Why Ratings are not a Significant Factor When Trading Legacy Non-agency RMBS

William Van de Water, Portfolio Manager
William R. Van de Water, Portfolio Manager is portfolio manager of an event-driven, non-agency RMBS strategy at Rational Funds. He joined ESM as a RMBS analyst and trader in June 2009 and became a managing director in December 2009. In 2014, Mr. Van de Water became a co-portfolio manager at ESM Management. From 2005 through March 2009, Mr. Van de Water worked in the Boston office of Susquehanna International Group. His primary responsibility was to analyze, and trade mortgage backed securities. Mr. Van de Water earned joint B.S. degrees in Physics, Business, Economics, and Management from the California Institute of Technology in 2005.

When investors first familiarize themselves with corporate and municipal bonds, they quickly learn that credit ratings from S&P, Fitch, and Moody’s are of paramount importance when it comes to pricing bonds and assessing risk. However, the relevance of ratings to non-agency residential mortgage backed securities (NARMBS) could not be more different.

Why is this the case? Why wouldn’t a NARMBS investor be interested in whether a security is rated investment grade or junk? In my view, there two main reasons:

First, the ratings for pre-2008 NARMBS are often stale and irrelevant to current conditions. It is fairly common to find an MBS that experienced heavy losses during the financial crisis, got downgraded by the rating agencies, but went on to perform quite well in the 10+ years following. If the delinquencies are low and the borrowers have been reliable for the last several years, do we really care about the fact that S&P either withdrew its rating or downgraded the security back in 2008?

In fact, the situation may be even better than the history suggests. The borrowers that remain in the securitization after the crisis (and after the ratings downgrade) are likely the stronger borrowers, and as time goes on, they typically build equity in their homes and become even stronger borrowers. Thus, the rating from 2008 becomes less and less relevant as time goes on.

Secondly, NARMBS are often expected to take losses, but this does not mean financial ruin for the bondholders. For example, suppose that there is a bond that we fully expect to take some low level of losses, but it is priced at a significant discount. It could still be a low risk investment in this case. Remember that a low rating simply indicates that the rating agency thinks that there is a relatively high probability that the holder will not receive all the money promised to them. But if you are estimating that you’ll receive 90% of the money owed to you and only paying 80 for the bond, the rating agency’s concern that you will not receive 100% is not terribly important.

This is a common situation with NARMBS, and this is a stark contrast to the corporate bond market. If a corporate bond has a 5% chance of default, an investor might only expect to receive 40 cents on the dollar in those 5% of cases. What is the analogous outcome for an RMBS? An RMBS consists of hundreds of underlying mortgages, and a default could simply mean that the delinquency rate is 7% instead of 6%, and the investor will get 99% of the money they expected. This is hardly a disaster. Moreover, it would be foolish to put this situation in the same bucket as a corporate default.

In other words, defaults for NARMBS are not binary events like they are for corporate bonds. It is reasonable to regard a low-rated NARMBS that trades at a sufficient discount much less risky than a high-rated NARMBS that is priced to perfection.

For these reasons, NARMBS should be judged on their structure and the quality of underlying loans; the ratings are not really a consideration when it comes to analysis on whether you want to include a particular bond in your portfolio.