The big three credit rating agencies are in trouble for not taking taking risk seriously enough when they examined bonds made from residential mortgages before the housing market crashed. They’ve been roundly criticized for their overly generous assumptions about housing market hazards (Prices go down? No way!), and for the abysmal way that AAA-rated, mortgage-backed bonds performed during the financial meltdown.

Now it looks like those same agencies are arguing to see who can be the toughest on those very same securities.

Redwood Trust (RWT) is getting ready to bring to market a $290.4 million residential mortgage-backed security. It’s called Sequoia Mortgage Trust 2011-1, and among other things it features a top AAA rating from Fitch. But in the prospectus filed with the Securities and Exchange Commission, Redwood mentions that it had “terminated” its request for Moody’s to rate Sequoia because Moody’s thought the loans in the pool were riskier than Redwood thought they were. Moody’s wanted a 10% subordination level in order to stamp the deal with an AAA rating. (Think of subordination as a protective cushion should mortgages in the pool start going bad). Fitch agreed with Redwood that a 7.5% subordination level would be fine.

Redwood can’t comment on the deal until it closes in early March. Fitch did not return calls for comment.

Given that we’ve yet to see meaningful rating agency reform since the financial crisis, Sequoia Mortgage Trust 2011-1 doesn’t come as a huge shock. Redwood got to choose its agency, and it went with the one that saw its mortgages the way it saw its mortgages.

But what is interesting is that Moody’s went ahead and issued a report on the deal anyway, even though it can’t officially rate the bonds. Moody’s read the prospectus and calculated that at least 18% of the 303 mortgages in the pool are located in the San Francisco Metropolitan Statistical Area, a definition used to identify the Bay Area’s earthquake prone region. “If a major earthquake were to strike the San Francisco MSA,” writes Moody’s in a report embedded below, “the decline in the values of damaged properties, and the likelihood that borrowers could abandon properties whose value has plummeted, will likely result in either losses to senior certificate holders or deterioration of the credit quality of the certificates to junk status.”

Noting that only 12% of homeowners in the area with a fire policy are covered for earthquake shake damage, Moody’s decided that the natural disaster risk, though small, couldn’t be ignored. Yes, the loans in the pool are very strong. They’re predominately primary homes sold to people with high incomes with 30-year fixed rate mortgages. “But an earthquake event is binary,” says Linda Stesney, a co-author of the Moody’s report. There is no gradual deterioration of credit risk when a natural disaster hits. It’s an all-at-once event that impairs the pool beyond the damage one might assume is a black swan-free world.

In a separate report, Standard & Poor’s agrees that an earthquake, mudslide or even employment prospects could disproportionately affect the San Francisco MSA, and adds that they would have looked for more credit enhancement than Redwood wanted to give.

There’s only about a 6% chance that an earthquake with the magnitude to seriously damage the homes in this pool could happen over the next five years, according to the US Geological Survey, but 6% is still higher than the odds many gave the idea that home prices could ever fall.

Now when investors think about buying a piece of the Sequoia deal, they have a little more than the AAA-rating from Fitch to go on.

This isn’t the first time the rating agencies have publicly disagreed, and absent hard and fast reform they have been encouraged to publish unsolicited ratings. When Redwood brought an RMBS to market last year (Sequoia 2010-1H), Moody’s gave it an AAA rating and S&P put out a long, dissenting report. Certainly this strategy won’t win them customers, but maybe it can help win them a little respect in a world that rates them as junk.

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