Note how, nevertheless, S&P bends over backwards to look supportive….
U.S. Treasury Secretary Henry Paulson’s plan to freeze some subprime mortgage rates in an effort to stop a wave of foreclosures may lead to ratings cuts on some mortgage bonds, Standard & Poor’s said.
“Simply freezing interest rates on some U.S. first-lien subprime mortgage loans would have a negative impact” on ratings of some residential mortgage-backed securities, analysts at New York-based S&P wrote in a report today. S&P said modifications to the loans will mean reduced payments available to investors from creditworthy borrowers…
The U.S. plan may “help stabilize mortgage default rates and mitigate the risk of future downgrades of highly rated tranches,” said Glenn Costello, a managing director in the residential mortgage-backed securities group at Fitch Ratings in New York. “However, the implications for the lower-rated tranches of these transactions are unclear at this time.”
S&P, the largest ratings company, said bondholders may benefit from mortgage modifications if they result in fewer foreclosures….
“In certain instances, the negative effects may outweigh the positive benefits,” S&P said….
Interfludity discussed possible price (as opposed to ratings) impact earlier this week:
Suppose it is true that, on-average, cashflows to the whole class of affected securities changes very little under the workout, that the savings to investors from avoiding defaults roughly balances the cost of the reduced income stream. Consider what this workout does to the certainty of cashflows for any particular MBS pool. Prior to the workout, under a low-default scenario cashflows are very high, while under a high default scenario they are very low. In the “good case”, the senior tranches get paid, but so do the tranches a few levels down. In the bad case, the junior tranches lose everything, and the senior tranches lose some fraction of their value. For valuation purposes, the marginal junior tranches now resemble at-the-money call options, valuable when outcomes are volatile, worthless when they are certain.
And what would the Bair/Paulson plan do? It would increase the certainty of the cash flows, to a level where, on average, senior tranches would be made whole, but marginal tranches would lose out. In other words, even if the effect on total cashflows in the aggregate is very small, the Paulson plan would wipe out the option value of tranches at the margin. Holders of these tranches won’t take a 5% haircut, but a 100% haircut off the tranch’s current value. You betcha they’ll sue if they have any hope of relief. [*]
On the other hand, holders of senior debt will be made whole with much greater certainty. The proposal effectively represents a transfer of wealth from junior to senior trancheholders. Which gets us to its clever systemic implications.
The current credit crunch stems not from the absolute scale of writedowns, but from the distribution of the losses. Highly leveraged entities with very little capacity to bear risk, who thought they were holding “supersenior” (but yield enhanced!) securities, are facing catastrophic unexpected losses. If those losses could be shifted to investors with a greater capacity to bear risk, the systemic implications would diminish towards the absolute scale of the losses, that is, towards insignificance.
Less senior trancheholders are being asked to take a hit, because they can, to save other investors who can’t afford their losses. From each according to his ability, to each according to his need. You’ve gotta love capitalism.
The observation about saving top-rated paper is clever, but I doubt that this crowd got much further than crafting a plan that would have minimal negative impact on investors (a point Tanta at Calculated Risk made yesterday) so as to minimize objections (the side effect of minimizing impact is of no consequence….).