Structured financial products linked to homebuilding and real estate continued to suffer more downgrades than upgrades in the third quarter and the outlook remains dim, according to a Standard & Poor’s quarterly report on rated global structured securities.
Both areas could experience additional stress if housing demand is further constrained by a deeper, more protracted recession and/or continued turmoil within the home lending industry. We will continue to closely monitor homebuilder cash positions and revolver availability, as liquidity remains critical to surviving this downturn.
Downgrades on residential mortgage-backed securities (RMBS) rose in the quarter ended Sept. 30 as monthly delinquencies and foreclosures on the underlying collateral increased, especially for transactions issued between 2005 and 2007, S & P said.
Commercial mortgage-backed securities (CMBS) also took a turn for the worse in the quarter, with four times as many rated CMBS sinking to speculative-grade status.
Among the other trends for the third quarter:
–Asset-backed securities (ABS) saw fewer downgrades in the third quarter, with S & P lowering its ratings on 119 ABS classes, down from a record-high 555 downgrades in the second quarter of 2008.
–Collateralized debt obligations (CDOs) were most negatively impacted by the September bankruptcy filing of Lehman Bros. Holdings Inc.
–Downgrades outnumbered upgrades by more than 4.7 to 1 in Europe, with CDOs accounting for the majority of the lowered ratings.
For details, see “Ratings Roundup: Third Quarter 2008 Global Structured Finance Trends.”
Technorati Tags: ABS, asset-backed-securities, CDO, CMBS, commercial mortgage-backed securities, commercial-real-estate, home sales, homebuilders, homebuilding, housing crisis, residential mortgage-backed securities, residential real estate, RMBS, structured-finance
The market for collateralized debt obligations is unlikely ever to fully recover from the credit crunch, no matter how much better the credit rating agencies get at assessing the risks of the complex structured finance derivatives, a new working paper* published by Harvard Business School argues.
Some practitioners believe that the credit crunch of 2007 and 2008 will work itself out, as such episodes tend to do, and the market for structured credit will return as before, the paper’s authors write.
We hold the more skeptical view that the market for structured credit appears to have serious structural problems that may be difficult to overcome.
“As we have explained, these claims are highly sensitive to the assumptions of (1) default probability and recovery value, (2) correlation of defaults, and (3) the relation between payoffs and the economic states that investors care about most. Beginning in late 2007 and continuing well into 2008, it became increasingly clear to investors in highly-rated structured products that each of these three key assumptions were systematically biased against them. These investors are now reluctant to invest in securities that they do not fully understand.”
The ability to create large quantities of AAA-rated securities from a given pool of underlying assets is likely to be forever diminished, as the rating process evolves to better account for parameter and model uncertainty, the authors write. “The key is recognizing that small errors that would not be costly in the single-name market, are significantly magnified by the collateralized debt obligation structure, and can be further magnified when CDOs are created from the tranches of other collateralized debt obligations, as was common in mortgage-backed securitizations. The good news is that this mistake can be fixed. For example, a Bayesian approach that explicitly acknowledges that parameters are uncertain would go a long way towards solving this problem. Of course, adopting a Bayesian perspective on parameter uncertainty will necessarily mean far less AAA-rated securities can be issued and therefore fewer opportunities to offer investors attractive yields.”
“Additionally, investors need to recognize the fundamental difference between single name and structured securities, when it comes to exposure to systematic risk. Unlike traditional corporate bonds, whose fortunes are primarily driven by firm-specific considerations, the performance of securities created by tranching large asset pools is strongly affected by the performance of the economy as a whole. In particular, senior structured finance claims have the features of economic catastrophe bonds, in that they are designed to default only in the event of extreme economic duress.”
Because credit ratings are silent regarding the state of the world in which default is likely to happen, they do not capture this exposure to systematic risks. The lack of consideration for these types of exposures reduces the usefulness of ratings, no matter how precise they are made to be.
*The Economics of Structured Finance by Joshua D. Coval (Harvard), Jakub Jurek (Princeton), Erik Stafford (Harvard).
Technorati Tags: CDO, collateralized debt obligations, credit-rating-agencies, mbs, mortgage-backed-securities, structured-finance
A survey of major bond market firms from mid-July to mid-August found that pessimism remains high in the industry and few participants see an end in sight to the downturn in global bond issuance, with structured debt hit hardest in 2008.
Standard & Poor’s Ratings Services commissioned the survey from Massachusetts-based Business Communication Strategies for 11 categories of bonds and five categories of structured finance.
Industry estimates of 2008 bond issuance remain very pessimistic and vary more widely than they usually do. In addition, bond market professionals seem very unsure about how low issuance is going and when it will turn around.
Among the findings of the survey:
- CDO, or collateralized debt obligation, issuance is expected to plunge 89 percent in 2008 after rising 1.1 percent in 2007.
- RMBS, or residential mortgage-backed securities, are down 90 percent in 2008, with respondents expecting little recovery through the end of the year.
- Corporate bond issuance is forecasted to decline through year-end, paced by an expected 43 percent drop in speculative-grade issuance.
- Credit card-backed securities could drop 6 percent in 2008, after surging 41 percent last year.
For details, see “Bond Market Professionals See Less Global Issuance in 2008.”
Technorati Tags: bond issuance, CDO, collateralized debt obligations, corporate-issuance, credit-crisis, credit-default-swaps, credit-markets, credit-outlook, residential mortgage-backed securities, RMBS, subprime-mortgage
Recent actions by ratings agencies on financial companies in the news:
AIG (NYSE: AIG)
Fitch Revises Rating Watch on AIG to Evolving (Sep 17)
S&P: Ratings On 16 AIG Subsidiary Insurance-Supported Bonds Lowered And Placed On Watch Negative (Sep 16)
Fitch Places AIG South Africa and AIG Life South Africa on Watch Negative (Sep 16)
Fitch Downgrades AIG to ‘A’; Remains on Rating Watch Negative (Sep 15)
Lehman Brothers (NYSE: LEH)
S&P: Lehman Brothers Holdings Inc. Downgraded To ‘D’ (Sep 16)
Fitch Assessing Lehman Counterparty Exposure in 9 European CMBS Transactions (Sep 16)
Fitch Assessing Lehman Counterparty Exposure in 2 European ABS transactions (Sep 16)
Fitch Assessing Lehman Counterparty Exposure in 31 European RMBS Transaction (Sep 16)
Fitch Reviewing Ratings on Tender Option Bonds with Lehman Liquidity and Credit Enhancement (Sep 16)
Fitch Monitoring Potential Implications of Lehman Bankruptcy on Global Synthetic CDOs (Sep 16)
Moody’s Places Lehman Brothers 2007-LLF C5 Floating Commercial Mortgage Trust on Review for Downgrade (Sep 16)
Previous Ratings Roundup.
Technorati Tags: (AIG), (LEH), asset-backed-securities, CDO, CMBS, commercial-real-estate, credit-crisis, credit-rating-agencies, credit-ratings, credit-risk, Lehman-Brothers, RMBS, structured-finance
Moody’s Investors Service’s outlook for global derivatives has turned decidedly more downbeat, with at least five major asset classes getting more negative ratings in the firm’s mid-year outlook released this week.
Only two global derivatives products maintained a stable performance outlook on their underlying assets: Japanese balance sheet collateralized debt obligations (CDOs) and emerging market CDOs.
Since January, Moody’s has provided enhanced sector outlooks periodically for key structured finance assets, such CDOs, collateralized loan obligations (CLOs), and loan transactions backed by small- and medium-sized enterprises (SMEs).
Credit derivative product companies, on the other hand, are expected to have generally stable ratings despite the negative outlook on asset performance.
The outlook has deteriorated on the performance for most derivative asset classes because of the rising corporate default rate, tight credit conditions and the projected lower recovery rate, Moody’s said.
Asset classes that moved to negative from stable/negative include CDOs globally, CLOs and SME CLOs in Europe, the Middle East and Africa, and SME CDOs in Japan. In the U.S., CLOs and SMEs moved to negative.
For full details, see 2008 Mid-Year Outlooks for Global Derivatives.
Technorati Tags: CDO, CLO, credit-crisis, credit-outlook, derivatives, global-credit, structured-finance, subprime
As banks struggle with how to value their impaired stuctured finance assets, Fitch Ratings has introduced a new asset-level projected loss analysis (PLA) to quantify loss expectations on Collateralized Debt Obligations CDOs).
Fitch said the new analysis builds off its Residential Mortgage-backed Securities (RMBS) mortgage loss assumptions to estimate the impact to SF CDOs. Fitch’s PLA analysis complements its criteria used for the review of existing SF CDO transactions with portfolio concentrations of subprime and Alt-A RMBS issued between 2005 and 2007.
Fitch initially developed the SF CDO PLA to identify tranches that were at risk for downgrades based on loss expectations for the underlying RMBS assets. This analysis shows how much mortgage distress any one SF CDO tranche can sustain before experiencing losses. The criteria report presents these RMBS loss estimates by RMBS issuance year, as well as sensitivity of RMBS loss estimates to underlying mortgage loss assumptions.
Fitch’s PLA has proven very effective in identifying SF CDOs in which the potential for losses to a particular CDO tranche many not be captured by traditional CDO analysis.
Fitch has applied the PLA criteria in screening Fitch-rated SF CDOs to identify tranches to be placed on Rating Watch Negative where asset credit migration had not materialized at that point in time. The continued RMBS downgrade activity experienced this year corroborated the insights from this analysis. The PLA also allowed Fitch to generate stressed CDO loss estimates for SF CDOs not rated by Fitch, but held by Fitch rated entities. This analysis has been used in analyzing CDO squared transactions, financial guarantors, financial institutions, and credit derivative product companies (CDPCs) that have exposure to SF CDOs.
Fitch’s ‘Projected Loss Analysis Criteria for Existing Structured Finance CDOs‘ is available for purchase.
Technorati Tags: CDO, credit-rating-agencies, RMBS, structured-finance, subprime-mortgage
Standard and Poor’s is “very cautious” about the outlook for US regional banks, despite the fact that they have fared better than their larger counterparts so far.
“We believe that key factors in their outperformance at this stage are their lesser exposure to subprime consumer lending, and in some instances their more-contained exposure to high loan-to-value home equity lending, or purchased loan portfolios, ” S&P says in a new Industry Report Card. “In addition, this group has not had the sizable investment securities write-downs experienced by larger banks, although possible impairments in certain types of securities, such as pooled trust-preferred collateralized debt obligations (CDOs), are emerging, thus far in the form of unrealized losses. Still, compared to larger institutions, these banks benefit less from revenue diversification and may have less financial flexibility in the capital markets.”
Overall, we are very cautious about these banks’ overall credit quality through 2009, because of factors including the banks’ high exposure to commercial real estate (CRE) loans, particularly residential construction loans.
“Although they are rising, total CRE nonperforming assets (NPAs) are still not very high, but this loan category typically experiences deterioration at a later stage in economic downturns. Similar to the past few quarters, in the second quarter, many of the banks provisioned at multiples of net charge-offs to build a cushion against potential problem loans. We expect them to use these reserves as the credit environment continues to weaken into 2009. ”
The major CRE asset-quality issues so far continue to be concentrated in residential construction, with the greatest occurrence of problem projects in the formerly hot markets of Florida, California, and Arizona., S&P said. Other soft markets include areas of Ohio and Michigan, given the Midwest’s recessionary economies. “Besides our focus on home builder loan trends, we are also watching a broader-based market decline that may affect lending on retail, office, or hospitality properties.”
Technorati Tags: CDO, commercial-real-estate, regional-banks, structured-finance, subprime-mortgage
Moody’s has issued a new Q&A outlining its views on the prospects for bond insurers. Moody’s said it has received many investor calls about recent rating activity in the financial guaranty industry.
For example:
Q. Do recent rating actions indicate that Moody’s believes that Aaa ratings are no longer sustainable in this industry?
A: Moody’s decision to place the ratings of FSA and Assured Guaranty (NYSE: AGO) on review for downgrade reflects company-specific credit issues and is not in itself a statement about the sustainability of triple-A ratings in the industry. These reviews were prompted by a substantial shift in demand for financial guaranty insurance, in addition to the presence of large, complex and concentrated risks within the portfolios of both firms in an environment where business opportunities have been exposed as being extremely sensitive to market confidence. FSA’s review also reflects material credit stress within its insurance and financial products operations.
Other topics addressed include:
- Why is Moody’s considering downgrades of Assured and FSA when they have sufficient resources to meet your Aaa threshold? Has your methodology changed?
- If a decline in industry fundamentals is an important factor leading to the rating actions on FSA and Assured, why was Berkshire Hathaway Assurance (NYSE: BRK.A) not similarly affected?
- How does Moody’s view the recently announced agreement between SCA (NYSE: SCA) and Merrill Lynch (NYSE: MER) regarding credit default swaps on troubled ABS CDO exposures? What are the implications for other guarantors?
Moody’s believes that most guarantors are involved in discussions with bank counterparties for the commutations of credit default swaps on ABS CDOs, although in many cases, there remain significant obstacles to reaching agreements – primarily related to settlement amounts.
- How sensitive are the various financial guarantors to future deterioration in mortgage performance?
- To the extent that the ratings for firms within the industry migrate lower into the Aa range, how do you see that affecting the overall business?
Details are available in Moody’s Financial Guaranty Update: Frequently Asked Questions.
Technorati Tags: (MER), (SCA), bond-insurers, CDO, monoline-insurers
Issuance of synthetic collateralized debt obligations totalled just $47 billion in the first quarter, about one tenth of that seen in the first quarter of 2007, according to CreditSights.
In its first half review of the sector, CreditSights notes that protection selling on index tranches has barely changed during the credit crisis from a notional perspective, “though the decline in delta relative to notional suggests that activity has been concentrated in the higher-rated tranches. ”
The Cash flow CDOs that are being launched increasingly appear to be designed to help banks clean up their balance sheets rather than attempts to arbitrage the agency ratings.
Until the commencement of the subprime crisis last year, it was frequently suggested that CDOs and other structured products would make a sustained spread widening nigh on impossible, CreditSights says. “Any widening, it was claimed, would rapidly be exploited by a wave of CDO issuance. The most important driver of this stabilisation was synthetic CDOs - specifically the idea that bespoke single-tranche deals could be placed with investors without the need to fill the entire capital structure and this protection selling would push spreads lower.”
“Such arguments have been demolished by the events in the past 12 months with both synthetic and cash flow CDO issuance falling like a rock owing to a slew of economic, ratings, and funding concerns.”
The full report is available for purchase.
Technorati Tags: CDO, structured-finance
Certain structured finance derivatives such as collateralized debt obligations of asset-backed securities could see their ratings downgraded under a new proposal from Standard & Poor’s designed to take credit stability into account.
Under the proposal, when assigning and monitoring ratings, S&P “would consider whether we believe an issuer or security has a high likelihood of experiencing unusually large adverse changes in credit quality under conditions of moderate stress (for example, recessions of moderate severity, such as the U.S. recessions of 1960 and 1991 and the European recession of 1991 or appropriate sector-specific stress scenarios).”
In such cases, we would assign the issuer or security a lower rating than we would have otherwise.
S&P says the proposal “does not imply that we believe that issuers or securities should become—or are likely to become—less stable.” Rather, the proposal expresses a theoretical outer bound for the projected credit deterioration of any given issuer or security under specific, hypothetical stress scenarios.
“We do not intend the proposed change to result in rating upgrades in sectors that have historically displayed above-average credit stability. Instead, we intend this proposal to function as a limiting factor on the ratings assigned to credits that we believe are vulnerable to exceptionally high instability.”
The primary focus of the stability consideration is intended to be ordinary business risk rather than special types of risk, such as changes in laws, fraud, massive natural disasters, or corporate acquisitions.
S&P expects the proposed change “would have very little, if any, effect on our ratings in the corporate and government segments of the capital markets.”
S&P anticipates that the proposed change would have a more pronounced impact in certain areas of the structured finance segment, particularly on ratings of derivative securities such as:
- Collateralized debt obligations of asset-backed securities (ABS CDOs).
- Constant-proportion debt obligations (CPDOs).
- Leveraged super-senior (LSS) structures.
Transactions and structures that create more significant cliff risks would likely experience the largest impact. The proposed change could result in downgrades to significant numbers of the securities listed above when we first implement the proposal.
If adopted, the proposed change would be it implemented over a period of roughly 180 days.
S&P is requesting comments to criteriacomments@standardandpoors.com. by Aug 6 on the following questions: “Do you support the proposal to explicitly recognize credit stability as an important factor in our ratings? Why or why not”
Full details are available here.
Technorati Tags: ABCP, asset-backed-securities, CDO, credit-ratings, mortgage-backed-securities, structured-finance