You know in many newspapers they have those boring legal notices? You know, the ones which have to be published by law in prominent newspapers so they’re visible but are normally formatted to look really dull – so most people glaze over them?
Well, I found one in the FT yesterday, and strangely enough … it wasn’t very dull at all.
Holland Homes – Notice:
Notice is hereby given to the [holders of Holland Homes debt] that Fitch Ratings, following an update of its criteria for assessing mortgage backed securities, placed on ‘negative rating watch’ several securities related to Holland Homes.
Further to this criteria update, the existing debt no longer satisfies the new Fitch criteria for an AAA rating. A downgrade of the current ratings assigned to the debt to BBB or a similar level is expected if no action is taken.
(edited for clarity, FT 18/08/2011 p17). Which immediately made me go ‘wtf’? You’re jumping from ‘never lose money’ AAA to ‘quite speculative’ BBB? I thought we’d left the silliness around mortgages-which-were-supposedly-AAA-but-not-really all back in 2008. Obviously not.
The most interesting thing about this is that these securities were issued in 2007 (they expire in 2039), so it’s not like Fitch hasn’t had very long to correct their sums. They’ve had 4 years, most of which were filled up with a financial crisis caused in part by incorrectly rated securities.
The detail of the debt isn’t too complicated. Holland Homes has two types of debt, firstly “class A notes”, which get paid back first if things go belly up and secondly “class B notes” which lose out first if things go bad. Obviously the class B notes have a higher rate of interest to compensate for this higher rate of risk. There are €577m of Class A and €2.9m of Class B debt. But the problem is that it is the Class A debt that is being downgraded.
The proposed solution by Holland Homes is not encouraging. It seems to consist of more financial wizardry:
- A mandatory issue of a new class of debt (“the class S notes”), which will be subordinated to the class A notes and will be senior to class B notes in terms of payment of principal and interest,
- The reduction of the amount outstanding on the class A notes to equal the amount of the new class S notes,
- The undertaking of reasonable efforts to obtain a new rating for the class A notes from a second rating agency, subject to the condition that the class A notes will receive the highest credit rating.
(same source, edited for clarity) Which means that if you’re a Holland Homes investor, basically they’re diluting the Class A debt you hold into Class S debt and then playing the system so than can try and maintain a AAA rating on the Class A stuff. Which will undoubtedly work in the short term, but misses the point: the house-building industry is not a AAA industry. The risk doesn’t go away. Even the most highly stacked, highly classified debt is subject to the factors like the bankruptcy of the company.
This is where the fundamental disconnect happens, which led in part to the collapse of big banks like Lehman Brothers. The banks pile into the mortgage industry, and take the Class A debt, which is AAA rated. Translation: you’ll never lose money. Only a fool would miss out on this bargain of a century!
The problem is of course, that the wider view is not taken. You don’t have to be a genius to see that if Holland Homes losses in any year are greater than the €2.9m, then the class A debt gets affected. Lehman and other banks had taken positions such that only a tiny shred of the class A debt would have to be affected, such as 5%, before Lehman made huge, huge losses.
Consider this: 99.5% of all Holland Homes debt is class A. The shield of the class B debt was paper thin – 0.5%. But because class B debt existed at all, class A debt was supposedly invulnerable – so naive investors would look at its AAA rating and miss the bigger picture.
A 6% decline in the housing industry – which is really, really not very much, meant that Lehman would lose an enormous amount of money very quickly.
