Triple-A Ratings Grade on a Curve, Making It Difficult to Assess Risk

By AARON LUCCHETTI and SERENA NG October 6, 2007; Page B1

When it comes to bond ratings, all triple-A grades aren't created equal.

[Scrubbed Clean] That's one reason debt-rating companies such as Standard & Poor's, Moody's Investors Service and Fitch Ratings have met such criticism over their role in the subprime-mortgage crisis.

The trio of rating companies -- owned, respectively, by McGraw-Hill Cos., Moody's Corp. and France's Fimalac SA -- has served as bond-market gatekeepers for decades, publishing letter grades designed to keep nervous investors out of risky bonds. But as the bond market has grown more complex, ratings have evolved to mean different things, depending on what's being rated.

While all ratings refer to the likelihood of default, some newer, more complex bonds don't default in the same way -- or at the same pace -- that old-fashioned corporate bonds do.

For instance, when corporations issue debt, the triple-A rating is the gold standard, awarded to only about a dozen companies, such as General Electric Co. and Berkshire Hathaway Inc. But in the trillion-dollar market for mortgage securities, triple-A ratings are as common as corner coffee shops.

Indeed, in dollar terms, more than half of the mortgage bonds outstanding -- including those backed by risky subprime loans -- boast the top triple-A rating. The same goes for collateralized-debt obligations, which pay investors higher interest rates than corporate and municipal bonds with the same ratings.

The proliferation of triple-A ratings has made it easier for pension funds and other investors to pile into newfangled bonds that recently have been losing market value at an alarming rate.

The sheer volume of these ratings is noteworthy now that investors across the globe have lost confidence in the ratings and values of some bonds. Hundreds of mortgage-related bonds have been downgraded in recent months amid a decline in housing prices.

Regulators from the Securities and Exchange Commission and attorneys general in New York and Ohio are looking into issues including whether credit-rating firms' close relationships with Wall Street influenced their ratings improperly during the mortgage boom.

For both companies and mortgages, a triple-A rating means the chance of default is remote. Companies with that rating have the financial wherewithal to withstand blows to their business and still make their interest payments. There's an alphabet soup of ratings below that; the lower a bond is rated, the bigger the chance its issuer won't be able to make the payments.

Companies care so deeply about their bond ratings that when they are making strategic decisions, the impact on their bond rating will often be a serious consideration.

While companies have to earn their bond ratings, mortgage securities are designed with their ratings in mind. Critics such as Joseph Mason, a finance professor at Drexel University, say rating firms could be more influenced by their relationships with the few Wall Street firms that repeatedly create mortgage securities than they are with corporate issuers, where business is spread across thousands of companies.

Ratings firms deny there is anything improper about their dealings with Wall Street and say they have policies to maintain independence and transparency. They also point to an SEC official's recent comment that the conflicts of interest are manageable.

Mortgage bonds are backed by pools of home loans, most of which are expected to keep paying even if some loans go bad. The companies that package them deliberately fashion some bonds to pay higher yields -- but also to absorb any losses first. Those bonds get lower ratings.

Since the first losses are assigned elsewhere, other bonds are designed to be much safer. In some pools, more than 30% of the loans would need to go bad before a triple-A-rated bond would take a loss.

That sort of scenario looked unlikely until this year, when delinquencies among certain pools of subprime loans hit unprecedented levels and continue to rise. In the 12 months ended Sept. 30, Moody's lowered its rating on 36 triple-A subprime bonds, about 1.8% of the Aaa's it had assigned in the market.

From subprime bonds issued in 2006, Fitch recently cut 32 triple-A ratings and S&P dropped ratings on eight, both small parts of the subprime market.

Over a few days in August, S&P lowered the rating on two hard-hit structured vehicles from AAA to CC, a rating on the brink of a default. An S&P spokesman said that type of deal was rare.

Downgrades this extreme are certainly uncommon in the corporate-bond world. Moody's says it hasn't had a Triple-A bond default since Macy's, then under previous management, defaulted in the early 1990s after losing its Triple-A rating a few years earlier. S&P hasn't had a default of a Triple-A corporate bond in the past decade either.

"The corporate rating is tried-and-true," says H. Sean Mathis, an executive at valuation-advisory firm Miller Mathis. Ratings on structured-mortgage products, by comparison, were created recently "as the product of a model."

A Credit Suisse study found that ratings on asset-backed securities, which include some mortgages, were more stable than corporate-bond ratings but were more likely to fall sharply when downgraded.

Ratings firms point out that, through last year, mortgage bonds and other structured deals overall proved less likely to default than corporate bonds. The five-year default rate for investment-grade structured bonds was about 0.73% of dollars raised from 1994 to 2006, compared with a rate of 1.44% for corporate bonds, according to Moody's.

S&P, which has a stricter definition of default, says triple-A structured bonds defaulted within five years only 0.04% of the time since 1981, compared with 0.3% of the corporate triple-A's. Those figures, however, don't take into account current problems in subprime mortgages.

For "asset-backed" bonds issued from 1998 to 2002, about 70 rated triple-A defaulted within five years, according to research by Credit Suisse. That represented about 0.9% of triple-A asset-backed securities, much of it in "ugly sectors," such as manufactured housing, says Rod Dubitsky, a senior strategist at Credit Suisse. Moody's says the recovery rate in such defaults is usually high, lessening the impact of the defaults.

QUESTIONS:

1.) What does a triple-A debt rating imply about the chance of default?

2.) How does the number of firms with triple-A ratings compare to the number of mortgage securities with triple-A ratings?

3.) What protects investors in triple-A corporate bonds and what protects investors in triple-A mortgage bonds?

4.) Historically, fewer triple-A mortgage bonds than triple-A corporate bonds have defaulted. Why might this historical track record provide little comfort to mortgage bond investors today?

5.) Why have rating agencies been downgrading mortgage bonds?