Fitch: Subprime Defaults Hit AA and AAA Tranches With 1-2% Price Declines

This bombshell came courtesy Michael Shedlock, in “Fitch Discloses Fatally Flawed Rating Model“:

What follows are excerpts from Absence of Fear, an excellent article written by Robert L. Rodriguez at First Pacific Advisors.
We were on the March 22 call with Fitch regarding the sub-prime securitization market’s difficulties. In their talk, they were highly confident regarding their models and their ratings. My associate asked several questions.

FPA: “What are the key drivers of your rating model?”
Fitch: They responded, FICO scores and home price appreciation (HPA) of low single digit (LSD) or mid single digit (MSD), as HPA has been for the past 50 years.

FPA: “What if HPA was flat for an extended period of time?”
Fitch: They responded that their model would start to break down.

FPA: “What if HPA were to decline 1% to 2% for an extended period of time?”
Fitch: They responded that their models would break down completely.

FPA: “With 2% depreciation, how far up the rating’s scale would it harm?”
Fitch: They responded that it might go as high as the AA or AAA tranches.

In case it isn’t evident, this is a serious revelation. First, it is just about certain that Fitch’s models don’t differ significantly from those of S&P and Moody’s, so Fitch’s experience is likely to be replicated at the other ratings agencies. Second, it is looking increasingly certain that HPA depreciation isn’t going to be just 1% to 2%. About a month ago, Bloomberg reported that the National Association of Realtors, a group not predisposed to convey bad news about the housing market, forecasts that 2007 will be the first year since the Great Depression to show a nationwide price drop. Nouriel Roubini, admittedly a card carrying bear, called for a 5% decline from the market’s peak, which seemed like a dire forecast.

Roubini was outdone earlier this week by S&P, which in its press release on how it intends to improve its mortgage security ratings methodology, predicted an 8% decline in housing prices from their peak in 2006 (they also foresaw the bottom as 1Q 2008, which seems inconsistent with the depth of decline). The Economist in 2005 said the US housing market was overvalued by 20%, and that housing often corrects through fair value. And (see the Absence of Fear link) Robert Shiller, who has created a housing price index, has said prices would have to fall 45% to bring them into alignment. For our purposes, the specter of 5-8% declines is serious enough to stick with that.

Now admittedly, these are national averages, while the performance of individual deals will reflect HPA in the local markets in which those loans were made. And there are places like Utah where prices are still rising. But with a national decline of 5%-8% means that there will be some areas where the price falls will be even greater. Thus, it seems reasonable to expect to see a good deal more subprime paper, including the supposedly safe tranches, trading like junk.

We had a long post on this topic earlier (which was either detailed or longwinded, depending on how you feel about such matters) which delved into why no one could give crisp answers on how many subprime-related securities might be at risk under various default scenarios. The long answer is that this is terribly complicated and security-specific, but the short answer is that the models used to assess risk were complete and utter rubbish, an exercise in garbage in, garbage out. The subprimes originated in late 2005 and 2006 (and likely much earlier) bore no resemblance to the historical subprimes, which were originated using much sounder practices (more conservative equity, income verification, etc.). A completely irrelevant data set was used as the foundation for evaluating the more recent vintages.

Shedlock provides some additional color:

Fatally Flawed Model

Essentially Fitch extrapolated a model of constantly rising home prices forever into the future, in spite of obvious signs of rampant speculation and home price appreciation far above the long term average for four consecutive years. In addition, Fitch made no allowances for reversion to the mean on home prices, in fact did not even make provisions for a flattening market let alone a reversion to the mean at a time of massively declining lending standards, and with home price appreciation orders of magnitude above affordability indices and rental prices.

That is some set of assumptions that Fitch made in their model isn’t it? One might think that those flaws are so obvious that anyone with any reasonable degree of competence would catch.

Absence of Fear Continues

The asset quality problems in sub-prime and Alt-A have the potential to affect other areas, such as the collateralized debt obligation (CDO) market, in ways that many of the holders of those securities have little idea of how exposed they might be to unexpected changes in the security’s credit rating. It is estimated that U.S. banks have invested as much as 10% of their assets in CDOs, and the Office of the Comptroller of the Currency (OCC) requires that all of those CDOs be investment grade, says Kathryn Dick, deputy comptroller for credit and market risk. She says, “We rely on the rating agencies to provide a rating.”

As Kevin Fry, chairman of the Invested Asset Working Group of the U.S. National Association of Insurance Commissioners says, “As regulators, we just have to trust that rating agencies are going to monitor CDOs and find the subprime.”

While so many investors and regulators are relying on these ratings, the rating agencies take the position, as exemplified by S&P, “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.”

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  1. David

    For those that have worked in the securitized bond markets, this isn’t much of a revelation. Internal participants knew that housing price appreciation was embedded in the ratings. They should have been using some sort of reversion to trend model, but they didn’t.

    A one gets further away from plain vanilla asset backed securities, the worse the rating agencies get. The market knows this, which is why even in the best of times, the yields on asset-backed securities is higher than that of similarly rated corporate debt.

    David Merkel

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