Subprime mortgage borrowers, it appears, are more creditworthy than Uncle Sam.
Standard & Poor’s, the ratings agency that recently downgraded the credit of the United States, is giving a higher rating to a group of subprime mortgage loans – yup, just like the type that lead to the financial crisis – than the bonds issued by the U.S. government. The mortgage trust – 59% of which is set to get a AAA rating from S&P – is mostly made up of loans to borrowers with below average credit scores who have made little or no downpayment on their houses, according to Bloomberg. That’s a rating that bonds issued by the U.S. no longer enjoy. Back in early August, S&P lowered the U.S.’s credit rating to AA+. Cue the outrage:
“I’m trying to sort out why debt backed by the ability to tax in the United States is rated lower than securities that are backed by no particular ability to have additional revenue,” said John Milne, who oversees about $1.8 billion as chief executive officer of JKMilne Asset Management in Fort Myers, Florida, in a telephone interview on Aug. 23.
We have here at Curious Capitalist had a somewhat split stance on the S&P downgrade. We have shown our own outrage over the downgrade. I, for one, have been more understanding of S&P. Many have taken the downgrade as an assessment by S&P that the U.S.’s bonds are now extremely risky, which it is not. AA+s don’t tend to default, either. I think S&P was prudently indicating that the headwinds for the U.S. economy are likely to be stronger than they have been in the past and will continue to be that way for some time. That has given some U.S. politicians the idea that it is better to default on our bonds than actually deal with budget compromises. And those politicians have grown increasingly vocal. So for that reason the downgrade makes sense to me, even if over at our sister blog Swampland Adam Sorensen thinks I am 100% incorrect for thinking so.
(SPECIAL: 25 People to Blame for the Financial Crisis)
Still, the fact that S&P continues handing out AAA ratings to subprime mortgage bonds highlights a significant and ongoing problem with the credit ratings agencies. S&P ranks all types of bonds, including those backed by corporations and sewer systems and malls and even loans to purchase farm equipment. Despite the S&P U.S. downgrade there are still some 14,000 other bonds in the U.S. that still get AAA ratings. And as the Springleaf subprime deal shows, many of those bonds are backed by assets much more risky in nature than the government of the U.S.
It has long been understood that at S&P and other credit ratings agencies that a AAA is not the same thing as another AAA. Different types of bonds get rated in different ways. S&P and others say they have made their ratings more universal. But it’s very hard to do so, particularly because of the way these deals are structured. Unlike government bonds, mortgage trusts and corporate bond deals are often structured in a way that some bonds payout before others. So the reason that some bonds issued by subprime lenders like Springleaf get AAA ratings is that they are backed by other bonds that have to absorb the losses before the AAA ones do. That’s not the case with U.S. Treasury bonds, which all have the same rating. The problem with rating mortgage bonds, which is what S&P and others have run into in the past, is deciding where that cut off should be. And that becomes even trickier when you are dealing with subprime borrowers or other assets where the ability for a borrower to pay can change rapidly. So maybe S&P should factor in its ratings the inability of its models in the past to get this right, and award no subprime bonds or similar assets a AAA. That would certainly be a better PR move than downgrading the U.S.
Of course, none of this matters that much to the market. S&P’s ranking of country debt has long been less important to investors than what it says about corporate or mortgage bonds. The credit crisis has downgraded as well what investors think of credit ratings in general. The market, for instance, has largely ignored S&P’s downgrade of the U.S. In fact, Treasury bonds have risen in price since early August as more investors have bought up U.S. debt looking for safety. And here’s what one investor had to say about S&P’s AAA rating of the subprime mortgage deal:
“We didn’t even start to look at the deal,” Paul Norris, a senior money manager at Dwight Asset Management Co. in Burlington, Vermont, which manages and advises on about $54 billion of assets, said on Aug. 25. “For the funds we would buy this in, we need a AAA rating and we don’t have any confidence S&P would hold this rating for any period of time.”
But the problem is that average investors don’t necessarily get that. And down the road there will be some bond manager or broker trying to sell these subprime bonds or something similar based on the fact that they get a AAA rating, which they can now say makes them safer than even the debt of the U.S. government. And that’s the real problem with the U.S. downgrade.