What is a Toxic Security?
Rich Berg and Douglas Wilding of Performance Trust explain what a toxic security is and why it is important
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In a bundle of 1000 loans pooled into a single security all the loans start out making payments on time and the security is rated AAA. Then over time, let’s say 100 loans or 10% fall into default (delinquent payments) and those loans now have an increasing likelihood of some future realized partial loss (severity) thru foreclosure. So now I understand why the ratings downgrade from AAA. But wait, aren’t the other 900 loans still paying on time with never a missed payment? Aren’t those 900 loans still considered excellent credit and rated AAA? How does the rating agency blend the rating to reflect the portion of excellent credits with the riskier credits? How does the rating scale relate to the percent of loss the investor can expect? Are bank examiners classifying the entire security as doubtful or loss based solely on a below investment grade rating or are they analyzing the underlying collateral and classifying only that portion of the security, the 100 loans out of 1000, that is doubtful or loss?
Mr. Perry-
You’ve asked several excellent questions. And you hit the nail on the head regarding some of our strongest issues with the current ratings system. The current ratings system has no way of representing the magnitude of losses on a security. The ratings provided by the rating agencies reflect the likelihood of a bond not paying 100% of principal, but make no representation of how much principal they are projecting will be lost once that bond is determined not to pay back 100% of principal. For example: Are you going to lose all of your money or just 1%? The current system does not tell us this. This becomes a serious issue when dealing with multiple-obligor securities. The example you provided refers to a multi-obligor security (in this case a Mortgage-Backed Security) which is comprised of a large amount of excellent borrowers who are still paying their mortgages as contracted. Unfortunately, in your example, the rating on the bond would be downgraded to CCC or lower, even if all 900 paying borrowers continued to pay their mortgages until full payment is made.
For an individual investor, the rating may not be prohibitive. However, for banks that own this security, once it’s been downgraded to below investment grade (and possibly purchased originally with a AAA rating), the entire balance of their investment will be classified as substandard. You read that right. Even the “performing” portion of the security will be classified since the entire security has been rated CCC (or worse).
As you might suspect, this in turn creates a much larger problem in the securitization market since many banks will not want to continue to own these securities after they have been downgraded since they will become classified as substandard (and now perceived as “toxic”). And certainly because of the substandard classification issue, other banks are extremely hesitant to buy more of these securities. So what we are now left with is a huge decrease in demand for these securities, and a lot of banks being forced to sell these securities because of downgrades (increasing supply in the market). This, in a nutshell, is why prices have plummeted for mortgage securities and the secondary mortgage market is no longer functioning as it used to.
I hope that helps. Your example and questions touch on the very reason we feel so strongly about the need to revamp the current ratings system. This must happen before we can realistically expect to get the secondary mortgage market moving again, which in turn must happen before our economy truly recovers.