AAA to CCC and Other Rating Agency Horror Stories

The news from rating agency land goes from bad to worse.

This Bloomberg article does much to explain why investors are avoiding subprime like the plague. AAA paper revealed to be CCC. Repeated incidents of financial institutions saying they have no/little subprime exposure, then shortly thereafter fessing up that they have a lot. And rating agencies, like the emperor who has suddenly realized he is naked, trying to disguise the fact that the data underlying their models isn’t germane.

While it was only $254 million of face value of CDO paper that was downgraded from AAA to CCC, that sort of downgrading is unprecedented. It’s worse than turning gold to lead, it’s closer to revealing that gold is actually nuclear waste. And the fact that it happened to several collateralized debt obligations suggests that other AAA rated tranches are similarly close to worthless.

From Bloomberg:

Last week, Standard & Poor’s butchered the ratings on $3.2 billion of debt from structured investment vehicles spawned by Solent Capital Partners LLP in London and Avendis Group in Geneva. About $254 million was slashed from the top AAA grade to CCC+ and CCC — slides of 16 and 17 levels, triggered by their investments in mortgage-backed bonds.

Think about that for a second. You left the office Tuesday owning a AAA rated security. By the time you got back to your desk on Wednesday morning, it was eight steps below investment grade in a category S&P defines as “currently vulnerable to nonpayment.” Try explaining that to your pension-fund trustees….

DBS Group Holdings Ltd., Singapore’s biggest bank, said on Aug. 7 it had S$1.4 billion ($921 million) at stake in collateralized-debt obligations. This week, it boosted that total to S$2.4 billion. It seems the bank had overlooked its commitment to a unit called Red Orchid Secured Assets….

A rare moment of comedy arises from what Moody’s Investors Service had to say about the oversight. “I don’t think DBS will be the only one who has missed something the first time,” said Deborah Schuler, a senior Moody’s analyst in Singapore….

Moody’s recently added some new phrases to its lexicon of code words. When the rating company refers to “updating its methodology” or “refining its risk assessments,” what it really means is that its historical models say absolutely nothing about how the future might turn out.

Last week, for example, Moody’s summarized “the most recent refinements” to how it treats bonds backed by so-called Alternative-A mortgages. “In aggregate, the change in our loss estimates is projected to range from an increase of approximately 10 percent for strong Alt-A pools to an increase of more than 100 percent for weak Alt-A pools,” Moody’s said.

So a mortgage-backed security with a rating based on, say, a 1.5 percent loss rate might now suffer 3 percent losses in its collateral, Moody’s said. How’s that for missing something the first time?

Here’s what is most worrying about the coming flood of downgrades and defaults. The U.S. Securities and Exchange Commission is investigating how the biggest brokerage firms priced securities caught up in the subprime meltdown as their values collapsed. My colleague Jonathan Weil last week detailed some of the accounting shenanigans that accompany how banks measure the “fair value” of their assets….

Suppose regulators decide to play hardball on how the financial community marks to market, imposing rules that outlaw the existing freewheeling approach to how over-the-counter derivatives are assayed.

Moreover, suppose those new decrees come just as much of the underlying collateral is so tarnished as to be almost worthless compared with its initial valuation.

The ensuing carnage in the balance sheets of every financial-services company in the world would dwarf the damage wrought in the securities industry by the subprime crisis so far.

It will be hard enough for central bankers in the U.S. and Europe to set monetary policy at next month’s meetings when they have no way of knowing how bad the financial storm might get and how much it might hurt economic growth. The more things that go boom in financial markets in the coming weeks, the harder the task facing the rate setters will get.

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  1. unlawflcombatnt

    Since many pension funds are not allowed to hold anything less than AAA-rated bonds, won’t this force them to sell these newly down-graded bonds, demonstrating their true mark-to-market value, while exposing the overvaluation of their mark-to-model prices?

    The market-value repricing of only a few securities should bring down ratings of other bonds, whose prices are still determined only by mark-to-model valuation.

    It seems this market-price discovery, by even a trickle of market exposure, would cause more sales, followed by still further revaluation to mark-to-market prices.

    Doesn’t this scenario seem likely?

    Economic Populist Forum

  2. Yves Smith


    What I have read suggests that many institutions have not remarked their positions on their books, the logic being something like “Yes, we know the price is wrong, but we don’t have a better price, so let’s not do anything till we have to.”

    But as you point out, for many institutions, a rating going below BBB- (the bottom of investment grade) will force them to sell. For others, a serious downgrade requires the to hold more capital against it.

    Big downgradings like this will force sale, which will force price discovery for at least some paper.

    I think the rating agencies are trying to walk a fine line between trying to restore the credibility of their ratings vs. downgrading so much so fast that they put the markets into a tailspin.

    But even one rerating of this magnitude calls everything they have done into question. Which begs another question: let’s say they rerate other paper not this far down, but say 4-5 rating grades, rather than the usual one or at most 2. That too would raise serious doubts about all the paper they haven’t re-examined yet. But will they have credibility if they don’t change the ratings very much?

    You can see what a complete mess this is…

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