Moody's Downgrades Residential Mortgage-Backed Securities

Moody's Investors Service has cut its ratings for 399 residential mortgage-backed securities (RMBS), citing higher-than-expected delinquencies in the underlying loans, the same day that Standard and Poor's said it may start cutting ratings on $12.1 billion of mortgage-related debt.

Moody's has an additional 32 securities under review for possible downgrade.  The securities were originated in 2006 and their downgrades would affect a total of $5.2 billion in debt.

The downgraded securities were issued in 2006 and are backed mostly by first lien adjustable and fixed rate subprime loans.

CNBC's David Faber reported that "moving these all below investment-grade ratings conceivably has an impact on the CDOs that are created from these residential mortgage-backed securities.  Moody's beat S&P to the punch."

Earlier Tuesday, Standard & Poor's said it may start cutting ratings on $12.1 billion of mortgage-related debt this week on expectations of a larger than expected drop in U.S. home prices and more mortgage defaults, rattling financial markets.

The $12.1 billion in affected debt rated by S&P represents 2.13% of the $565.3 billion U.S. subprime market. However, despite its relatively small size, it could have a large impact, said CNBC's David Faber.

"That's because it may force the liquidation of some collateralized debt obligations which hold as their collateral the same securities that S&P will be downgrading," Faber said.

S&P, which said it failed to see the extent of losses on some home loans, said the debt under review includes 612 residential mortgage securities backed by U.S. subprime loans.

S&P also is rehauling its rating methodology and reviewing its ratings of the $1 trillion market for collateralized debt obligations, the ratings agency said in a statement.

"This subprime situation is being underestimated and is worse than many people had expected," said Thomas Metzold, a portfolio manager at Eaton Vance in Boston. "Investment managers' exposure to this is greater than they say and they will get less recovery than they expect."

The move by S&P comes on the heels of increasing troubles in the subprime mortgage market that caters to borrowers with spotty credit histories, which have raised fears that the problems could spill into the broader economy.

The news spooked investors, driving them away from financial stocks and other riskier investments and into the safety of U.S. government bonds.

"Beginning in the next few days, we expect that the majority of the ratings on the classes that have been placed on CreditWatch negative will be downgraded," S&P said in a statement.

S&P's projected fall in home prices would exceed the record 6.5% drop between 1991 and 1992, making subprime loans issued in 2006 particularly vulnerable, David Wyss, chief economist at Standard & Poor's in New York, said on a conference call.

In its report, S&P said its chief economist estimates property values could fall an average of 8% by the end of next year, Faber said.

"If S&P is right, the severity of losses within residential mortgage backed security pools and the CDO's that use them as collateral will increase sharply," said Faber. "That will in turn mean these CDO's, that credit rating for which S&P says it's also reviewing, will be worth less than their current marks, many of which remain at par."

Because most subprime loans carry adjustable interest rates, more borrowers face trouble making payments as loans reset at higher rates. And declining home prices mean that borrowers unable to pay loans cannot solve their problems by selling their homes.

Stress Testing

"If S&P, in fact, downgrades these issues, it is an admission that they weren't appropriately rated in the first place," said Andrew Harding, chief investment officer of fixed-income at Allegiant Asset Management in Cleveland, adding the situation "is pretty ugly now."

Ohio Attorney General Marc Dann earlier this week said that S&P, along with Fitch Ratings and Moody's Investors Service were all on his radar screen for giving top ratings to pools of subprime loans that were sold to bondholders.

The high ratings created a bigger market for the subprime securities, enticing bond buyers, including Ohio pension funds, according to Dann.

"The folks on Wall Street knew or should have known these loans they were remarketing were fraudulently obtained," he said.

S&P may lower ratings using "stress test" models. Ratings on bonds will be cut to "CCC," in the middle tier of junk, on any class of bonds that experience a loss on principal with one year, S&P said.

Bonds will be cut to "B" on any class of bonds that has losses within 13 to 24 months, and "BB" for bonds with losses between 25 and 30 months.

S&P's Wyss also expects a 10% drop in housing starts. The rating company said it underestimated loss rates of the subprime loans that back CDO debt structures, and said the situation will get worse before it improves.

"This could be important," said Lou Brien, a strategist with DRW Trading Group in Chicago. "Keep an eye out for the other rating agencies to follow suit."

Moody's said last month it expects to downgrade more subprime-related CDOs in the next two years than it did in 2006.

Fitch Ratings also said on June 22 that it may cut its CDO manager rating on Bear Stearns Asset Management, part of Bear Stearns, after Bear Stearns said it would provide up to $3.2 billion in financing for a struggling hedge fund it manages.

Representatives from Moody's and Fitch didn't immediately return phone calls seeking comment.

CDO Exposure

CDOs are a rapidly growing class of securities created by packaging together bonds, including risky subprime loans, junk or high-yield bonds and high-grade debt, to help diversify risk.

In a separate report, S&P said on Tuesday that 13.5% of U.S. cash flow and hybrid collateralized debt obligations it rates are exposed to subprime loan deterioration.

The rating company said 218 U.S. cash flow and hybrid CDOs have exposure to poor-performing subprime loans. European and Asian CDOs have little exposure, S&P analyst Patrice Jordan said on a conference call on Tuesday.

Only 20 European CDOs, or less than 1% of publicly rated CDOs, have exposure to U.S. subprime loans, S&P said.