A small US residential mortgage bond issue this week is giving the latest hints of how investors will assess risk on the type of bond whose failure was central to the 2007-09 financial crisis. The structure of the $290 million bond from real estate investment firm Redwood Trust has drawn unsolicited challenges from Moody's Investors Service and Standard & Poor's.
Both credit ratings agencies have suggested they would require Redwood to put up more protection from potential losses in exchange for a AAA rating. Fitch Ratings won the ratings business, placing its AAA rating on the deal based on an investor insurance - or credit enhancement - of 7.5 percent of the deal.
Publicly competing views are what regulators have been seeking for rating companies in the $1.5 trillion market for private mortgage bonds.
Rating companies have come under fire for "issuer-pay" models that put them in a competition which critics say compromises their independence and encourages "ratings shopping" by the issuers. Ratings shopping still occurs, but investors are not kept in the dark about it, said Scott Buchta, head of investment strategy at Braver Stern Securities in Chicago.
"As an investor, you are going to get more access to information, to make our own judgement call," Buchta said. Despite its small size for a bond, the Redwood issue is garnering attention by the rating companies and investment banks eyeing future profit.
The second such bond issue since 2008, it represents the slight movement of private capital into a market that lawmakers and regulators are hoping will take the reins from government-backed programs.
In a filing with the Securities and Exchange Commission, Mill Valley, California-based Redwood said that it sought Moody's opinion, but dropped the company due to disagreement over the risks due to concentration of loans on San Francisco homes. Last year, Redwood said it hired Moody's and was not required to disclose whether it has sought other opinions and what those opinions turned out to be, Buchta said.
The wisdom of unsolicited rating comments remains in question, however, since ratings agencies are competing for business, said Paul Norris, head of structured products at Dwight Asset Management in Burlington, Vermont.
Managers are just best suited to do their own analysis, he said. "That way, we will not be subject to the whims of one rating agencies comments of another," he added. "My hope is that as we move through the Dodd-Frank rule-making process we can correct these types of defects and get it right."
By many measures, the loans are conservative, the rating companies agreed. The average credit score is 775, and the loans on average are 63 percent of the properties' worth.
But given the fragile state of the housing market, some investors are wary of risk despite tight underwriting. All rating companies note the concentration risk of the 303 loans, with most of them in California. Moody's based most of its report on potential losses from an earthquake. Still, the ratings flap is not spooking buyers. Given the technical support in a market that has seen one bond in three years, the issue likely had enough demand, Sullivan said.