NEW YORK ( TheStreet) -- "What is a triple-A?" The rating agencies look at their long-term historical default profiles of triple-A investments. They may differ slightly in whether or not they are rating to the first dollar of loss or the expected loss profile of a triple-A, but this is essentially what they are seeking. So they look at ratings migrations, jumps to default, etc. of their histories rating assets. They may determine, "OK -- less than 0.01% of triple-A-rated assets default over a 10-year horizon." So if they are going to rate a structured finance instrument, they want to make sure that it has less than a 0.01% chance of defaulting over a 10-year period.
So how do they do that? This is where they analyze the historical performance of similar looking mortgage pools. Here they might say, "The typical MBS pool experiences a 2.5% loss rate, so we want you to cover six times that amount to get a triple-A, and we want to run several scenarios front-loading and back-loading these losses to see that the tranche you want rated survives to triple-A standards." Furthermore, they release their ratings methodology so people can see to how they got there.
And the institutions that play in this market have their own portfolio managers and analysts who do their own modeling with their own assumptions and their own stress tests. If you play in this market, there are loads of analytics providers that cater to the evaluation of these securities.> > Bull or Bear? Vote in Our Poll But there is a little bit of a "framing" issue here. If the historical loss averages 2.5% for these pools, then one is not likely to think 20% is even in the realm of possibility. And that is a problem, particularly when there is a structural shift in how mortgages get originated. I am not sure if it was causal or coincidental, but starting in the 1990's when the nonagency mortgage market began to pick up pace, so too did the way mortgages were originated. Maybe it was because banks no longer kept their loans in their portfolios and used securitization to get them off the books and refresh, but I also suspect it was the development of "the food chain" of the mortgage process.