Mortgage-backed securities are back, but Moody's, Standard & Poor's, and Fitch are approaching their job rating them with very different tactics.

What would happen in an earthquake?

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 () 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 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  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.

Having worked for Ms. Linda Stesney at Moody's, I can confirm that Moody's evaluates a AAA scenario and credit subordination from an "Armageddon" perspective. This approach is not realistic to say the least.

In addition, it wasn't conservativeness that led to Moody's downfall. It was Moody's lack of consistent ongoing monitoring of its rated securitizations. Once a deal was rated, Moody's analysts would rarely revisit them to see if they were performing to expectations. Consequently, rating modifications, especially downgrades, were seldom done.

It also didn't help that many senior Moody's officers, including Ms. Linda Stesney, were lawyers, not economists or statisticians. Moody's preferred its structured finance senior officers to be lawyers since it was more concerned with the legal structure of a deal (e.g. was the deal truly bankruptcy-remote) than whether the economics and math were correct.

Much like the Madoff fraud investigation at the SEC, we've seen what happens when you put lawyers in charge of business/economic/accounting situations and issues. More "cover your a$$" and less analytical investigation.

Posted By Truther NYC: February 24, 2011 2:52 pm

The Moody's report has an exaggerated assumption of risk. It assumes 80% of borrowers will default and that property values will decline by 70% in the event of a large Bay Area earthquake. Having lived through the 1989 Loma Prieta earthquake I can tell you no widespread abandonment of the region or significant drop in property values followed that large earthquake.
The people who choose to own homes in the SF Bay Area accept the risk of earthquakes.
The report mentions that the homes in the pool have a 60% loan to value ratio. It is likely that most homes in the Bay Area have at least 50% of their value connected with the land. Structures can be repaired or rebuilt.

Posted By Daniel Kemp, Novato, CA: February 23, 2011 7:21 pm « »CNNMoney.com Comment Policy: CNNMoney.com encourages you to add a comment to this discussion. You may not post any unlawful, threatening, libelous, defamatory, obscene, pornographic or other material that would violate the law. Please note that CNNMoney.com may edit comments for clarity or to keep out questionable or off-topic material. All comments should be relevant to the post and remain respectful of other authors and commenters. By submitting your comment, you hereby give CNNMoney.com the right, but not the obligation, to post, air, edit, exhibit, telecast, cablecast, webcast, re-use, publish, reproduce, use, license, print, distribute or otherwise use your comment(s) and accompanying personal identifying information via all forms of media now known or hereafter devised, worldwide, in perpetuity. .

Katie Benner joined Fortune in October 2006. As a writer for the magazine and the website, she focuses on Wall Street and the economy. Prior to joining Fortune, Benner worked at TheStreet.com, CNNMoney, and as a freelancer in Beijing for China International Business, the South China Morning Post, and as a columnist for Beijing Review. She has a B.A. in English from Bowdoin College.

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