Q&A with Emily Hollis

Emily Hollis
May 6, 2009 | COMMENTS

Question: I found your article on the structure of bonds extremely interesting. I was told that the mezzanine bonds were rated AA, which is a very high rating, so how can they potentially lose principal? Also, how can I look at a rating and know how much principal will be lost?

Super senior, senior support, and mezzanine securities each have their own rating. The higher the credit support, the higher the protection and the higher the rating. Generally principal pay downs have been paid pro rata to the senior and senior support securities leaving the other securities at par until certain triggers are met. This warranted AAA ratings, not only to the senior bonds, but also to the senior supports. Senior supports were designed to be the “first principal loss” piece only if things got really bad. In most cases, the senior mezzanine securities were rated AA.

AAA-rated securities are defined as “bonds of the highest quality that offer the lowest degree of investment risk. Issuers are considered to be extremely stable and dependable.” AA securities are defined as “bonds of high quality by all standards, but carry a slightly greater degree of long-term investment risk.” However, I must caution you, ratings are just opinions and unfortunately projected delinquencies have not even been close to what has actually materialized.

In other words, rating agencies never fathomed that the cumulative losses in mortgage pools would be so high and therefore couldn't imagine that principal losses would be realized for AA bonds. Downgrades have been massive in recent months. Most of the downgrades have lowered securities to below investment grade, with over 40 percent of previously AAA securities now rated CCC or below by at least one rating agency . Of these downgraded securities 92 percent are those backed by Alt-A loans. Greater than 60-day delinquencies in Alt-A hybrid loans are fast approaching 35 percent. Delinquencies of this magnitude could produce cumulative losses in excess of 30 percent, which could impact senior supports in varying degrees.

How could the rating agencies miss the mark so badly? The answer? It is all in the assumptions, not the analysis itself. The credit analysis process can be made complex with projected defaults being dependent upon zip codes, mortgage insurance, etc. Statistics can be used to project the probability of loss severities and voluntary prepayment rates. However, while greatly dissimilar to market values that are based on hundreds or thousands of interest rate paths, credit analysis is fairly straight forward.

My point is that credit analysis is just not that complicated and no matter the sophistication of the model inputs, the rating agencies just don't know and even disagree with one another on how high cumulative losses might go. For example, take a support type bond which comprises two percent of the mortgage pool with 15 percent credit support. Suppose that Moody's projects cumulative losses of 14 percent and S&P projects 17 percent, not too much of a variance. If Moody's is correct, you lose zero percent, if S&P is correct, you lose 100 percent. Moody's might currently rate the bond BBB and S&P C.

As you can see, it is difficult to take a rating and ascertain that a certain amount of principal will be lost. Most market specialists believe that the downgrades are complete.And AAA securities are probably fairly safe, but I wouldn't rely just on the rating, conditions are far too uncertain.

Emily Hollis is a CFA and president of ALM First Financial Advisors in Dallas, Texas. Contact Hollis at 800-752-4628 or ehollis@almfirst.com.