Why the S&P-Triggered Subprime Selloff Makes No Sense

Ratings agencies are normally behind the curve: the market will generally start selling off long before a company actually gets downgraded. And so it might seem to be in the case of bonds backed by subprime mortgages: in the wake of the massive sell-off in such securities over the past few months, Standard & Poor's is finally saying that it might (or might not) downgrade 2.1% of the $565 billion in subprime-backed bonds that it rates.

What's fascinating is the market reaction to this news. I'm not saying that I expected this kind of thing – which was entirely expected – to cause a major rally. But surely a relatively small announcement like this – no actual downgrades, just one in fifty bonds being put on credit watch negative – was priced in to the market already?

It seems not:

The announcement triggered the biggest rise in U.S. Treasuries in more than a week and prompted the U.S. dollar to fall to a record against the euro. Shares of securities firms tumbled and an index tracking the performance of mortgage-bonds dropped to a new low...
An index of credit-default swaps linked with 20 securities rated BBB- and created in the second half of 2006 fell 9.5 percent this morning to a new low of 50.25, according to New York-based derivatives broker GFI Group Inc. The ABX-HE-BBB- 07-1 index has fallen by nearly half since January, reflecting growing expectations of defaults on the bonds.

Remember that a downgrade alone is not enough to trigger payment on a credit default swap, and that nothing has changed in the actual credits underlying the ABX indices. And yet there's still this massive sell-off.

To make things even more puzzling, the S&P downgrades really are, to use an over-used word, contained:

Many of the bonds S&P is reviewing were made up of loans originated by New Century Financial Corp., which filed for bankruptcy protection in April, and Fremont General Corp., which federal regulators forced from the subprime-loan business in March.

This does go to show that underwriting matters, and that the companies with the loosest underwriting standards are the ones whose bonds are now performing the most badly. (It doesn't help, of course, that now those companies are in bankruptcy, provisions allowing bondholders to put mortgages back to the originator are worthless.)

But it seems to me that S&P's announcement today tells us nothing that we haven't known for months about the subprime market. So count me utterly baffled by the market reaction.