July 17, 2008

SEC Finds "Serious Shortcomings" At Credit-Ratings Agencies

Lack of staffing, conflicts of interest and poor business practices are among the reasons the SEC has found caused the three largest credit-rating agencies (Moody’s, S&P and Fitch) to award high credit ratings to questionable structured finance securities. Due to an unprecedented increase in mortgage-backed and structured finance securities between 2002-2007, the big three fought to keep up with volume while maximizing their own market share. In this environment, all three ended up compromising their standards and integrity.

The ratings agencies did not hire enough people when their workload began increasing in 2002. As a result, the SEC concluded that they did not have enough staff, and “sometimes cut corners.” The firms also did not document their processes or decisions in awarding “AAA” ratings (the highest rating) for questionable securities. In certain situations, there was no evidence that any surveillance work was done by the agency.

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April 28, 2008

This Time Around, Bondholders May Only Get 10 Cents On The Dollar

Bondholders usually do better than most other creditors in bankruptcy proceedings. The upcoming wave of bankruptcies is unlikely to be kind to such bondholders. They already face limited recoveries from companies that filed for bankruptcy.

According to Caroline Salas on Bloomberg.com on April 23, however, New York-based Fitch Ratings reports that, instead of receiving the historical average recovery of 42 cents on the dollar, in a default situation, bondholders of a third of high-yield, high-risk bonds rated B+ or lower may receive no more than 10 cents on the dollar. Another 22 percent are likely to only get 11 to 30 cents.

“When leverage was so ample, private equity firms were able to buy companies at multiples that didn't make sense,” said James Keenan, who is co-head of leveraged finance at BlackRock Inc. “Most people use the assumption senior unsecured bonds are going to recover 40 percent. I don't think you're going to see that,” Keenan advised.

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April 23, 2008

Congress Is Concerned About The Ratings Agencies' Conflicts Of Interest

In the aftermath of the subprime crisis and resulting credit crunch, Congress is encouraging the SEC to increase its policing of the ratings agencies (Fitch, Moody’s, and Standard & Poor's). The ratings agencies have come under severe criticism since they were forced to downgrade thousands of mortgage-related investments after making overly optimistic initial calls about the quality of such investments.

The ratings agencies have been accused of having serious conflicts of interest which influenced them into giving unduly favorable ratings to many mortgage securities. Critics have suggested that the agencies’ ratings were affected by their direct involvement in structuring many of the very securities that they were rating and by the huge fees paid to them by the issuers of the securities. These accusations seem supported by recent articles in The Wall Street Journal which have reported that Moody's, on occasion, switched ratings analysts from specific deals at the request of the Wall Street firms and altered its approach on certain deals after the Wall Street firms complained.

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April 10, 2008

"Safe" Bond Funds Get the Blues

Many bond funds, which are supposed to be the pillars of stability during times of market upheaval, are suffering serious subprime mortgage investment losses. The Lehman Brothers U.S. Aggregate bond index, which tracks taxable bonds, Treasury notes, corporates, and some mortgage securities, is up 2.3% from January 1 through April 4 of this year. Yet, as reported by Shefali Anand of The Wall Street Journal on April 8, 2008, 20 percent of all investment-grade U.S. taxable bond funds are in the red for that same period.

The Regions Morgan Keegan Select Intermediate Bond fund is down 44% since the start of the year and 72% over the past year. Since the start of the year, State Street Global Advisors Yield Plus is down 18% and Schwab YieldPlus has fallen 23%.

Many bond funds have been dragged down by the massive sell off of mortgage securities because of the subprime crisis. Among the casualties are Metropolitan Strategic Fund (down 8% this quarter and 12% for one year), UBS Absolute Return Bond (down 8.5% year to date and nearly 15% over the past year), and Principal Investors Ultra Short Bond Fund (down nearly 7% this quarter and nearly 10% over the past year). Metropolitan West had more than half of its investments in mortgage and other asset-backed securities as of December 31, 2007.

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March 14, 2008

Investors Are Being Misled About The Real Values Of Their Subprime Securities Holdings

Many investors are being provided with grossly inflated valuations of their subprime securities holdings because Standard & Poor’s and Moody’s have failed to cut the ratings of many AAA-rated securities even though those securities do not meet the criteria to be classified AAA. The bulk of these securities are believed to be held by banks and insurance companies.

A recent study by Bloomberg concluded that 80 of the AAA securities in the ABX indexes fail to meet S&P’s criteria for AAA-rated securities. The study concluded that, if the ratings standards were accurately applied, at least $120 million in AAA bonds would be downgraded. According to Credit Suisse Group, record home foreclosures have caused AAA debt to fall to 61 cents on the dollar, but those same bonds would be worth only 26 cents if downgraded to AA. If Credit Suisse is correct, investors in just these securities currently rated AAA have an undisclosed loss of at least $42 billion.

Kyle Bass, chief executive officer of Hayman Capital Partners, was blunt about the situation when he said, “The fact that they’ve kept those ratings where they are is laughable. Downgrades of AAA and AA bonds are imminent, and they’re going to be significant.”

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February 3, 2008

UBS Investigated For Improperly Valuing Mortgage Bonds And Related Securities

On February 2, 2008, Kara Scannell, Anita Raghavan and Amir Efrati of The Wall Street Journal reported that federal criminal prosecutors are investigating whether broker-dealer UBS “misled investors by booking inflated prices of mortgage bonds it held despite knowledge that the valuation had dropped....” According to the report, the Securities and Exchange Commission (SEC) had also initiated a formal investigation into whether UBS improperly mispriced mortgage securities.

While the potential criminal and administrative consequences of these investigations are very serious, the civil consequences of such misconduct could be both massive and far reaching. Wide-spread mispricing of subprime mortgages and related securities would almost inevitably have caused significant damage to much of UBS’s customer base as well as to purchasers of its mortgage securities and its shareholders. Such misconduct would be particularly troubling because of the potential benefits that inured to UBS in the form of inflated sales proceeds, excessive management fees, and avoidance of losses. Such misconduct would also likely cause irreparable damage to UBS’s reputation because it may be indicative of efforts by UBS to unload risky mortgage securities off on its customers at inflated prices just as the credit crisis was heating up.

January 31, 2008

Bond Insurers MBIA And Ambac To Incur Predicted Subprime-Related Losses Of $11.6 Billion Each

Bond insurers MBIA and Ambac may lose $11.6 billion (each) on guarantees of mortgage-backed debt and other related securities, as predicted recently by Managing Partner of Pershing Square Capital Management LP, William Ackman, and as reported by Bloomberg.com's Christine Richard and Mark Pittman (1/30). Such losses could have far reaching effects by increasing investor losses in municipal securities and raising future borrowing costs for states and municipalities.

Using a model supplied by an unnamed bank, Ackman recently posted a list of asset-backed collateralized debt obligations and other securities guaranteed by MBIA and Ambac that allow readers to create their own loss predictions.

Ackman sent his findings to the Securities and Exchange Commission as well as the Superintendent of New York Insurance, Eric Dinallo, who is currently in talks with unnamed banks regarding raising new capital for bond insurers, stabilizing the bond insurers, and bolstering financial markets.

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January 21, 2008

Is The Market's Doomsday Scenario Here?

An old Wall Street adage says that you should never plan to bring a new offering to market right after a three-day weekend because you never know what could happen from Friday night to Tuesday morning. US markets were closed today for the Martin Luther King, Jr. holiday but it was an event-filled weekend that will cause further market turmoil on Tuesday when the markets re-open.

On December 18, 2007, The Wall Street Journal wrote “Credit Crunch Could Worsen if . . . Bond Insurers Sink, ‘Buck Breaks’.” According to Dennis K. Berman of the Journal, the two events that are of most concern to Wall Street bankers, traders, and regulators are ratings downgrades of bond insurers and money market funds losing value below $1. Unfortunately, recent events suggest that this very scenario may be playing out.

First, on Saturday, January 19, 2008, Christine Richard of Bloomberg.com reported that Fitch Ratings announced that it had downgraded the credit rating of Ambac Assurance Corporation from AAA (the highest rating available) to AA after Ambac abandoned plans to raise new equity. This in turn caused a downgrading by Fitch of approximately 140,000 municipal and non-municipal bonds insured by Ambac.

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