he said.

Pittman applied the now-defunct criterion to $300 billion of mortgage-backed bonds, and concluded that $200 billion of them didn't meet it – that's where his headline comes from.

Ratings agencies, quite rightly, don't simply plug a bunch of ratios into a formula to generate a rating. If they did, they'd add precious little value. Instead, they have a dynamically-changing set of criteria which they use to help them make an informed decision as to what their ratings should be.

It seems that between 2000 and early 2007, one of S&P's four criteria for rating mortgage-backed bonds was a ratio between that bond's credit support and the quantity of impaired loans. In February, S&P decided that wasn't a particularly useful a criterion to use, but if it had continued to use it, then it would have discovered that a lot of mortgage-backed loans would no longer meet it. Which wouldn't mean that those bonds should necessarily be downgraded, of course, but it might be a red flag.

How that means that S&P, let alone Moody's, is "masking bond risk," I have no idea.

In fact, I'm far from clear what the criterion really shows, since Pittman's explanation of how it works is very hard to understand. For one thing, the criterion doesn't seem to change at all depending on the rating desired, which is weird: the criterion for an AA-rated bond can't be the same as that for a BBB-rated bond.

Pittman goes on to sum up the criterion when he talks about loans which "contain so many defaulted loans that the credit support is outweighed by potential losses." But the does the criterion really measure potential losses? Only, it would seem, if you consider the potential losses on a delinquent mortgage to be the entire value of the mortgage. Which is crazy: home prices might have fallen, but they haven't fallen to zero. And in any case, the criterion said that the credit support had to be twice the potential losses, using total delinquent loans as a proxy for potential losses.

One can see why S&P changed its criterion. For one thing, it used this criterion to rate bonds as they were being issued: that is, when the underlying mortgages were very young indeed. Over time, any pool of mortgage-backed bonds is going to see the number of delinquencies in it go up from where it was at the very beginning. That's only natural, and shouldn't be cause for a downgrade. Somewhere in the criterion, one would think, would be some adjustment for how old the pool of loans in question is. And if there wasn't, then the individual making the rating would in any case take that into account when working out what the credit ratings should be.

But Pittman did none of that. Instead, he took a single, now-defunct criterion, applied it to a pool of loans, and came up with a highly contentious headline. Then, he buried his argument at the bottom of an extremely long article.

The whole thing made Tanta's brain explode, which is bad enough in itself. But it also looks very much as though Pittman is trying to play "gotcha" with the ratings agencies. And that really isn't helpful.