Wednesday, February 27, 2008

S&P on the monolines: No problem. Why?

S&P and Moody's have now both affirmed MBIA. S&P also more or less said they would affirm Ambac as well if the reported $3 billion capital infusion is completed. MBIA's infamous 14% surplus note is now trading comfortably above par ($101 bid, $104 offer last night). So are we out of the woods with the monolines?

Well let's start by looking at S&P's methodology. In short, S&P will bestow a AAA rating if they believe an insurer can survive their "stressed" scenario. Here are their assumptions for various types of mortgage-related securities.

First, the cumulative losses for various types of loans. Note these are losses, not default rates. If you assume, say 50% recovery on first liens, then the default rates assumed would be roughly double what you see here. For some context, during the 2001 recession subprime default rates got as high as 9%, so clearly these loss rates are a multiple of historic norms, even during a recession.

Table 2 shows S&P's loss assumptions on direct RMBS transactions. That's where the monoline has insured a pool of loans directly, as opposed to a tranche of a RMBS transaction. So here a AAA-rated RMBS tranche means that S&P estimated the whole pool was worth a AAA at the outset.

Table 3 is starting to get to the real problems. What they mean by a "tranched" RMBS is one where there is a subordination credit enhancement. In other words, losses hit the lower-rated tranches first, and higher rated tranches only if the lower-rated pieces are completely wiped out.

You can't get much worse than those 2006-2007 loss levels, even on AA-rated tranches. Note that these loss levels will dictate the loss levels on ABS CDOs, which is table 4.

I noted in a previous post that CDOs was the monolines biggest exposure, so this table is the real kicker. Remember that the monolines basically only insured senior tranches of CDOs, so these loss rates would seem to represent an assumption that all the subordination will turn out to be worthless. When they say "high-grade" CDOs, they mean a CDO made up of ABS paper rated A or better. That does mean that the transaction is more leveraged, i.e., there is less subordination under the AAA-rated tranche. "Mezzanine" CDOs were usuallly made up of paper rated A or BBB. Since a lot of these mezz ABS pieces are turning out to be worthless, its not surprising that the CDOs are going to take huge losses. I'd say the only thing preventing these losses from being 100% is that most CDOs had more than just RMBS in them, and not all that paper will turn out to be worthless.

So all in all, I'd say that's a pretty stressful scenario.


Anonymous said...

I think it is real, real important to keep in mind what the general public will do when they understand the nitty-gritty of all this, assuming that is in the realm of possibility.

I mean, there is an appearance problem.

And here it is, boy, here it is:

That is the sort of thing that gets the peasants to storm the castle, gets them to cross the Shinnecock Canal if you will.

Anonymous said...

Anonymous said...

My read on table 4 is that those are loss rates on just the ABS CDO collateral that's in CDO squared transactions. Is your interpretation of the report that those ABS CDO collateral loss assumptions that underpin their CDO^2 loss assumptions are the same as the loss assumptions that are the basis of Moody's first order CDO loss estimate?

I realize that was a bit convoluted. Basically I'm trying to wrap my head around how $32Bn in ABS CDO exposure , at these implied ABS CDO loss estimates of 30% - 50% (mostly high grade from what I can tell), could possibly yield the $3-4Bn of CDO losses that Moody's is estimating, even if you take into account the tax shield and the timing of the cash flows. The only explanation that makes sense to me is that the assumption of losses on the high grade CDO liabilities is lower than the assumption of losses on the ABS CDO liabilities that are collateral underpinning CDO squared liabilities.

And if that's the case, is the assumption just that the CDO of CDO collateral is lower tranches? Isn't there a fear that correlation in the stress tested scenario, per your earlier posts, should tend towards 1 between the Mezz and AAA tranches of an ABS CDO?

Sorry for the long-winded post -- I appreciate your blog and the tremendous amount of time you devote to it.

Anonymous said...

So spell it out for us novices if you don't mind. If S&P's conclusion isn't skewed by baseless optimism, as your analysis seems to show, how can they still affirm a AAA rating with numbers as bad as this?

Ben Bittrolff said...

Durable Goods and New Home sales sucked. Fannie Mae sucked. Plus all of the economic releases yesterday sucked... and the market breaks UP, on a technical break of a Triangle formation.

Check out these simply insane facts, figures and charts.

Anonymous said...

One has to admit that the stock market's behavior is somewhat perplexing.

Can it be a flight to quality?

Money coming out of debt into equity?

Anonymous said...

Regarding loss rate assumptions...

Many subprime MBS are already showing 30%+ default rates, yet S&P is only assuming 17% worst case losses across the whole lifetime.

The Alt-A assumption is what's going to get them--9%?! Those are primarily interest-only loans that will be exploding as they hit their recasts at 115-125% of orig loan balance. We have barely begun to feel the Alt-A tsunami...9% indeed...

Even under S&P's stress scenario, they barely make it, almost completely wiping out their equity value.

Anonymous said...

re: Anon 11:02

I was going to post that link myself. The idea that Pfizer, for example, is a greater credit risk than MBIA is of course absurd.

Everyone except apparently Moody's and S&P knows that the Emperor has no clothes.

What I can't understand is why Moody's is risking potentially suicidal lawsuits by perpetuating what is universally accepted as a complete fraud.

Even weirder, Moody's is @20% owned by Berkshire Hathaway, and I can't understand why Buffett would allow this sort of shenanigans to continue.

Anonymous said...

re: eckalectic

I would say that the mavens of the "financial industry" are scared out of their wits by a potential reaction to the great Ponzi scheme they have foisted on the US.

It's great to drive your BMW down the Sunrise Highway with the hair ruffling your hair as you fantasize about your night on the beach with a clutch of hussies from the Harmony Club, but facing some pretty brutal music from the people you've cheated out of their life savings...well, that's not quite as appetizing.

Anonymous said...

Permit me to be more specific:

The Foreclosure Prevention Act of 2008 has crucial implications for bankruptcy that are not related to loan modification. Specifically, take a look at section 421, which proposes a solution to a problem with current bankruptcy law. Many Chapter 13 debtors pay for 3 to 5 years on a repayment plan, doing everything the law requires of them, and only a week or two later, face a foreclosure. How does this happen? Because the mortgage servicers frequently assess charges during a bankruptcy case, but fail to disclose these fees. Courts don't approve them; trustees don't adjust the debtor's payments to account for them; and debtors aren't even given notice that these charges are piling up. Instead of emerging from bankruptcy with a fresh start, homeowners find themselves defending a foreclosure or having to immediately pony up hundreds or thousands of dollars.

Creditors have a tight grip on the throats of debtors in the United States and have been able to sing a song of tax cuts and sticking it to chiselers on relief for a long, long time in the US.

They have to be very, very careful now. Very careful.

How careful? You want a barometer?

The euro. The higher it goes the more careful they have to be.

Look at it this way. Remember the wave of Francophobia that swept the country after France had the temerity to oppose the war in Iraq in the United Nations?

Well, most Frenchmen can now visit the US and light their cigars with $50 dollar bills. Except they wouldn't, because they save their money.

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