The downgrade shock wave

Credit rating agencies were the among the last to pick up on the implications of stalling housing markets. However, once they figured out what was going on, they quickly backtracked and re-examined the risks associated with huge numbers of mortgage-related assets. Suddenly, a belated wave of downgrades hit the rocky shores of investor balance sheets, and huge losses began to pile up.

These downgrades and the associated losses pulled away the foundations of the housing bubble. In their place, the credit rating agencies dug a huge pit of misery, where all those unrealistic dreams of easy housing wealth are about to be buried.

Since the credit crunch began, the rating agencies have been very busy. During the first quarter of this year alone, Standard and Poors made almost 9 thousand downgrades.

A similar thing has happened on this side of the Atlantic. Although the numbers are less impressive in the UK, downgrades picked up dramatically after the credit crunch hit last summer.

Behind these downgrades lies a pile of formerly pristine AAA grade paper that within a matter of months was transformed into CCC rated junk. The pain felt by investors is red raw. They thought they bought virtually riskless assets and ended up with paper that is virtually worthless.

Mortgage backed securities and their high credit ratings played a central facilitating role in the housing bubble. Many banks, particularly small ones like Northern Rock, developed a new business model called originate and distribute. This model worked on some simple principles; sell huge numbers of mortgages, bundle them up into bonds, sell them to investors and use to cash to originate more mortgages.

During the huge housing upswing, banks depended on mortgage backed securities to shift new originations off their balance sheets. A key player was the credit rating agencies, who needed to give new bonds investment grade ratings in order that banks could sell MBS bonds to unwary investors.

This arrangement worked so long as house prices kept rising and borrowers had positive housing equity. Appreciating house prices obscured any difficulties borrowers might have paying off loans. If a borrower did begin to wobble, the property could be sold, the mortgage paid off, while the borrower kept the remainder of her equity.

Today, a new chain of consequences has come into play. MBS securities have been downgraded right across the board. Issuance has collapsed, and banks can't get new funding. Without the funding, banks have cut back on their lending activity. Without new credit, housing demand falls back and prices decline. As the housing market collapses, home equity evaporates, default risk rises, and rating agencies downgrade mortgage debt.

The credit crunch has also wrecked the reputation of rating agencies. How did the agencies miss the risks inherent in slicing and dicing sub prime mortgages and calling them investment grade bonds? The risks seem obvious in retrospect, but there was something obscuring the view of the rating agencies. Could it have been fees and fat profits?

If the credit rating agencies tried upgrade MBS securities, the news would be greeted by skepticism. Investors have irreparably lost faith in ratings. Investors now understand that a triple-A rating may not actually mean that much. In future, regardless of the rating, investors will demand higher spreads in order to hold mortgage related debt.

The whole thing reminds me of that old adage "fool me once, shame on you: fool me twice, shame on me." Investors are very unlikely to be fooled twice by the banks and their dubious high risk housing debt. Maybe in a decade, when memories have dimmed, banks can play the same game. In the near term, a recovery is impossible. Investors have learnt a profound lesson - keep away from low-yield mortgage debt.