Was S&P right to call the bottom of the subprime collapse?

14 03 2008

Was S&P right to call the bottom of the subprime collapse?

Posted by: in Products and Services

Filed under: Products and services, McGraw-Hill Companies (MHP), Economic data, Recession

Bloomberg News reports that McGraw Hill Co.’s (NYSE: MHP) Standard & Poor’s (S&P) reportedly called the bottom of the subprime meltdown after estimating its toll at $285 billion, up from a previous forecast of $265 billion. It raised its estimate because of increased loss assumptions for collateralized debt obligations (CDOs). And it claims that, “The bulk of writedowns may have already been taken.”

Maybe, maybe not. S&P is not exactly objective about this. It was among the ratings agencies that caused the problem in the first place. How so? As I posted, back when the $6.1 trillion MBS market was booming, investment banks would pit rating agencies against each other to see which one would give a AAA rating to the toxic waste they were brewing. If S&P won the contest, it would get the lucrative fee from the investment bank.

S&P and its peers made good money by lending their credibility to the firms they were supposed to rate objectively in exchange for those fees. And when the MBS market began to collapse, the ratings agencies suddenly realized that there was no more new ratings business to be had. So they’d to go plan B — trying to salvage their reputations by downgrading the MBSs that they had previously blessed. This reinforced the collapse of the MBS market.

Now I am wondering whether S&P’s claim that the end is near has any substance behind it. Does it know the payment status of each of the, say, 14,000 mortgages within each of the MBSs being held by institutions around the world? Does it understand the specific valuation methods that each MBS holder is using and determined that these methods will pass muster with their auditors?

And perhaps most importantly, has it taken into account the effect that a fire sale of MBSs will have on their values? This comes to mind in light of the default of Carlyle Capital, about which I posted here. If banks take possession of these MBSs to try to minimize their losses, won’t more and more of these MBSs be thrown on the market? And won’t this further depress prices?

I would like to believe S&P. But in my mind, its credibility is suspect. And even if it had been perfectly objective throughout all this, MBSs are so complex that I don’t think anybody can really say how bad the situation is prone to become.

Peter Cohan is President of Peter S. Cohan & Associates. He also instructs management at Babson College and edits The Cohan Letter. He has no financial interest in the securities mentioned.