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Kass: Ratings Are Subprime's Dirty Secret

Credit will contract as subprime downgrades expand.

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 and readers. For more information about subscribing to Street Insight, please click here .

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 --


(MCO) - Get Moody's Corporation (MCO) Report

, 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).

But what will happen when the ratings agencies finally downgrade MABS 2006-FRE1? (Which seems inevitable, but late!) Answer: Investors will sell.

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subprime fungus has only recently been uncovered, and the seriousness of the problem for the sector of housing that has stirred the drink of the residential real estate market has only recently been uncovered in the "see no evil, hear no evil" capital markets of 2007. (Indeed, over on


, Jim "El Capitan" Cramer

argues that the subprime woes are a good thing, because the carnage will contribute to a


rate cut. I view this as highly unlikely but consistent with the Cramerica psyche that has inundated the investment community -- good news and bad news are both treated favorably.)

What is astonishing to this observer is the almost universal view that the prime market is in good shape and that the weakness in subprime will be contained.

It will not be isolated, as nearly as half of all the mortgages made over the last 12 months -- even to prime customers -- are nontraditional, creative loans (interest-only, adjustable option ARMS, negative amortization, etc.). These, too, are vulnerable. At the very least, today's lemmings (a.k.a. mortgage lenders) will begin to restrict lending and will dramatically tighten standards. And Katie bar the door if this economy doesn't perform in a Goldilocks fashion.

The subprime mortgage news this week is the first shot across the bow of a boat called Market Optimism. Throughout the balance of 2007 and into 2008, mortgage defaults will accelerate into the prime market (as a result of a moderating economy, too-leveraged mortgage instruments, rising interest rates and ARM resets).

Credit is about to be less plentiful.

Doug Kass is founder and president of Seabreeze Partners Management, Inc., and the general partner and investment manager of Seabreeze Partners Short LP and Seabreeze Partners Short Offshore Fund, Ltd. Until 1996, he was senior portfolio manager at Omega Advisors, a $4 billion investment partnership. Before that he was executive senior vice president and director of institutional equities of First Albany Corporation and JW Charles/CSG. He also was a General Partner of Glickenhaus & Co., and held various positions with Putnam Management and Kidder, Peabody. Kass received his bachelor's from Alfred University, and received a master's of business administration in finance from the University of Pennsylvania's Wharton School in 1972. He co-authored "Citibank: The Ralph Nader Report" with Nader and the Center for the Study of Responsive Law and currently serves as a guest host on CNBC's "Squawk Box."

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