Vitaliy’s Contrarian Edge

Subprime Downgrade…more to come?

June 18th, 2007

By Vitaliy Katsenelson, CFA

There was an interesting article in the WSJ on Moody’s downgrading 131 bonds backed by a pool of subprime mortgages. As dramatic as it sounds this downgrade only impacted $3 billion worth of bonds, less than 1% of the $400 billion in subprime mortgage issue in 2006.

Though these numbers don’t sound earth shattering, it is becoming painfully apparent that credit rating agencies are extremely reactive, not proactive. This downgrade took place because more data came to the surface (i.e. higher defaults in second mortgages that were lumped together with subprime loans in 2006).

Credit agencies are held to a higher standard than sell side analysts whose recommendations are as useful as last month’s newspaper. Credit agencies have legal access to non-public information and thus one would expect a better, proactive analysis. The problem is that the credit agency’s actions may have dire consequences on corresponding companies and turn into a self fulfilling prophecy (i.e. a downgrade to junk status may shut the company from credit markets and cause a bankruptcy).

Why does this matter? Well, if you think we are in the beginning stages of the subprime default cycle (I believe we are), than you’ll see more and more (reactive) downgrades from Moody’s and the likes. Be skeptical of credit agency ratings, use your own common sense.

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Entry Filed under: Analysis & Research