Bond funds could get hit by mortgage mess

updated 4:45 p.m. ET Sept. 9, 2007

WASHINGTON - Could the housing market’s woes spread to bonds held in mutual funds by millions of ordinary investors?

Some experts — and hedge fund investors who have made big bets that the mortgage crisis will worsen — are saying that’s exactly what will happen. Some bond funds that invest in riskier short-term debt already have been whacked by soaring default rates on bonds backed by subprime loans made to borrowers with weak credit.

Critics charge that Standard & Poor’s, Moody’s Investors Service and Fitch Ratings routinely give triple-A ratings — the safest rating there is — to far too many mortgage-backed bonds backed by subprime home loans.

“The rating agencies just completely missed the boat in their methodology for rating these things,” said Janet Tavakoli, president of Tavakoli Structured Finance, a Chicago consulting firm.

About 80 percent of debt in bonds backed by subprime loans is rated triple-A, the same rating on virtually risk-free U.S. Treasury bonds, experts say.

If that seems shocking, there are bonds backed by delinquent credit card accounts — one of the riskiest forms of debt — in which up to 40 percent of the accounts in the security are rated triple-A, says Drexel University finance professor Joseph Mason.

The Securities and Exchange Commission said Friday it had launched a review of what the three agencies’ ratings mean and whether conflicts of interest were created if they gave advice to sellers of mortgage debt. Credit rating agencies say their role is to rate the creditworthiness of securities, not advise buyers or sellers of bonds.

Congress has also pledged to hold hearings on the role the ratings agencies played in the subprime mortgage mess that has triggered Wall Street selloffs and dampened consumer spending.

The rating agencies defend their methodology and argue that the problems of the $10.4 trillion mortgage-backed market are being exaggerated.

S&P, which is owned by the McGraw-Hill Cos., says it has only had to downgrade about 1 percent of the subprime mortgage debt the agency has rated in recent years, with the overwhelming majority occurring in the lowest-rated debt.

Over the past 30 years, the average five-year default rate for investment-grade mortgage-backed bonds is less than 1 percent, said Chris Atkins, an S&P spokesman.

“Our long-term track record of assessing credit quality of bonds is exceptionally strong,” Atkins said.

At Moody’s, the amount of downgraded bonds is small compared with the total amount issued and has been focused on lower-rated securities, said Claire Robinson, a senior managing director.

The downgraded bonds “are riskier securities that are more prone to downgrade in a stressful environment,” she added.

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