Ratings agency Standard & Poors has managed a stunt which to my knowledge has no precedent in the history of the dark art of ratings. It downgraded some not all that highly structured commercial mortgage bonds last week to an eyepopping degree, from AAA to BBB-, just this side of being junk.
Then they restored them to AAA this week. And the reason was not some semi-defensible “the dog ate my homework”, like someone external had given them erroneous information that got plugged into their methodology. No, they had implemented a new model, it gave garbage results, and somehow no one inside the firm noticed the massive downgrades that resulted and bothered to check to see if there might be an error in the model. No, they published and then got customer howls. Now this only involved three bonds, but this happening at all is quite an impressive feat.
From Blooomberg:
Standard & Poor’s backtracked on ratings cuts issued last week and raised the ranking on commercial mortgage-backed debt from three bonds sold in 2007.
The securities, restored to top-ranked status, had been downgraded as recently as last week, making them ineligible for the Federal Reserve’s Term Asset-Backed Securities Loan Facility to jumpstart lending.
S&P lowered the ratings on a class of a commercial mortgage-backed bond offering from AAA to BBB-, the lowest investment-grade ranking, on July 14. The New York-based rating company reversed the cut today, S&P said in a statement. In a related report, S&P said it adjusted assumptions on the timing of projected losses on the mortgages.
“It is a stunning reversal and certainly raises questions concerning the robustness of their revised model,” said Christopher Sullivan, chief investment officer at United Nations Federal Credit Union in New York. “It may engender further uncertainty with respect to ratings outlooks.”
Reader Entirely Random adds a vignette to this comedy of errors:
I finally got someone from S&P on the phone… tried to explain to them that capital markets simply won’t work if bonds go from AAA to BBB and back to AAA in the space of a week, that a number of people had been forced to sell the bonds last week when they had been downgraded and had lost quite a bit of money for the experience, and that any sort of credibility S&P had hoped to re-establish would likely be destroyed as a result of what they’d done. Of course the 25 year-old analyst at S&P didn’t have anything on his script to deal with those concerns and could do nothing but refer me back to their press release. I got so frustrated I suggested they completely disregard any pretense of “official methodology” and go straight to the South Park method — i.e., cut the head off a chicken and see where it lands on the rating board. I don’t think he found it nearly as funny or cathartic as I did.
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S&P's model run wild is a result of S&P's frantic attempts to reinvent itself…an effort to ward off investigations and prosecutions into S&P's collusion with the Wall Street Mafia. S&P's prostituted itself, providing S&P's stamp of approval on the "securities" peddled by Wall Street's scam artists.
And remember – even now – the stability of the world financial system rests on the accuracy of these ratings!
Even funnier than S&P marking AAA down to BBB- is that people actually believed it. Surely, rather than selling them because they had to, they should have been on the phone last week to S&P to say that there was no way these products should be BBB-. But they had products in their portfolio which they didn't understand, so much better to blame S&P for its mistake rather than questioning why the heck they are so ignorant in the first place. *If you don't understand the product, don't buy it.*
a
@Entirely Random, you've got game mate, right arm pump for your comedic enterprise!
They implement a new model without doing any quality control??
I do not think the word "incompetence" begin to describe this monumental screw up.
I'm no financial expert, so please correct me if I'm far out the left field here.
Say someone within S&P knew by anallyzing the results that their "new and improved" models was nothing more than a demented creation of the Fuckup Fairy. Let's further assume there was a way to short those securities that would be suddenly downgraded if the results were made "official; wouldn't it be a surefire way to make like a bandit?
Given their abysmal lack of ethics, I'm not inclined to give them the benefit of the doubt.
What interests me is the claim that they got things wrong due to the timing of projected losses on the mortgages. As leases expire over time you would expect renegotiation of leases to a lower value and some to just give up on the leases, putting mortgage holders under pressure. You could then project losses based on lease expiration. My concern would be that when a firm leasing property goes bankrupt those leases become void which would tend to front load losses. For the securities to move from BBB to AAA you would expect losses from here on in to reduce which fits in nicely. My guess is that the wrong assumption made is that firms will continue to go out of business over the next year keeping losses high. Iguess we will never know what really went wrong but it looks suspicious that only 3 securities were changed.
"Even funnier than S&P marking AAA down to BBB- is that people actually believed it. Surely, rather than selling them because they had to, they should have been on the phone last week to S&P to say that there was no way these products should be BBB-. But they had products in their portfolio which they didn't understand, so much better to blame S&P for its mistake rather than questioning why the heck they are so ignorant in the first place. *If you don't understand the product, don't buy it.* "
Most fund managers have mandates that restrict what they can hold. No matter how well you understand a product, if your mandate says you can't hold anything less than AAA, you have to sell if it's downgraded.
S&P seem to have pulled the updated CMBS loss and recovery assumptions from the website, and the actual rating actions contain comically little context, so I can't really say yet how the loss timing had such an impact. As soon as I get hold of it (or the analysts behind it) I'll update.
Ok, got it now. Here's the relevant passage, describing first the original methodology update, then the one that caused the bonds to be re-upgraded:
"First, we aggregate recoveries from defaults in the 'AAA' scenario and credit impaired assets up to the crossover
date. The crossover date is the point in time where the allocation of principal and losses to the super seniors
changes to pro rata from sequential. For many deals, the crossover date occurs when aggregate losses reach
30% in the scenario.
Looking at it a bit more carefully (but still waiting to hear back from S&P), it seems I got it a bit backwards. These were time tranched pieces. As best I can tell, under normal circumstances the A-1 tranche would be paid down first, then the A-2, then the A-3. But once allocated losses on the portfolio hit a certain level (30%), they switch to pro-rata payment, ie principal and losses allocated according to the relative size of the tranches. So, obviously, for a given level of losses, the earlier they hit that threshold, the better for the later timed tranches and the worse for the earliest.
Yves and others…why not consider the possibility that the 'new model' might actually be a more accurate model.
given the situation overall, and knowing the history of ratings generally and typically above what they should be for safety within the total system…likely all rating agencies SHOULD be creating new models..and very likely these new models should produce downgrades in ratings.
perhaps not from AAA to BBB..but i don't see this discussed here…a site where it might well be discussed.
michael
Thanks, Ginger, for that information. This S&P episode is another example of how the same clowns who rated everything under the sun and didn't know what they were doing then are still in charge and as believable now.
Companies should be doing their own risk analysis. Trusting to the ratings agencies in their unreformed state, well a ouija board would be better.
Ginger @7:39 -Thanks for digging out the S&P description of the methodology. That description reminds me of the "scholarly" articles accepted by professional journals but submitted by pranksters using scholarly words in a random text generator.
I think that there needs to be prosecution around the moral turpitude of the rating agencies and this answer is directed at Steve Koch from the daily links comments where he thought that they should not be punished for their part in the criminal behavior (not his words, mine)
psychohistorian