Ratings Fraud And Structured Credit?

Ok, if you weren't cheered up enough from last night's Ticker and The Fed's shenanigans, this should really honk you off.

See, there's a lot of so-called "AAA" mortgage bonds out there.

But are they "AAA"?

Bloomberg says no, and did the work to back it up, and goes further, alleging that this is concealing bank losses.

"None of the 80 AAA securities in ABX indexes that track subprime bonds meet the criteria S&P had even before it toughened ratings standards in February, according to data compiled by Bloomberg. A bond sold by Deutsche Bank AG in May 2006 is AAA at both companies even though 43 percent of the underlying mortgages are delinquent.

Sticking to the rules would strip at least $120 billion in bonds of their AAA status, extending the pain of a mortgage crisis that's triggered $188 billion in writedowns for the world's largest financial firms. AAA debt fell as low as 61 cents on the dollar after record home foreclosures and a decline to AA may push the value of the debt to 26 cents, according to Credit Suisse Group."

$120 billion in bonds valued at 26 cents would be a haircut of about 75%, or a loss to the banks of (another) $88 billion. Among these deals alone.

Fraud? You tell me. What's clear is that if Bloomberg is right in their analysis the issues they identify are clearly not "AAA" credit under the rules the agencies use. Yet they are still rated "AAA".

Oh, and if you want an interesting graph to go with it, click here.

Why?

Good question. Might it be that the ratings agencies are a BAD JOKE and are now intentionally refusing to downgrade when appropriate due to a fear of sparking yet more (deserved) "credit contagion?"

More to the point, how is anyone supposed to know if a given institution is solvent or not if the debt they are holding is rated well above its actual credit quality?

Now let's talk about Fannie and Freddie.

Specifically, their gearing.

Fannie and Freddie, for example, have ~40ish basis points (that 0.4%!) of capital on their credit portfolio if I'm reading their financials correctly. That's a gearing of about 200:1!

The credit itself is geared 10-20x assuming 5-10% down payments.

This is likely to prove an object lesson on what "bracket creep" does to you when things go bad. As an example it once was true that "prime" loans all had 20% down and a "back end" ratio of 36% (DTI) maximum.

But now Freddie and Fannie will buy loans with DTIs in the sixties under certain circumstances, and they will also buy loans with 5-10% down, not 20%.

And on top of that they gear internally as well in terms of their book .vs. their capital reserves.

What does this all mean?

It means that odds are quite high that these institutions are in fact "short to zeros" and that the next big "boom" may come from this direction.

In a "normal" market where a "prime" loan defaults at a 1/2% (50 bips) rate and has a recovery of 70, you only take risk of 30% of 50 bips, or 15 basis points.

If you have 40 basis points of capital behind 15 basis points of "bad", you're still ok. Of course you have to write lots of business in order to make any sort of real return, but that's been the game lately, hasn't it? All quantity, no quality. Standards be damned so long as the volume comes in the door.

Now let's consider what happens to you if the default rate goes to 1% and recovery is 50.

We now take 50% of 100 bips, or 50 bips of losses.

But we only have 40 bips in capital, you see. That could be bad, no?

Now let's be a bit more realistic. Like, for example, what's being reported here:

"At the end of September, nearly 4 percent of prime mortgages were past due or in foreclosure, according to the Mortgage Bankers Association."

Oh my. About 1 in 2 of loans that get in trouble eventually foreclose, which means I might have been being nice, and by the way, that's for September of 2007. Its gotten worse since hasn't it?

So exactly how exposed are Fannie and Freddie?

Well, let's assume that the prime foreclosure rate were to hit 2%, which is about double where it is now. Let's further assume recovery is a generous 60% (current recovery rates are running under 50% according to various industry source.)

This means we'd have losses of 40% of 200 bips, or 80 basis points. This is more than double the capital reserves available!

Do you see why people might be a bit, uh, nervous?

Oh, Freddie is saying this morning in their analysts meeting that "home prices have only fallen 1/3rd as far as they are going to go."

Hmmmm...... anyone got an old-fashioned calculator in that meeting? Dollars to donuts none of those "analysts" will use their calculators and then ask one simple hard-hitting question - "how can you operate with reserves of 40 bips when a simple back-of-the-envelope says that at the present rate of change all of that capital will be depleted within the next year - and this assumes no further declines in home prices?"

The problem as I have repeatedly pointed out is that top-to-bottom we have a solvency issue, not a liquidity one. When anyone with 30 seconds worth of effort can pull out a calculator and determine that leverage underlying an asset has quadrupled over the last 10 years (20% to 5% down is a quadrupling of the underlying credit leverage inherent a mortgage), the level of credit support in that mortgage (DTI) has been cut as well, and yet the capital reserve is measured in basis points instead of percentages, it does not take a rocket scientist to know what happens if the value of the underlying collateral decreases.

Leverage is a monster that eats all who use it imprudently. When you gear up something at 200:1 you better be right about your assumptions - all of them - or you are DEAD. This is especially true when you can't exit your positions FAST if they go against you, and Real Estate is about as illiquid as it gets! Gearing Real Estate at 5:1 is fairly reasonable (20% down payments) but 200:1?!

What were these people smoking?

Unfortunately for "The Bulls" this all comes down to the value of the collateral behind these loans. That's the beginning and end of it, and nothing can change this reality, whether people want to face it or not.

We have inflated a huge bubble and it cannot be reinflated; you simply cannot have home prices at more than 3x incomes, on balance, in a given area, over a long period of time.

So until the haircuts are taken and collateral revalued, along with the loans behind that collateral revalued to wherever they fall, we have a downward trend and the risk of "explosion events", otherwise known as "tape bombs", continues to be perilously high.

The underlying issue is that home prices are very "sticky." We've yet to see REAL drops in valuations, believe it or not. Banks are bidding on their own REO auctions in a crass and transparent attempt to prevent marks to the market by those who ARE bidding, much like Hedge Funds are trying to do the same thing by locking redemptions, thereby avoiding the need to sell into an "illiquid" market.

This is all creative financial engineering, just like someone who is in a boat with a failed engine headed for a waterfall paddles furiously in a vain attempt to prevent the impending disaster. Paddle mightily they will, but the outcome is not in doubt - we are in fact taking bets over how long our intrepid boater can keep it up, not whether or not he will succeed.

This waterfall will be crossed, and it will happen when the "acceleration events" pile up to the point that sellers simply can't hang on any more. When desperate sellers are forced to give up and take whatever is offered, lest they go bankrupt (or when they actually go down the chute straight up!) When banks are finally forced to take the offers given because they are saddled with so much RRE on their books that the operating costs (taxes, insurance, upkeep, etc) are just too much, and they see the individual sellers bailing off at whatever they can get.

THAT will trigger the final revaluation of these loans and THEN we will know who goes "boom" and who does not. THAT will mark the bottom of the credit mess, and while the stock market may lead this by some significant amount of time, we have no indication that we are even approaching that point in time here and now.

This is going to be a tremendously messy process and I'm still hearing echoes of The National Anthem from the game that has just gotten under way.

Trade accordingly.

Disclosure: Neither long or short Fannie or Freddie at this point in time. No need to be; if they crack you can throw darts at the stock page of the WSJ for your short selection.