Kass: Ratings Are Subprime's Dirty Secret

This item by Doug Kass was originally published on Feb. 9 on Street Insight at 9:30 a.m. EST. It is being republished as a bonus for TheStreet.com and RealMoney.com readers. For more information about subscribing to Street Insight, please click here.

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The little-known secret in the subprime market is that the ratings agencies have been lax in their downgrades of subprime paper. The recalcitrant agencies -- Moody's(MCO Quote), Fitch and Standard & Poor's -- have quietly abetted (blessed) the mushrooming of very aggressive subprime lending that has allowed the Wall Street firms selling these mortgage products to prosper.

According to Jim Grant, the number of downgrades at Moody's, for example, were even with upgrades in 2005. Last year, the downgrades/upgrades ratio rose slightly to 1.19:1. The problem is that the historical downgrade/upgrade ratio stands at 2.5:1!

Up to now, lenders (and borrowers) have greased the subprime market -- making it the swiftest-growing portion of residential real estate lending from 2001 to 2007. Lenders relied on the candor of the borrowers -- as nearly half of the subprime mortgages originated last year were low or undocumented.

Here is an example of the relaxed behavior of the agencies. This week's Grants Interest Rate Observer calls attention to a 13-month-old, $350 million asset-backed pool of mortgages, MABS 2006-FRE1. Foreclosures now stand at 9%, delinquencies at 10.5% and real estate owned at 3.5%. In other words, about 23% of the loans are problematic -- and neither Fitch nor S&P has downgraded the issue. No doubt investors in MABS 2006-FRE1 (hedge funds, brokerages, institutions, etc.) mark the issuance to par (since it has not been downgraded).