Another Day, Another Rating Agency Fail, This Time S&P « naked capitalism

Thursday, December 16, 2010

Another Day, Another Rating Agency Fail, This Time S&P

If you thought that the rating agencies had cleaned up their act in the wake of the crisis, think again. Our Richard Smith reported on a couple of black eyes by Moody’s, one a rather implausible 180 degree turn on its take on the US tax deal, the other a suspiciously flattering take on whether Countrywide had indeed transferred notes (retaining them, as an executive testified they did on a routine basis, would confirm our suspicions about widespread problems in the securitization industry.

Now we have a big blooper by S&P, this one in the form of mass rerating, based on an admitted faulty analysis. That is code for “big error in the model that everyone missed.”

The subject of this screwup is 129 so-called re-remics, consisting of about $85 billion of bonds which were devised by repackaging existing residential mortgage backed securities. Never heard of re-remics? There’s a good reason why. This market has been very active since early last year, but third party purchases were limited. Given the scarcity of third party buyers, which means the deals were largely retained by banks, one has to assume that the object of re-remics was to manipulate capital levels. Just like CDOs, which are now understood to have been over-rated, re-remics achieve the seemingly impossible task of increasing ratings of junky RMBS. From an October Bloomberg report:

Bank of America Corp., seeking to reduce risk and meet new capital standards, upgraded billions of dollars of distressed mortgage bonds by repackaging them into new securities using a variation of a Wall Street technique that failed during the credit crisis.

The transactions, known as re-remics, are designed to add a layer of protection to residential mortgage-backed securities that sustained losses, enabling them to regain investment-grade ratings. The strategy helped the bank pare its RMBS holdings by $5.2 billion in the second quarter, or about 15 percent, according to a company filing.

The most questionable part of this exercise is that 308 re-remic tranches had been downgraded by S&P from AAA to CCC, which is junk, back in May. Earth to base, any instrument that has so much embedded leverage that it can be downgraded that dramatically in the absence of accounting fraud means it should never have been rated AAA in the first place.

One has assume that the reason they were so popular is that the issuers and banks knew they were rated incorrectly.

That of course means the banks will be hoist on their own petard as downgrades proceed apace. There may not be enough re-remic paper at any one bank for these downgrades to make a meaningful dent in their balance sheets. Nevertheless, this is an indicator that even with asset-value-flattering super-low interest rated, banks still carry more dreck on their balance sheets than most investors realize.

At least one source for the Bloomberg story on S&P’s latest pratfall was suitably pointed:

“An admission of guilt by a rating agency: How refreshing, and also what a wonderful Christmas-time present,” said Sylvain Raynes, a principal at R&R Consulting in New York and co-author of “Elements of Structured Finance,” published in May by Oxford University Press. “What I want to know is, is anyone going to get fired over this?”

20 Comments:

Conscience of a Conservative says:

December 16, 2010 at 5:41 am

I do structuring. I take S&P at its word that this was a mistake. But considering what they were rating(I think of these as more CDO’s than Re-Remics) the mistake was also an example of sloppiness and not reviewing the waterfall of their models.

These structures were all about Time tranching a questionable bond and asking how many of the flows were AAA. S&P clearly never reviewed their model and relied on an old, outdated and incorrect waterfall.

At the end of the day, we learned once again, that the rating agencies don’t bring value to the table. Incidentally a fair number of these types of transactions one, only a year ago or so have been downgraded.

Oh one other point, and this may not be obvious to all your readers. These transactions were pure and simple regulatory arbitrage for a large bank who had non-investment mbs paper that no longer qualified for zero risk weighting. All this
badly done engineering had one purpose, to salvage some amount of paper as being zero risk for regulators, who clearly blessed this non-sense or were alseep at the wheel(again).

GAS MAN says:

December 16, 2010 at 5:48 am

“That of course means the banks will be hoist on their own petard as downgrades proceed apace. There may not be enough re-remic paper at any one bank for these downgrades to make a meaningful dent in their balance sheets. Nevertheless, this is an indicator that even with asset-value-flattering super-low interest rated, banks still carry more dreck on their balance sheets than most investors realize”

It could mean that. Especially if the incoming Congress gets serious about doing something about Fannie and Freddie. It would warm my heart so to see Demint, Paul and Co insist that we shut down Freddie and Fannie forcing the banks to take back all the crap they put on the GSEs balance sheets. It would of course mean instant insolvency for the banks and it would show that any “paybacks” of govt “loans” was a complete farce.

Once they were aware of the consequences of this action though, I’m sure our Tea Party heroes would fall in line with their corporate overlords and cool their rhetoric.

Conscience of a Conservative says:

December 16, 2010 at 5:50 am

One other point, I disagree with your supposition that these structures were an attempt at gaming bad ratings. I think this was large scale panic structuring to satisfy capital levels. The bank probably kept the front end bond and sol the back end bond. The buyers (we’re talking post bubble) were probably sophisticated enough to do their own analysis an these were all private placements. There was nothing sophisticated in the mistake here. The error would have been obvious to anyone doing a clean review of the underlying prospectus. The mistake was probably discovered as some of the underlying seniors must be taking interest shortfalls.

Yves Smith says:

December 16, 2010 at 3:49 pm

You are straw manning. I never said that.

What I said was the high level of issuance may be due to the fact that the banks realized the structure was being misrated.
- Conscience of a Conservative says:
  
  December 17, 2010 at 5:50 am
  
  What you said
  One has assume that the reason they were so popular is that the issuers and banks knew they were rated incorrectly.
  
  MY responses
  These transactions were pure and simple regulatory arbitrage for a large bank who had non-investment mbs paper that no longer qualified for zero risk weighting.
  ——————————-
  ——————————
  Yves, banks were not choosing to maximize profits here. This was pure and simple capital arbirage, attempting to maximize their capital position. I’m sure you know more about this and I, but I’ll say this anyway. Ratings reflect first and foremost the probability of a bond taking a loss. If the loss occurs toward the back end the reasoning is that some percentage of the front end cash flows are good. They were just after salvaging some amount of AAA that could count as zero risk weighting.
  
  What’s absurd are the rules imposed on the banks by the regulators that clearly make no sense here.

Entirely says:

December 16, 2010 at 7:03 am

Hey there Yves… I think you’re being a bit harsh on the rationale behind the re-remic. I think about it like this… surgery done on the battlefield, if critiqued years later in a university operating theater, would probably look quite ugly. The right way to look at it (IMHO) is in the context of when, why, and how it was done.

Here’s the thing… the need for re-remics is less an indictment of the RAs or the banks that constructed them and more simple proof of how idiotic the ratings-based accounting and regulatory structure which governs the global banking system. This points to the failure of regulators… not the regulated.

In structured products, Rating Agencies assign ratings based on probability of first dollar of loss. So assume a bank owns a $950 bond that was originally rated AAA and had 5% original credit enhancement. The $1000 pool of loans has deteriorated in credit quality and an updated review of the loss expectations suggests the pool will take $100 of losses. What this means in the RA model is that the $950 original AAA-rated bond will take $50 of losses so therefore must be rated CCC. Even though $900 of the original $950 will be paid back, the entire $950 of bonds must be carried by the bank as a CCC-rated investment.

In the regulatory/accounting regime of banks, the capital charge for CCC-rated investments is dollar-for-dollar. And while its unfortunate, the simple truth is that the banking sector just isn’t capitalized to take that sort of capital hit. At the same time, while banks can fund themselves through deposits at sub-1%, the required yield in the market should the bank decide to just sell the $950 bond in question would be 10%. So selling the bond is also a much less than efficient use of capital by the effected bank.

The creation of all these re-remics was an attempt to solve this problem. Split the $950 bond into a $850 bond that is again rated AAA and a $100 that is rated CCC. It lets the bank keep the money-good front end bond and hold capital against it accordingly and minimize its losses by only having to sell the piece of the whole that is truly going to take losses.

This doesn’t forgive the RAs for the mistakes they made or the fact that performance of private credit mortgages CONTINUES to be worse than modeled by the RA stresses. But I think its unfair to conclude that there is something devious behind the technology or motivation of the re-remic. In desperate times, being held to stupidly rigid and confusing capital and accounting rules, smart and honest people did their best to preserve as much value as possible for the banks at which they worked. Just my $0.02…

Anonymous Jones says:

December 16, 2010 at 12:59 pm

“This points to the failure of regulators… not the regulated.”

I get that someone living in an alternate universe (or an ivory tower) could believe something like this in theory.

But you do realize who has been running the regulatory show the last few decades, right?

It *is* the regulated. They have the lobbyists write the bills, and they have the relationships with those at the enforcement agencies. They set this up, intentionally, with the idea that the obfuscation and “regulatory theater” would give the impression to others that there was real regulation when in fact they were just gaming the system to benefit themselves and hide it as much as possible (which is not very easy given the outsized share of national income they are skimming).
ScottS says:

December 16, 2010 at 1:15 pm

So the bank are scooping the skin off the top of a pot of gravy, then the ratings agency rates the skin as CCC and the rest of the pot as AAA, and we’re expected to believe that the AAA pot will never develop skin again?

I fail to see the integrity of such a system.
- ZADOOFKA FLORIDA says:
  
  December 16, 2010 at 10:55 pm
  
  The word “integrity” used in the same article with “banking” and “ratings agencies” is insanity. Surely the english language has better word choices.

Chaim Kaufmann says:

December 16, 2010 at 8:01 am

I am leaving thsi here as i can find no other way to contact Yves or the blag admin. I have been subscribed via e-mail for about a year; 4 days ago I stopped receving updates. Tried to re-subscribe; failed as already subscribed. If there is anyone who can help, please do.

Thanks.

Conscience of a conservative says:

December 16, 2010 at 9:06 am

Yves, My understanding is this is an “interest shortfall” issue. We’ve always had this issue. Why is S&P creating a kerfuffle over this issue now?

John F. Opie says:

December 16, 2010 at 9:07 am

What I don’t understand is how anyone could be so lacking of cognitive abilities to buy anything remotely associated with MBS of *any* kind. I mean: come on. If you have serious bucks and fail to do any sort of due diligence, I have a synthetic option on the likelihood that I might have a bridge for sale at a yet to be determined time point that I’ll let you have for a serious discount because you’re such a trustworthy fellow/gal…

MBS are a black box that you, the investor, can know nothing about besides what the seller is willing to tell you (and they aren’t required to tell you much of anything). If you trust the seller of MBS to be telling you the truth, then I seriously wonder at your mental competence. Really. Period. Full stop. Seriously.

Are there really people out there who trust the Rating agencies that helped destroy billions by giving us ratings that were scarcely more than a published lie (protected by the 1st Amendment)? Caveat emptor, people, caveat emptor!

The mind boggles…

Fractal says:

December 16, 2010 at 2:16 pm

For those readers who are not employed in the securitization industry, these grafs from the Bloomberg story need more explanation:

More than $85 billion of re-remics have been issued since the start of last year, as bondholders and Wall Street firms transformed downgraded home-loan securities into new debt, some of which receives top grades from rating companies, according to a Dec. 7 report by Austin, Texas-based Amherst Securities Group.

Bank of America Corp., based in Charlotte, North Carolina, and Bank of New York Mellon Corp. are among financial companies that turned to re-remics in the past two years as they restructured mortgage-bond holdings to lower the amount of capital they needed or to make it easier to sell the investments.

*************

More than $30 billion of the bonds, many of which received ratings only from S&P, may be affected, according to Scott Buchta, head of investment strategy at New York-based broker Braver Stern Securities.

“That could have some big implications for the holders of these bonds, depending on how much the new ratings get changed,” he said in an e-mail.

In re-remics, typically senior-ranked mortgage securities or a series of the bonds get split into new debt, some of which becomes safer because it ranks higher than the rest. The process mirrors the original securitization of the loans.

In addition, what the hell are the implications of THIS?

Mortgage-bond trustees occasionally make a similar mistake when sending out payments to investors as S&P said today it did in grading debt, meaning investors need to carefully monitor their holdings, according to Raynes, a former Moody’s analyst whose current firm advises bondholders.

“What that rating firm isn’t saying is they usually incorrectly analyze every deal,” he said.

Fractal says:

December 16, 2010 at 2:19 pm

For those readers who are not employed in the securitization industry, these grafs from the Bloomberg story need more explanation:

More than $85 billion of re-remics have been issued since the start of last year, as bondholders and Wall Street firms transformed downgraded home-loan securities into new debt, some of which receives top grades from rating companies, according to a Dec. 7 report by Austin, Texas-based Amherst Securities Group.

Bank of America Corp., based in Charlotte, North Carolina, and Bank of New York Mellon Corp. are among financial companies that turned to re-remics in the past two years as they restructured mortgage-bond holdings to lower the amount of capital they needed or to make it easier to sell the investments.

*************

More than $30 billion of the bonds, many of which received ratings only from S&P, may be affected, according to Scott Buchta, head of investment strategy at New York-based broker Braver Stern Securities.

“That could have some big implications for the holders of these bonds, depending on how much the new ratings get changed,” he said in an e-mail.

In re-remics, typically senior-ranked mortgage securities or a series of the bonds get split into new debt, some of which becomes safer because it ranks higher than the rest. The process mirrors the original securitization of the loans.

Fractal says:

December 16, 2010 at 2:20 pm

A little bit of knowledge about html code is obviously dangerous!

ChrisPacific says:

December 16, 2010 at 5:13 pm

I think one of the biggest sources of systemic risk at present is the concept of the AAA rating. Maybe the government should consider banning it.

There inevitably seems to be a large element of unmeasured risk, in the form of model error, that would completely destroy the AAA rating if properly accounted for. Combine that with the common practice of using the AAA rating as a license to leverage up to the eyeballs and you have a recipe for disaster.

I would allow Moody’s and S&P to continue operating, but forbid them from assigning any ratings above CCC until they have demonstrated accuracy commensurate with the implied risk.

scraping_by says:

December 16, 2010 at 5:34 pm

Strange how this happens at the end of the year. Year end statements, bonus calculation, all that little stuff.

Most of the banks in this country are insolvent. Or, their continued solvency depends on continued denial, deception, abstracting abstracts, agreed falsehoods, with a lot of official compounding of the felonies. Entirely’s minderbender exercise of blaming the regulators for the bank’s lying is familiar to anyone who has worked with career felons: “Well, if you didn’t want me to do it you should have stopped me!” I thought that the regulators were supposed to be bossy about solvency.

Conscience’s bland agreement that the bonds are overvalued, but his note that the previous bonds done this way were downrated after a year is key, I think. This isn’t even kicking the can down the road, this is creating nothing and pretending it’s a lot. Window dressing that takes over the whole front of the building. Potemkin capitalism. If the regulators accept this as capital for reserve they’re definitely part of the game.

In any case, this is not what capital is about. I thought Benjamin Graham’s little story of Mr. Value and Mr. Market was the party line these days. Those who say there’s a difference between capital and money should take their entire salary in capital, which apparently can’t be used to buy groceries. Exists only as an abstract. Just a coincidence it’s denominated in dollars.

As far as anyone buying these bonds, check your mutual fund/retirement fund/hedge fund. If the management is buying into these, it’s time to find somewhere else for your money. Get out of Enronia and back into the real world.

Jason says:

December 17, 2010 at 12:27 am

Everyone’s mad at what the banks have done, and no one’s doing anything about it. Some say just vote for the right folks. I don’t think so, as they’ll just cave to the lobbyists. Why? Because money=power. Lobby’s are paid by the banks, who have the $$/power. The banks will not fail, by design. A bank run may cause financial collapse. Banks and risk shouldn’t mix but they did, and we all know what happened, or what’s still happening.
If you’re mad at the bank, dont give them your money. If you leave your money there, they essentially have your vote. I say, we collectively induce a minor bank run, or “bank walk”. Take some of your money out and put it in your local credit union. If enough people do that collectively, with an agenda, the banks will start listening.
Maybe this idea is too ambitious, or might not work at all. But all I read are bank problems here and bank fraud there. It’s been two years since the market plunge. Where are the solutions?!? So the banks can basically push us around and do anything they want??

Opinionated Bloviator says:

December 17, 2010 at 4:12 am

So the banks can basically push us around and do anything they want?? Correct. Where are the solutions?!? Take your money and give it executives for bonuses then bailouts for there bad mistakes. Repeat until you are living under a bridge then find some other sucker to fleece. That is the ONLY solution being offered.

Nathanael says:

December 24, 2010 at 9:23 am

As an individual investor, I never paid any attention to ratings agencies (who have built-in conflicts of interest preventing them from giving decent ratings), and neither should anyone else.

I’m not sure what deranged lunatic started putting references to ratings agency ratings in the law, in the accounting rules, in the definition of money market funds….

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