Unsafe at Any Rating, CDO Speeds to CCC From AAA: Mark Gilbert

Aug. 30 (Bloomberg) -- Watching the rating cuts trickle out of the derivatives forest is akin to searching for elephant dung on a path to try and work out how many pachyderms are in the jungle. There's clearly a herd in there. And it's probably much bigger than the ordure you have seen so far would suggest.

Last week, Standard & Poor's butchered the ratings on $3.2 billion of debt from structured investment vehicles spawned by Solent Capital Partners LLP in London and Avendis Group in Geneva. About $254 million was slashed from the top AAA grade to CCC+ and CCC -- slides of 16 and 17 levels, triggered by their investments in mortgage-backed bonds.

Think about that for a second. You left the office Tuesday owning a AAA rated security. By the time you got back to your desk on Wednesday morning, it was eight steps below investment grade in a category S&P defines as ``currently vulnerable to nonpayment.'' Try explaining that to your pension-fund trustees.

The rating companies are sifting through the billions of dollars of repackaged bonds and structured investment funds they graded in recent years. You can bet the world's biggest and smallest banks are also panning for risk in the structured investment vehicles and off-balance-sheet companies they casually sponsored in the gold rush.

DBS Group Holdings Ltd., Singapore's biggest bank, said on Aug. 7 it had S$1.4 billion ($921 million) at stake in collateralized-debt obligations. This week, it boosted that total to S$2.4 billion. It seems the bank had overlooked its commitment to a unit called Red Orchid Secured Assets. As the man said, a billion here and a billion there and pretty soon you're talking about real money.

`An Oasis of Calm'

A rare moment of comedy arises from what Moody's Investors Service had to say about the oversight. ``I don't think DBS will be the only one who has missed something the first time,'' said Deborah Schuler, a senior Moody's analyst in Singapore.

Could this be the same Moody's that called structured investment vehicles ``an oasis of calm in the subprime maelstrom'' in a July 23 report? ``The vehicles are not structured to forcibly liquidate assets in times of crisis,'' Moody's said. Their ability to access several sources of finance ``obviates the need to liquidate large buckets of assets at potentially the worst period in the life of the vehicle.''

Tell that to Cheyne Capital Management Ltd., which said yesterday it may be forced to dump the securities owned by its $6 billion Cheyne Finance LLC fund because the asset-backed commercial paper market is freezing up and the SIV is struggling to fund itself beyond November.

Shifting Scenarios

Moody's recently added some new phrases to its lexicon of code words. When the rating company refers to ``updating its methodology'' or ``refining its risk assessments,'' what it really means is that its historical models say absolutely nothing about how the future might turn out.

Last week, for example, Moody's summarized ``the most recent refinements'' to how it treats bonds backed by so-called Alternative-A mortgages. ``In aggregate, the change in our loss estimates is projected to range from an increase of approximately 10 percent for strong Alt-A pools to an increase of more than 100 percent for weak Alt-A pools,'' Moody's said.

So a mortgage-backed security with a rating based on, say, a 1.5 percent loss rate might now suffer 3 percent losses in its collateral, Moody's said. How's that for missing something the first time?

Marked to Which Market?

Here's what is most worrying about the coming flood of downgrades and defaults. The U.S. Securities and Exchange Commission is investigating how the biggest brokerage firms priced securities caught up in the subprime meltdown as their values collapsed. My colleague Jonathan Weil last week detailed some of the accounting shenanigans that accompany how banks measure the ``fair value'' of their assets.

What happens if the SEC discovers that different units of a single bank assign different values to identical securities? That seems like a viable scenario for what might happen when a complex market of infrequently traded securities whose prices are dependent on a series of assumptions hits trouble.

And what happens if the SEC finds that banks marked the securities they owned at high prices, while attributing much lower values to identical securities offered by their hedge-fund clients as collateral? Again, that seems like a plausible strategy for a bank concerned about the longevity and liquidity of its customers.

Moving the Goalposts

Suppose regulators decide to play hardball on how the financial community marks to market, imposing rules that outlaw the existing freewheeling approach to how over-the-counter derivatives are assayed.

Moreover, suppose those new decrees come just as much of the underlying collateral is so tarnished as to be almost worthless compared with its initial valuation.

The ensuing carnage in the balance sheets of every financial-services company in the world would dwarf the damage wrought in the securities industry by the subprime crisis so far.

It will be hard enough for central bankers in the U.S. and Europe to set monetary policy at next month's meetings when they have no way of knowing how bad the financial storm might get and how much it might hurt economic growth. The more things that go boom in financial markets in the coming weeks, the harder the task facing the rate setters will get.