S&P Rates Some Subprime Mortgage Bonds Higher Than the U.S.—So What?

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If you understand MBS, then this possibility doesn't seem ludicrous at all

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Sometimes a potential headline is so sensational that it becomes almost impossible to resist writing an accompanying article. Yesterday, we saw a perfect example of this when Bloomberg published a story titled: "Subprime Mortgage Bonds Getting AAA Rating S&P Denies to U.S. Treasuries."

This headline is great for a couple reasons. First, you've got S&P's controversial downgrade decision in there. Then, you paired it with much-hated subprime mortgage bonds -- the securities often blamed for creating the financial crisis. Better yet: you've managed to imply that S&P has the audacity to say that those potentially toxic bonds are safer than U.S. debt! As great as this headline is, the point its accompanying article makes is worthless.

Those who aren't familiar with how mortgage-backed securities work might find this seriously disturbing: the rating agency Standard and Poor's recently rated a new subprime mortgage-backed security deal AAA, the same pristine grade that it recently denied U.S. sovereign debt. But those who understand mortgage-backed securities (MBS) will shrug and say, "So what?"

How MBS Works

In general, people who don't understand MBS probably find it totally absurd that bonds created from subprime loans could ever be awarded a AAA-rating. After all, aren't these potentially dangerous loans that will likely sustain lots of losses? Yes, they are. But that doesn't mean all of the subsequent mortgage-backed bonds that could be dreamed up and structured will be equally dangerous.

It's hard to find a perfect analogy to explain MBS, but let's try by thinking about pulpy orange juice. If it's all shaken up, then the pulp with be throughout the juice. But if it's left undisturbed for some time, then that pulp will settle at the bottom. In fact, juice makers have methods to create virtually pulp-free versions of the juice. Those who hate pulp can buy this variety, but those who love pulp can buy a much pulpier version that the juice makers create with the left over pulp and juice. Imagine that pulp is risk.

An investor comes along and wants to buy a subprime MBS without much risk. Like the juice maker does with pulp, a bank can structure an MBS where it minimizes the risk for some bonds within that deal, while other bonds are much riskier. So that investor can buy one of the "senior" pieces of the security without taking on much risk -- just like you could buy orange juice without pulp.

Then went so horribly wrong during the housing bubble? Everybody underestimated how much pulp there was in the juice -- or how much risk there was in the subprime loans. Imagine that you thought that the volume of some orange juice was only 30% pulp, but it was really 40% pulp. If you try to drink more than 60% of that juice, then you'll hit some unanticipated pulp. In a similar way, investors suddenly began facing losses that they hadn't anticipated, because the loans were riskier than they thought.

Imagining a AAA-Rated MBS

I am not familiar with the particular mortgage-backed security that the Bloomberg article refers to. But it's easily the case that a subprime MBS could be created with AAA-rated bonds. Imagine that, even in the worst imaginable scenario, the loans it is created from would incur 50% losses. When you think about mortgages, such losses would be very severe.

Now say that you structure the MBS so that the senior bonds are the last to take on losses and that they make up just 35% of deal. The other 65% is made up of subordinate bonds, which would not be rated-AAA. Under this scenario, it is inconceivable that the senior bonds would ever take a loss. As a result, it seems perfectly acceptable to rate them AAA.

Think about what would have to occur for these senior AAA-rated bonds we just dreamed up to take a loss. The pool of loans -- on a whole, not just a few bad ones -- would have to sustain losses exceeding 65%. These loans would have to be beyond awful for that to occur. Remember, even if a mortgage fails and faces foreclosure, the bank will sell the property for something. For the senior bonds to sustain a loss, the bank would need to sell the underlying properties for less than 35% of the value of the mortgages, on average for the entire portfolio of loans.

What About the U.S.?

So it's definitely conceivable that there could be some mortgage bonds that deserve AAA ratings. As for the one that the Bloomberg article refers to, it may or may not deserve the grade. I was unable to find its prospectus when I searched for it. But even if I could evaluate it, my conclusion might differ from somebody else's assessment who has different assumptions about the future. For that reason, the risk that these bonds pose should be determined by individual investors who intend to purchase them. Remember, S&P's rating is merely an opinion.

And in its opinion, U.S. sovereign debt is not as pristine as sufficiently padded senior bonds contained in this particular subprime MBS. Although I happen to believe that S&P's U.S. downgrade was a mistake, its methodology isn't bonkers. The U.S. recently came very, very near an effective default and could have missed an interest payment if a debt ceiling deal was not reached and the Treasury decided to put other obligations ahead of Treasuries. Moreover, the long-term deficit reduction deal Congress reached doesn't meaningfully change the deficit's long-term, unsustainable trajectory. These issues worry S&P. Indeed, they should worry all of us.

For these reasons, S&P's decision to downgrade the U.S. isn't totally nuts, even if it may be a tad misguided. The alternative view says that the U.S. government does manage to get its act together at the very last moment fairly consistently and still has plenty of time to restructure its budget before facing a real default. But clearly there is some risk posed by government officials behaving badly. That risk was enough for S&P strip the country's AAA rating.

It might just happen that a newly issued subprime MBS is structured soundly with conservative enough assumptions that result in its senior bonds deserving a AAA rating. Their risk of default could easily be smaller than the political risk that U.S. Treasury securities face. To determine if this result is reasonable, you would need to look at S&P's analysis and decide for yourself.

Image Credit: REUTERS/Brendan McDermid

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.
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