Principal write downs on subprime residential mortgage-backed securities (RMBS) are much less than expected, according to Standard & Poor’s.
S&P projects AAA bonds will see write-downs of less than 1 percent.
Why such a small loss when pundits are crying the second Great Depression and newspapers are running front page photos of foreclosure signs?
"In the RMBS arena, there is a substantial difference between a collateral loss and a principal write-down on a rated certificate," says S&P credit analyst Andrew Giudici.
"When it comes to subprime RMBS, the difference might even surprise you."
In other words, tons of foreclosures and late mortgage payments do not necessarily equal losses for the banks holding these mortgage-backed bonds.
Losses on the underlying mortgages of subprime certificates issued from the second half of 2005 through the first half of 2007 will reach $180 billion over their lives, S&P predicts in a new report.
But principal write downs on the bonds will total about just $85 billion.
That’s still a big number, but it’s much less than the losses from the collateral, the mortgages themselves.
The difference between those figures, Giudici explains, is because of various forms of credit enhancement that support the rated securities, such as subordination, over-collateralization, and excess spread.
Unrated and lower-rated classes suffer before losses touch the highest classes (subordination).
Securities also can have slightly more mortgages than needed (over-collateralization).
They can also have leftover interest payments to help cover losses (excess spread). Securities only lose value when collateral losses surpass the credit support.
While S&P predicts that most subordinate subprime certificates issued from the second half of 2005 through the first half of 2007 will see substantial principal write-downs,
AAA bonds from that time will be written down by less than 1 percent, Giudice says.
Skeptics would say the rating agency is only trying to defend itself after the subprime debacle.
“The story of the credit rating agencies is a story of colossal failure," said Representative Henry Waxman (D-Calif.), chairman of the House Oversight and Government Reform Committee, which is investigating the credit crisis.
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