The Winter of Our Disconnect

Asset-Backed Alert has been kind enough to allow us to republish their one article from this morning's edition. It brings to the fore various of the topical issues that face and undermine the future securitization as a whole: lack of transparency, lack of supervision, and an unwillingness for market participants to take responsibility for anything that isn't explicitly defined to fit within their specified, direct jurisdiction. Without further ado, I hand you over to Asset-Backed Alert (all emphasis added by them):

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BONY Keeps Distance From CDO Tussle

Hildene Capital has hit a snag as it tries to have Cohen & Co. removed as manager of four collateralized debt obligations.

Hildene, which has been butting heads with Cohen for about two months, fired its latest salvo last month by trying to organize a vote among noteholders. But trustee Bank of New York balked when Hildene asked it to help arrange the ballot, saying it’s not the bank’s job to circulate such proposals.

The matter underscores an ongoing debate among market players about the roles trustees should play, especially when it comes to serving as a conduit of information and policing potential indenture violations. Some believe those shops are best suited to handle requests like the one from New York-based Hildene, as investors are often unaware of the identities of other bondholders.

Hildene holds junior paper from the Cohen deals — Alesco Preferred Funding 1, 2, 3 and 4 — and has nominated itself to step in as manager. The deals, issued in 2003 and 2004, were each backed by trust-preferred shares. Their combined face value was initially almost $1.5 billion.

At issue is a practice in which Cohen has moved collateral in and out of the transactions even though the underlying asset pools are supposed to be static. Cohen has said that it acted properly. But Hildene, which bought its interests on the secondary market, insists that Cohen’s moves are grounds for the Philadelphia firm’s dismissal.

Hildene’s complaint revolves around the idea that it was misled into basing its purchases on evaluations of the Alesco issues’ original obligors, as Cohen wasn’t supposed to trade the underlying collateral. Hildene cites an example in which Cohen removed $24 million of shares issued by FBR Capital from one of the deals this year and replaced them with $25 million of shares from Colonial Bank, which was subsequently seized by the FDIC.

Hildene said in an Oct. 5 letter to Bank of New York that such swaps violate the transactions’ indentures, and thus are illegal. The firm followed up on Nov. 25 by sending a letter to investors that it knows to hold stakes in the Alesco issues, requesting that they cast ballots to fire Cohen from its management role. It asked for Bank of New York’s help in the voting process around the same time.

Cohen, meanwhile, responded by asking Bank of New York to distribute a Dec. 7 letter in which it proposes to stop trading the deals’ underlying shares unless it receives investor approval. The firm also promises to direct any proceeds from such sales to investors, including all fees.

Cohen’s letter reiterates the firm’s denials of wrongdoing and reaffirms that it had the right to carry out the trades Hildene is disputing. “Moreover, we believe that asset exchanges helped to stabilize the portfolio and resulted in an enhancement of the financial interests of our investors,”
Cohen wrote.

The Alesco deals were among 17 that Cohen issued under that banner.

Too Big Too Frail, or a King’s Gambit

Looking back at the years from the late 1990s to, really, 2006, the escalation of securitization acted as a vehicle for tremendous growth in the United States. It provided an additional source of demand for receivables from student loans and credit cards to residential mortgages; and it allowed investors the ability to gain exposure to certain of these asset classes in accordance with their desired risk level.

If rapid economic growth was the advantageous result of securitization, what was the cause? The usual suspects: to avoid certain taxes and regulatory capital charges, taking assets off banks’ balance sheets in such a way as to allow or promote almost unlimited lending.

Having grown together and having fallen apart together, it’s difficult not to see securitization and our economy in a similar light, or at least to see the art form of securitization as a microcosm for the U.S. financial economy as a whole.

The parallels are uncanny

While European and Asian investors, post the Asian crisis, had an insatiable desire from the supposedly safe and reliable U.S. market, structured finance investors’ appetites were similarly indefatigable. Foreign investors moved steadily from U.S. Treasuries to agency mortgages to corporate bonds, non-agency mortgages and on as their confidence increased; structured finance investors transitioned from CMOs to CBOs, CLOs, trust preferred CDOs and then on to CDOs of CMOs, CDOs of CDOs of CMOs, and even collateralized fund obligations (CFOs).

Both foreign investors and structured finance investors were burnt. Both the U.S. economy and the securitization market are trying to struggling new ways to grow, to reinvent themselves. Both are recovering from severe criticism pertaining to their regulation (e.g., the SEC has been faulted for its failures to investigate certain Ponzi schemes like that of Madoff, and to monitor the credit rating agencies (CRAs); while the CRAs are heavily criticized for their ratings on residential mortgage-backed securities, among other products).

And both are realizing that the interconnectedness of their risks pose “systemic” risk issues: while “too-big-to-fail” banks are purportedly being supported by the U.S. government to mitigate against further widespread turmoil, the effects of single mortgage and corporate credit failures are rolling through the structured finance products network, from direct securitizations to resecuritized products like RMBS CDOs, CDO-squareds and even CFOs, backed by hedge funds that have often invested in structured finance securities.

The “holes” that exist in certain CDOs and have been exploited recently by, among others, TPG, Marathon, Goldman Sachs, Cohen and KKR, remind us of the vulnerabilities in our financial system, where Marxist (or Michael Moore-like) capitalistic short-term measures continue to be the order of the day, be it in the form of bonuses or aggressive trading strategies. It’s not your money, and hey if it doesn’t work out, there’s always another firm looking for an aggressive trader. Reputation and responsibility to the client or customer seem to be a thing of the past. (Think of Billy Joel's Allentown or Bruce Springsteen's -- ironically called the "Boss" -- My Hometown.) The U.S. work culture is moving further and further away from the “permanent employment” environment, such as that of Japan.

Financial product regulation needs to be mindful of, and consistent with, the changing working environment and investment tendencies.

The King’s Gambit opening in chess is just that – a gambit. White offers a free pawn and weakens his king’s safety in exchange for a gamble on speedy development. The quick expansion leaves “holes” that can only be ignored for so long. If the speedy development doesn’t prove successful (i.e. meaningful and lasting) white is in danger of having a weakened, exposed king, and must quickly consolidate if he wishes to survive.

Relative to the economy, the problem is not how big the banks are, but how exposed they are to poor investments, how well their risks are managed and how liquid their capital. Do we have the transparency to regulate them, and can they adequately manage themselves? (State Street and US Bancorp are examples of “big” institutions that have not failed, being service rather than investment-heavy: the key differences being strategy, focus and management.) It’s not, therefore, a question of “too-big-to-fail” as Mortimer Zuckerman suggests. Nor is it a problem of too-big-to-succeed. (BlackRock has shown us that.) It is a problem of too-complex-to-regulate.

Consolidation, thus, ought to comprise a slew of objectives, including: ensuring all players in the game are more responsible and perform the necessary due diligence; ensuring that regulators understand and are able to accurately gauge the marginal and cumulative risks involved before approving the usage or purchase certain financial products; and requiring that regulators be granted the necessary authority and be incentivized to apply it, responsibly, to enable their efforts to have a lasting effect.

And so we end off with our financial reform motto: the key challenges at hand are to better align regulatory interests and to create an environment that encourages market transparency, consistency, and responsibility. Liquidity will inevitably follow.

Introducing RatingsReform Blog

Expect[ed] Loss Readers,

We'll be moving our future blogs on rating agency reform and regulation to a new site: http://ratingsreform.wordpress.com.

Please visit us there to follow our commentary on credit ratings reform and to share your opinions with us. Oh, and don't be shy to sign up!

- ExL

Marathon, or Just a Quickie?

Friday’s Asset-Backed Alert describes the (mildly fascinating) behind-the-scenes activities of Marathon CLO I, a 2005-vintage CLO managed by Marathon Asset Management.

According to the article, Marathon itself recently purchased most or all of its deal’s senior-most tranche from Bank of America, at prices purported to be in the 85 cents on the dollar range. To turn a quick profit on their senior note investment, Marathon swiftly sold off roughly two-thirds of the collateral underlying the CDOs, with the proceeds being diverted towards substantially paying down their senior tranche, at par. By our back of the envelope calculations, if Marathon purchased the entire tranche, they would have made a profit on this trade of roughly $26.75mm already, with potentially more to follow.

As far as we’re aware all of the deal’s par coverage tests (“OC tests”) declined between mid-September and mid-October, despite continued improvement in the market for leveraged loans, which support these CLOs.

Why is this Interesting?

(1) While Marathon may have benefited greatly from its extensive trading activity, all other noteholders are, at least in our opinion, worse-positioned for it: in a month in which most CLOs’ OC test ratios improved, all OC ratios of Marathon CLO I suffered, arguably purely as a result of their aggressive trading during this period.

(2) The substantial paydown of the Class A1 notes (CUSIP 565763AA7) might encourage Moody’s to upgrade the tranche from its current rating of A1, with a possible Aaa rating in sight.

(3) Managers are typically disincentivized from any earlier-than-necessary unwinding of their deals: the longer their deals run, the longer they continue to collect management fees for managing the collateral; however, in this situation, the upfront profit of say $26mm would vastly outweigh the potential additional revenue stream of less than $2mm per year that a manager may hope to earn in fee from managing a deal such as this. (Managers earn fees based on the size of the portfolio, so a paydown decreases future fee generation.)

(4) The spirit of the deal is that managers are supposed to manage “across the capital structure.” In other words, though very difficult, they’re supposed to make managerial decisions that are in the best interests of all investors of the deal, certainly not only the senior-most tranche holders. At the same time, the dynamic is that rating agencies are trying to protect their rated noteholders, but not only the senior-most holders. Though it’s an imperfect system, the collateral manager is often required to purchase some of the equity of its own deal, to ensure that it manages across the structure, thereby sending proceeds down the waterfall as far as the equity notes (see here for examples of how this structural nuance can be manipulated).

(5) In this scenario, largely as a result of the early liquidation of assets, most if not all of the other rated noteholders will suffer, which could bring the rating agencies’ ratings on these notes into question, and the equity holders likely lose any potential upside they might otherwise have hoped to gain on their investment.

(6) Aside from allowing “Credit Risk” sales, rating agencies try to protect against aggressive management by limiting the amount of trading activity permissible by a manager (see example language below). With Marathon posturing such a large proportion of these sales as “Credit Risk Sales” it really calls into question the definition of a “Credit Risk Sale” and the question of a manager’s ability to arbitrarily designate a sale as a Credit Risk Sale simply to allow for its effectuation. Given that they were able to sell these assets at, on average, over 90 cents on the dollar, can they really have been Credit Risky? Does Marathon know something about all of these loans that the rest of the market does not? Did they all just suddenly become Credit Risks, encouraging Marathon to liquidate them in the best interests of all holders, or is Marathon acting in its own capitalistic interests?

Example Indenture Language

ARTICLE XII

SALE OF UNDERLYING ASSETS; SUBSTITUTION

Section 12.1. Sale of Underlying Assets and Eligible Investments.

(a) Except as otherwise expressly permitted or required by this Indenture, the Issuer shall not sell or otherwise dispose of any Underlying Asset. Subject to satisfaction of all applicable conditions in Section 10.8, and so long as (A) no Event of Default has occurred and is continuing and (B) each of the conditions applicable to such sale set forth in this Article XII has been satisfied, the Asset Manager (acting pursuant to the Asset Management Agreement) may direct the Trustee in writing to sell, and the Trustee shall sell in the manner directed by the Asset Manager (acting as agent on behalf of the Issuer) in writing:

(i) any Defaulted Obligation, Credit Improved Obligation or Credit Risk Obligation at any time; provided that during the Reinvestment Period and, with respect to Defaulted Obligations and Credit Risk Obligations, at any time, the Asset Manager (acting as agent on behalf of the Issuer) shall use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets having an Aggregate Principal Amount (A) with respect to Defaulted Obligations and Credit Risk Obligations, at least equal to the Disposition Proceeds received from the sale of such Underlying Asset (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon), and (B) with respect to Credit Improved Obligations, at least equal to the Aggregate Principal Amount of the Underlying Asset that was sold; and provided further, that the Downgrade Condition is satisfied;

(ii) an Equity Security at any time (unless earlier required herein); provided that during the Reinvestment Period, the Asset Manager (acting as agent on behalf of the Issuer) will use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets with a purchase price at least equal to the Disposition Proceeds of such Underlying Asset (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon) received from such sale;

(iii) any Underlying Asset which becomes subject to withholding or any other tax at any time; and

(iv) in addition, during the Reinvestment Period, any Underlying Asset not described in clauses (i), (ii) or (iii) above, if (x) no Downgrade Event has occurred and (y) with respect to any sale after the Payment Date occurring in September 2012, the Aggregate Principal Amount of all such sales for any calendar year does not exceed 25% of the Portfolio Investment Amount; provided that the Asset Manager (acting as agent on behalf of the Issuer) will use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets having an Aggregate Principal Amount at least equal to the Aggregate Principal Amount of the Underlying Asset sold (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon).

UPDATE, November 20, 2009: This morning's Asset-Backed Alert edition suggests, quite disturbingly, that Fortress and TCW may be considering similar moves to that of Marathon, in their Fortress Credit Funding CLO and Pro Rata Funding Ltd. deals, respectively.

Piercing the Securitization

Wells Fargo is cursing the day it agreed to act as trustee on the Tropic and the Soloso TruPS CDO series...

For those not following, TPG found a loophole in the deal docs which allows it to cherry pick assets directly out of the CDO's portfolio, at ridiculously discounted prices, if 66.66+% of the CDO’s equity agrees to it.

TPG aims to secure the equity’s vote by paying them a consent fee* – obviously, this is bad for all the rated notes (who were hoping for par or at the very least a real market price).

* bribe

Read more here.

Tropic IV CDO Ltd.'s equity has voted. No surprise there, the equity went with yes.

Whether or not to execute, on the equity’s yes, is now Wells Fargo’s call - this leaves them in a bit of an awkward position: (1) accept and get sued by the rated notes, (2) reject and get sued by the equity.

This past Monday, Wells Fargo turned to a higher power, the United States District Court Southern District of New York, to protect itself against/resolve the Tropic IV CDO Ltd. dispute and all related future disputes.

Only have a hard copy of the Wells Fargo's interpleader complaint. Will update with a link soon.

The complaint discloses some of the participants involved in the Tropic IV CDO Ltd. dispute – see below.

The Imperfect Hedge

The outlook continues to be bleak for trust preferred securities CDOs (TruPS CDOs).

Not only does the FDIC continue to seize bank after bank, but the rate of bank failure continues to increase. By our calculations, using FDIC data, we moved from an annualized FDIC-insured institution default rate of 1.1% as of mid-year 2009 to 1.53% as of quarter-end September 31.

These default rates appear to be relatively mild versus say corporate bond default rates (which are well north of 10%); but we must remember that TruPS CDOs were structured based on the implied and historically-observed lower default rates of banks, due to their operating in a more heavily regulated environment. Thus, TruPS CDOs were able to be arranged with comparatively low levels of subordination, despite the low recovery rate on TruPS CDOs' deeply subordinated underlying asset class: trust preferred securities. In other words, built to protect against annualized default rates around 0.35%, TruPS CDOs find themselves ill-positioned to stomach the exponentially higher default rates.

Nor does it help that the FDIC might be incentivized to close all banks -- that is, including the well-capitalized banks -- if they operate under the same bank holding company umbrella. With the FDIC's deposit insurance fund running low, the FDIC's ability to exercise their cross-guarantee authority results in this unfortunate consequence for the better performing banks, as was the case with Citizens National Bank (Teague, TX) and Park National Bank (Chicago, IL) who were brought down along with FBOP. Both Citizens and Park National are considered "Average" performing banks by PF2's internal analysis, based on 6/30 call report data.

With bank default and deferral rates moving up, resulting in deal-wide decreases in "excess spread" levels, many TruPS CDOs have become increasingly sensitive to their interest rate hedges.

In our July 22 report we noted that:

"With TruPS CDOs already being pressured by the lack of interest generation by the defaulted and deferring securities they’re holding, the additional burden caused by the deals’ interest rate hedges is becoming increasingly torturous. TruPS CDOs usually have asset‐level swaps (although sometimes the swap has been implemented on the deal level) that exchange a pre‐negotiated fixed rate for LIBOR. With LIBOR being low, the cost of the swaps to the deal becomes tangible, on average accounting for 1.23% of the total deal portfolio size on an annual basis, or 1.45% of the performing deal size. (The median cost is 1.31% of total or 1.58% of the performing
balance.)"

These detrimental interest rate hedges -- almost always at the top of the waterfall BEFORE any payments are made even to the most senior rated notes -- are now coming under scrutiny by the rating agencies. For the first time (as far as we're aware)Moody's explained in a press release on Friday that the interest rate swap in Soloso2007-1 may negatively affect the performance of the original senior Aaa tranche, Class A-1L, prompting its downgrade to sub-investment grade (Ba1 rating). Emphasis added by us.

"Furthermore, due to the significant increase in the actual defaulted amount (an additional $17mm occurred this past month), the transaction is now negatively impacted by an unbalanced pay-fixed, receive-floating interest rate swap that results in payments to the hedge counterparty that absorb a large portion of the excess spreads in the deal. Today's actions therefore reflect that the burden of making hedge payment over the remaining life of this transaction will significantly reduce the amount of cash available to pay Class A-1L Notes and put interest payments of Class A-1L at significant risk."

Moral of the blog: beware of the hedge.

UPDATE November 3, 2009: We have received a press release from Moody's stating that a supermajority of equity noteholders in at least one TruPS CDO, Tropic CDO IV, have voted to allow the execution of a certain problematic loophole. You can read more about the loophole here, but here's a summary: the loophole allows a third party, subject to obtaining supermajority equity vote, to purchase assets directly out of the CDO's pool at the proposed and voted-upon price. The caveat is that the equity holders are pretty much out of the money at this point in TruPS CDO world, and so for a reasonable consent fee may reasonably be induced to vote in the affirmative, having (as far as we're aware) no fiduciary responsibility to protect noteholders senior to themselves. In the case of Tropic IV, the bidder was Trust Preferred Solutions LLC, which we understand to be a Minnesota vehicle of private equity firm Texas Pacific Group (TPG). Their bid was 5 cents on the dollar for what we believe were among the better preference shares in the portfolio.

Here follows an excerpt from Moody's press release that speaks to this situation:

"In a notice dated October 30, 2009, Wells Fargo Bank, N.A., trustee for Tropic CDO IV, stated that the holders in excess of 66 2/3% of the Preferred Shares directed the trustee to accept an offer to sell certain [securities] to a third party. This offer to purchase part of the transaction collateral at a substantial discount, if executed, will have a negative impact on the rated notes. The trustee has also stated that it intends to file an interpleader action requesting a judicial determination regarding how to proceed in respect of the offer. Today's rating action reflects the uncertainty surrounding the outcome of this proceeding and the potential negative impact from the Offer. Moody's is following the development of this situation closely."

"and yes I said yes I will Yes."

The Wall Street Journal reports this morning that Dallas-based Highland Capital is putting together three CDO deals backed by corporate loans, one of which “will have no credit ratings at all.”

OUR OPINION

Highland is using the wide-spread investor dissatisfaction with rating agencies as a “screen” for not wanting to rely on them for CLO ratings.

Highland might wish to make the argument that the credit rating agencies (CRAs) are an unnecessary expense to the deal and that they are inaccurate anyway, right?

If, as a potential investor, you’re open to be swayed by this argument alone, we would ask you to consider at least three areas where we believe you will be losing out absent a rating:-

Structural Protections

While we have been critical of certain CRA ratings decisions, including in the CLO space, it is clear to us that underwriting quality has improved over time on the CLO documentation side. The rating agencies have learnt various lessons and imposed new restrictions over time to protect against what they believed were aggressive loan management plays, or against loan managers’ aggressive interpretation of the terms of the indenture. These “lessons” resulted in, for example, the implementation of the triple C bucket haircut (see here), which aims to disincentivize managers from building “fantasy” par or interest coverage by buying lowly-rated securities.

The CRAs, in other words, have warmed over time to the tricks of the aggressive management trade and have built in certain structural protection to protect the rated noteholders.

(Highland, like many other CLO managers, often hold an equity or residual stake in their own deals, and so may be otherwise incentivized to “flush” proceeds as interest proceeds down the CLO waterfall to the equity tranche. The “game” is thus for the rating agencies to protect their rated noteholders, ensuring only the justifiable proceeds are being alloacted for distribution to the equity holders and out of the deal, according to the design or "spirit" of the deal. More can be read on managers' interests in the CLO, and potential conflicts of interest in managing across the capital structure, here.)

Absent structural protections and rating agencies, who or what will protect the noteholder against a manager's running amok?

An Extra Eye on Deal Terms and Analytics

Even if you believe that the rating have been entirely wrong on the analytics side of their CLO ratings – and this is a hard claim to make for this asset class – they provide the investor with an additional set of eyes on the deal terms. While there are and will always remain certain loopholes and ambiguities (see for example the TPG issue in TruPS CDO world here), one can only imagine how many more difficulties would have arisen if it weren’t for the trained eye of the rating analysts.

Liquidity

Firstly, having rating agencies analyze the documents heightens the consistency across documents, and decreases the likelihood that your bond won’t have this minor helpful nuance that was introduced by the rating agencies for other bonds. Consistency is good – it helps subsequent potential investors compare apples to apples. This improves, among other things, the ability to value your security and, probably, the value of the security itself as complexities drive prices lower.

In tandem with consistency comes liquidity. The more similar your security to others that are traded, the less security-specific work any bidder would have to do on yours, which drives up the price.

But more importantly, certain funds and companies may still require or prefer ratings in the future on all purchased securities. If your security’s not rated, you’ll have a smaller set of bidders. Less demand, lower price.


Moral of the Blog: it’s not advisable to hop off the ratings wagon, especially for complex, already-illiquid securities such as CLOs, where the rating agencies provide a tangible service to the investor. Separately, we need to continue our efforts towards restoring investor confidence in ratings integrity as soon as possible.

Anatomy of a Recovery

A quick update on the rock star world of corporate loans after a bumper first three quarters of 2009…

Leveraged loans have now rallied for 9 consecutive months on the back of a perceived general economic recovery – or lower probability of total collapse - and the heightened availability of refinancing and loan modification options for the borrowers.

Having been battered throughout 2008, the first quarter of '09 kicked off with the recovery of the higher quality leveraged loans (generally the BBs). Since then, it’s all been about the lower quality loans (the single Bs and the CCCs) whose performance now far exceeds that of the BBs for 2009:
- the BBs, Bs, and CCCs have year-to-date total returns of 34.2%, 55.0% and 76.4% respectively, according to S&P’s LCD Loan Index as of October 9.

A second change in dynamics has been the evolution of loan refinancings, a trend we’ll continue to watch as a ton of loans are set to mature in the coming three years. Whereas in Q1 ’09 we saw borrowers trying to raise capital to buy back maturing loans, they’re now increasingly seeking to extend the maturities of those loans, often in exchange for a minor amendment fee and an increased spread on the loan or facility. (You can read more about the “amend-to-extend” pattern here.)

While loan covenant relief has staved off certain impending defaults, the rating agencies generally see default rates continuing to rise from their current peaks around 10% for these speculative-grade issuers, tailoring off towards year end or at latest mid-2010. (Note that while refinancing opportunities – in particular debt extension – are typically a net positive for both the borrower and the lender, it does little from the rating agency’s perspective, as they focus on the borrower's ability to meet its net outstanding debt payments, irrespective of their form.)

Moving into 2010 and 2011, growth and recovery remain key for this asset class: covenant amendments, while decreasing short-term default probability, often also restrict borrower purchases in exchange for allowing lower coverage ratios. Lower coverage ratios augur poorly for eventual defaults, if and when they do happen; and the purchasing restrictions, coupled with the more expensive debt coupon, may stymie growth potential.

Rating Agency Legal Liability Standards

Here follows PF2 Director Mark Froeba's written response to one of Senator Bennett's follow-up questions from the August 5th hearing on "Examining Proposals to Enhance the Regulation of Credit Rating Agencies."

SENATOR BENNETT: As we move forward on strengthening the regulation of credit rating agencies, it is important that we do not take any action to weaken pleading and liability standards of the Private Securities Litigation Reform Act of 1995. This Committee worked long and hard, and in a completely bipartisan fashion, to craft litigation that would help prevent abusive "strike" suits by trial lawyers. These suits benefitted no one but the lawyers who orchestrated these suits. This was a real problem then, and could become a real problem again if we dilute the current standard that applies to all market participants. Perpetrators of securities fraud, and those who act recklessly, can be sued under the law we passed in 1995.

Is there any justification for now altering this standard just for credit rating agencies?


MARK FROEBA: Yes, there is ample justification for altering the pleading and liability standards just for the credit rating agencies. Here are three arguments in support of changing these standards.

First, the major rating agencies have enjoyed the privilege of a government-sponsored monopoly for many years. In order to reduce the negative consequences of this monopoly, the government also encouraged competition among the agencies. There is overwhelming circumstantial evidence that the agencies responded by competing with each other not on price or efficiency or productivity or quality but, instead, on rating standards, revising rating methodologies and standards whenever necessary to build or maintain market share and revenue. Changing pleading and liability standards for the agencies would provide a key restraint should rating standards ever again end up in competitive free fall. Fear of liability will curb the appetite for market share, dampen the negative effects of competition, improve rating quality and, thereby, ultimately make lawsuits less necessary. The rating agencies, in exchange for continuing to enjoy the privilege of a government-sponsored monopoly, should be subjected to easier pleading and liability standards at least where litigants claim that bad ratings have injured them.

Second, when the rating agencies generate bad credit opinions, they have nothing at risk except their reputations. Other market participants involved in the transactions that failed in the subprime crisis, eg, investment banks, investors and collateral managers, all had some financial stake in these transactions. When these participants got it wrong, they were punished by financial losses, in some cases even to the point of bankruptcy. Having a significant financial risk is enough to warrant separate pleading and liability standards for these market participants. If reputation risk alone once provided the rating agencies with the same kind of incentives as financial risk, Enron taught them a new lesson. The bankruptcy of Enron within only days of losing its investment-grade ratings did severe damage to the reputation of the agencies but did little to hurt their business. In the aftermath of Enron, the rating agencies enjoyed some of their most profitable years ever. Thus, fear of reputation damage after Enron did nothing to check the ratings that caused the subprime crisis. It would be very difficult now to overstate the damage that the subprime crisis has done to the reputation of the rating agencies. If they all survive the current crisis unscathed – as seems almost certain -- they will be taught a lesson very dangerous to the world financial system: no matter how bad their ratings, no matter how damaged their reputations, they will not fail and the rating business will not go away because there is nowhere else for it to go. Without incentives that are far more potent than reputation risk, we cannot expect the rating agencies to reform themselves and impose greater quality and accuracy on their ratings.

Third, the rating agencies have long enjoyed near complete immunity from liability for bad ratings. This immunity is based upon an old line of cases that found the rating business -- assigning and reporting ratings – to be a form of journalism subject to free speech protections. More than forty years ago, this finding had some merit. The rating agencies assigned ratings to bonds and then reported all of their ratings in periodicals sold to subscriber/investors. Bond issuers paid the rating agencies nothing. However, the rating agencies largely abandoned this model forty years ago. The new model shifts the cost of the rating from subscriber/investors (eager for the most accurate rating) to bond issuers (eager for the highest rating). It is easy to see how the new model changed the rating agencies’ incentives. It is also difficult to imagine how real journalism could make a similar business-model switch. (It would be as if each newspaper story were commissioned by the subject of the story, based solely upon facts submitted by the subject, and published only upon the subject’s approval of the story and payment of a fee for its writing and publication.) Eventually, the courts will discover that the credit rating business is no longer anything like a form of journalism and should not be entitled to free speech protections. This will not happen overnight and may be a long and expensive process. In the meantime, the financial markets need help restoring their confidence in the quality and integrity of credit ratings assigned today. Changing the pleading and liability standards just for the agencies is an important first step in this process.

Rating Agencies: The More the Moroser

It turns out I couldn't find a better antonym for "merrier" than "moroser."

But it is a grave and serious (both suggested antonyms) issue we're approaching today: the regulators' and market participants' aim to foster competition in the credit rating agency market. Just yesterday, various market participants and reporters expressed great delight at the NAIC's ruling to allow Realpoint LLC to rate portfolios of commercial mortgage-backed securities. (Separately, the NAIC is purportedly considering the viability of creating their own, not-for-profit rating agency.)

While we don't have anything whatsoever against Realpoint -- and while we certainly support the need for reform -- we would want regulators to tread this path carefully to avoid the creation of too many new credit rating agencies (CRAs or "NRSROs"). Remember, it was ratings competition that encouraged the decline in ratings quality in the first place, as the CRAs competed to win and maintain market share and revenue by altering their ratings standards.

We are not alone in this opinion. A former rating agency managing director submitted the following in prepared testimony to the House Oversight and Government Reform Committee:

“Senior management [at Moody's] still favors revenue generation over ratings quality and is willing to dismiss or silence those employees who disagree with these unwritten policies.” - Eric Kolchinsky

Competition as a concept is not necessarily a bad thing: for one it serves to bring down prices. We are not saying the "Big Three" CRA oligopoly should remain status quo. Nor are we saying that there should be a Big Three nor that it need remain Moody's, S&P and Fitch who comprise the Big Three. But we are saying that CRAs are not like hedge funds. Having three or five or ten accurate CRAs is worth a whole lot more than having 30 CRAs, irrespective of whether those 30 are accurate.

Why?

First, the recent years since Enron's failure have shown that regulating the CRAs is no mean feat. (Indeed the reforms proposed then were ineffective in buffering against this financial crisis.) It's going to be much more difficult to regulate an army of CRAs with different methodologies than to regulate only the currently existing ones. The SEC's website indicates that at least ten CRAs have already been granted NRSRO status.

Second, the creation of additional NRSROs places additional burden on the investor, who now has to familiarize herself with the slew of new methodologies.

Third, the CRAs were never competing on ratings cost anyway - they're competing on ratings standards (and historical performance to a limited degree). In other words, the less conservative approach might achieve a higher rating and win business. Now there will be more approaches to choose from. Thus, the availability of several alternatives only increases the problem of "ratings shopping," as issuers and structurers cast a wider net to achieve their ideal mix of (i) ratings quality/timeliness/service, (ii) ratings cost and (iii) minimal subordination level required to reach their target rating, in the case of structured finance securities. In the worst case scenario, thus, the rating chosen by the issuer, which typically seeks the highest rating, will be the most lenient measure available from the numerous CRAs. But this does nothing for the investor, who is usually best served by the most accurate rating. And the rating agencies are, after all, an investors service.

Fourth, the CRAs better fit the mould of regulator than that of market participant (buyer/seller). This financial crisis has brought upon us the realization that often having too many regulators can cause a problem: in the U.K. there is talk of the absorption of the FSA; in the U.S. the independent functionings of the OCC, OTS, and FDIC has resulted in various discussions -- especially with regional and community banks being able to swiftly switch between regulators -- which may result in one or more of them being folded into the SEC or the Fed, bodies proposing to take on further responsibilities going forward. Perhaps, then, we should be keeping tighter reins on the CRAs too and rather working towards creating fewer, manageable NRSROs with more meaningful responsibilities.

- PF2

Step 1: Rating Agency Reform

Anybody who’s seen the movie Charlie Wilson’s War will appreciate the fact that signs of economic improvement doesn’t mean we can take our foot off the peddle.

The film describes Charlie’s (ultimately successful) efforts in leading Congress to support Operation Cyclone, the largest-ever CIA covert operation, which supplied weapons to the Mujahideen during the Soviet war in Afghanistan. But the movie ends on a somber note, citing the U.S.’s premature exit in the epitaph to the film:

“These things happened. They were glorious and they changed the world ... and then we f----d up the endgame.” – Charlie Wilson

(The result: the Mujahideen eventually flowered into the Taliban and backed Osama bin Laden's war against the U.S.)

Our situation is hopefully not as drastic, but the point remains: even if we feel we have survived the crisis -- and that unemployment and default rates are leveling off -- we still need to implement the necessary reform measures to avoid the creation of a different monster in future.

With this in mind, we’ve put out our first paper on rating agency reform. The piece ends:

“The ultimate objective of this reform is to encourage financial market transparency and responsibility, from which liquidity will inevitably follow.”

Read it; criticize it; share your thoughts.

- PF2

The CLO Also Rises

The May/June rally and subsequent stabilization of CLO tranche values has shown us that despite times of deep distress, culminating in loan downgrades and defaults, CLO managers on average have been at least temporarily able to build OC coverage. In sum, the par they were able to gain by way of their discount purchases, together with loan price appreciation and the ability to offload certain CCC assets, served as a greater combined force than the dual impositions of portfolio downgrades and defaults.

But one other item has become more readily apparent since May: that investors are increasingly differentiating between AAA CLO tranches (or, at least, between what were originally AAA CLO tranches), resulting in their trading within a wider bracket. As we shall see, not all AAA CLO tranches were created equal.

The complexities in evaluating CLOs, or even CDOs in general, are not limited to making long-term assumptions on a potentially dynamic, managed pool. Nor are the complexities limited to the modeling of each deal’s intricate structural features, such as pro-rata sequential paydowns or BBB tranche turbo features. The language of the indenture – the CLO’s governing document – brings with it a host of nuances in interpretation.

Our most recent piece explores one of the more timely nuances: the varying natures of CCC-rated loan haircuts.

The full report can be read here: Special Report: CLO CCC Buckets - Key Variations in Terms and Performance

An excerpt from the piece:

"... an investor looking for exposure to a CLO that does not have aggressive deleveraging provisions would want a CCC bucket has some or all of the following features:

- is as large as possible (at least 10%);

- references Moody’s loan rating not CFR in determining which securities are in the CCC bucket (and that has as “flexible” a definition of Moody’s rating as possible);

- includes only purchased CCC securities in the CCC bucket;

- haircuts excess CCC securities to MV (with as “flexible” a MV definition as possible);

- is ambiguous on which securities fill the bucket first (or even allows low MV securities to fill first); and,

- diverts cash‐flow for reinvestment and never for deleveraging.

In contrast, an investor looking for exposure to a CLO that has aggressive deleveraging provisions would want a CCC bucket that has all of the following features:

- is as small as possible (no more than 2.5%);

- references Moody’s CFR and not Moody’s loan rating in determining which securities are in the CCC bucket (and that has an “unambiguous” definition of Moody’s rating);

- includes all CCC securities (including both purchased and downgraded CCCs) in the CCC bucket;

- treats excess CCC securities the same as Defaulted Securities and haircuts them to the lesser of MV and recover value (and that has a strict definition of MV);

- clearly fills the CCC bucket with only the highest MV securities first; and,

- diverts cash‐flow for deleveraging only and not for reinvestment."

For Whom the Capital Flows

Thanks to some data mining on Bloomberg, we were able to put together a chart showing the slowing participation by U.S. banks in the Treasury's Capital Purchase Program.

As you can see from the table to the right, only approximately $1.2bn has been drawn down since mid-year, roughly 6% of the speed of the $134.2 bn NET participation witnessed since the inception of the program in October 2008. This is perhaps surprising given the increasing frequency of bank failures -- now bordering on an annualized rate of 1.5% for FDIC-insured institutions -- but may be indicative of the sharp demands made, and restrictions imposed, by the government upon its investment.

All numbers in this blog are NET of the $70.22 bn of capital contributions that had been made but have since been repaid by 36 banks, including repayments made by JPMorgan Chase, Goldman Sachs, Morgan Stanley, State Street, BoNY and U.S. Bancorp. (The most recent repayment came in January 2009.) Wells Fargo, Citigroup, BofA, Regions Financial, SunTrust and KeyCorp are among the institutions who have received large capital injections which they are yet to repay.

The following chart breaks up the capital injections by transaction type. You may notice -- after substantial squinting -- that very little investment has been made (only $0.15bn cumulatively) in pure preferred stock, without any warrants.

(Click on graph to enlarge)

Some are born investment grade, some achieve investment grade, and some have investment “grade-ness” thrust upon them

Morgan Stanley’s recent repackaging of a downgraded Aaa CDO tranche into a new Aaa and a subordinated Baa2 tranche caused quite a stir and what we feel is perhaps an unwarranted outrage. See for example Morgan Stanley, Goldman Sachs Plan To Rebrand Failure As Success and Turning Junk Into Treasure.

Rather, we would argue, the form of these restructured credit ratings -- the very essense of structured finance itself -- if performed correctly will share the common success of Viola’s makeover in Shakespeare's Twelfth Night: each transformation, despite causing initial confusion, will ultimately benefit all parties involved and hurt none, even if at first they may not appear to have done so. (One could argue that poor Malvolio was "most notoriously abused" but, well, it was a comedy after all.)

When the rules of the game change, one must adapt to them. Nobody was injured by the repackaging. No damage was one. And, thankfully, de minimis non curat lex.

It remains a bane of our economy (and a systemic risk) that credit ratings are so deeply intertwined throughout its workings. Thus, there are many reasons, aside from pure regulatory capital arbitrage designs, that may drive an investor to restructure her downgraded tranche. For example:

Fund-level Minimum Rating Criterion
Funds or companies (e.g., mutual funds, insurance companies) may not – according to their investment criteria -- be allowed to hold the tranche at the downgraded rating.

Fund-level Minimum Average Rating Criterion
Funds or companies (e.g., certain fixed income funds, hedge funds) may have mandated weighted average rating thresholds for the entire fund or for certain sections of the fund which may be compromised if they maintain the downgraded security.

Absent the ability to restructure, either of these two criteria alone might encourage or even force the holder to sell her security - and in this illiquid environment, being a forced seller typically translates into suffering a substantial loss on selling. Thus, the ability to repackage potentially stops the investor having to realize a larger-than-necessary loss.

We believe we’re seeing a mixture of the above in the repackaging of the G Square Finance 2007-1 Ltd.’s A-1 tranche.

Back in March, we wrote about how this original Aaa tranche was repackaged into an investment grade tranche (23%) – rated BBB(low) by DBRS -- and a subordinated note (77%). See Regulatory Capital Arbitrage.

As G Square Finance 2007-1 Ltd. continued to suffer credit deterioration in its underlying portfolio, we fear the holder of the note realized that her newly-structured investment-grade tranche, too, may be downgraded to sub investment-grade status.

We suspect that the tranche holder’s fund documents entice her to maintain as much of her portfolio in investment-grade securities (for criteria limitations or regulatory capital purposes, or otherwise), encouraging her to return to DBRS to re-repackage her original A-1 tranche, again trying to achieve as much investment grade as possible out of this declining security. The new breakdown is investment grade tranche (14.89%) – rated BBB(low) by DBRS -- and the remainder is essentially a subordinated note (85.11%).



(While the original A1 tranche was rated by Moody’s and S&P, the repackaged tranche can be rated by whichever rating agency the investor chooses. In this case, the rating agencies are in the ignonomous position of having to compete, among others, on (1) fees charged, (2) quality of service provided, and (3) amount of subordination they require to achieve the investment-grade rating desired – the less subordination the better for the investor.)

In sum, neither Morgan Stanley's nor Viola's approach was exactly what we would call transparent (shout out for the PR department), for which both parties temporarily suffered, and though these repackagings don't immediately create a new source of supply they keep the markets alive and the holders breathing. CDOs are intended as and designed to be long-term par-value products after all, and so almost any institution or implementation that increases the owner's ability to hold them through the illiquid times, and hurts no other party, ought to be met with open arms.

The End


Postscript: Incidentally, G Square Finance 2006-1 Ltd.’s Class A-1 Notes have also been restructured, synthetically, to allow the senior note (38%) to retain an investment-grade rating -- again, BBB(low) by DBRS.

Rating Agency Reform ... continued

An excerpt from our colleague Mark Froeba's testimony before the U.S. Senate Committee on Banking, Housing, & Urban Affairs' hearing on Proposals to Enhance the Regulation of Credit Rating Agencies (August 5, 2009):

-----

"First, [the rating agencies] enjoyed an effective monopoly on the sale of credit opinions. Second, and more importantly, they enjoyed the benefit of very substantial government-sanctioned demand for their monopoly product. (A buggy whip monopoly is a lot more valuable if government safety regulations require one in every new car). Third, the agencies enjoyed nearly complete immunity from liability for injuries caused by their monopoly product. Fourth, worried about the monopoly power created by the regulations of one branch of government, another branch encouraged vigorous competition among the rating agencies. This mix of regulatory “carrots” and “sticks” in the period leading up to the subprime melt-down may have contributed to making it worse than it might have been. Thus, a third goal of rating agency reform should be to untangle these conflicting regulatory incentives. Here are some proposals that I believe will help with all three reform goals.

First, put a “fire wall” around ratings analysis. The agencies have already separated their rating and non-rating businesses. This is fine but not enough. The agencies must also separate the rating business from rating analysis. Investors need to believe that rating analysis generates a pure opinion about credit quality, not one even potentially influenced by business goals (like building market share). Even if business goals have never corrupted a single rating, the potential for corruption demands a complete separation of rating analysis from bottom-line analysis. Investors should see that rating analysis is virtually barricaded into an “ivory tower,” and kept safe from interference by any agenda other than getting the answer right. The best reform proposal must exclude business managers from involvement in any aspect of rating analysis and, critically also, from any role in decisions about analyst pay, performance and promotions.

Second, prohibit employee stock ownership and change the way rating analysts are compensated. There’s a reason why we don’t want judges to have a stake in the matters before them and it’s not just to make sure judges are fair. We do this so that litigants have confidence in the system and trust its results. We do this even if some or all judges could decide cases fairly without the rule. The same should be true for ratings. Even if employee stock ownership has never actually affected a single rating, it provokes doubt that ratings are disinterested and undermines investor confidence. Investors should have no cause to question whether the interests of rating agency employees align more closely with agency shareholders than investors. Reform should ban all forms of employee stock ownership (direct and indirect) by anyone involved in rating analysis. These same concerns arise with respect to annual bonus compensation and 401(K) contributions. As long as these forms of compensation are allowed to be based upon how well the company performs (and are not limited to how well the analyst performs), there will always be doubts about how the rating analysts’ interests align.

Third, create a remedy for unreasonably bad ratings. As noted above, the rating agencies have long understood (based upon decisions of the courts) that they will not be held liable for injuries caused by “bad” ratings. Investors know this. Why change the law to create a remedy if bad ratings arguably cause huge losses? The goal is not to give aggrieved investors a cash “windfall.” The goal is to restore confidence — especially in sophisticated investors — that the agencies cannot assign bad ratings with impunity. The current system allows the cost of bad ratings to be shifted to parties other than the agencies (ultimately to taxpayers). Reform must shift the cost of unreasonably bad ratings back to the agencies and their shareholders. If investors believe that the agencies fear the cost of assigning unreasonably bad ratings, then they will trust self interest (even if not integrity) to produce ratings that are reasonably good.

My former Moody’s colleague, Dr. Gary Witt of Temple University, believes that a special system of penalties might also be useful for certain types of rated instruments. Where a governmental body relies upon ratings for regulatory risk assessment of financial institutions — e.g. the SEC (broker-dealers and money funds), the Federal Reserve (banks), the NAIC (insurance companies) and other regulatory organizations within and outside the US — the government has a compelling interest and an affirmative duty to regulate the performance of such ratings. Even if other types of ratings might be protected from lawsuits by the first amendment, these ratings are published specifically for use by the government in assessing risk of regulated financial institutions and should be subject to special oversight, including the measurement of rating accuracy and the imposition of financial penalties for poor performance.

Fourth, change the antitrust laws so agencies can cooperate on standards. When rating agencies compete over rating standards, everybody loses (even them). Eight years ago, one rating agency was compelled to plead guilty to felony obstruction of justice. The criminal conduct at issue there related back to practices (assigning unsolicited ratings) actually worth reconsidering today. Once viewed as anticompetitive, this and other practices, if properly regulated, might help the agencies resist competition over rating standards. Indeed, the rating problems that arose in the subprime crisis are almost inconceivable in an environment where antitrust rules do not interfere with rating agency cooperation over standards. Imagine how different the world would be today if the agencies could have joined forces three years ago to refuse to securitize the worst of the subprime mortgages. Of course, cooperation over rating analysis would not apply to business management which should remain fully subject to all antitrust limitations.

Fifth, create an independent professional organization for rating analysts. Every rating agency employs “rating analysts” but there are no independent standards governing this “profession”: there are no minimum educational requirements, there is no common code of ethical conduct, and there is no continuing education obligation. Even where each agency has its own standards for these things, the standards differ widely from agency to agency. One agency may assign a senior analyst with a PhD in statistics to rate a complex transaction; another might assign a junior analyst with a BA in international relations to the same transaction. The staffing decision might appear to investors as yet another tool to manipulate the rating outcome. Creating one independent professional organization to which rating analysts from all rating agencies must belong will ensure uniform standards — especially ethical standards — across all the rating agencies. It would also provide a forum external to the agencies where rating analysts might bring confidential complaints about ethical concerns. An independent organization could track and report the nature and number of these complaints and alert regulators if there are patterns in the complaints, problems at particular agencies, and even whether there are problems with particular managers at one rating agency. Finally, such an organization should have the power to discipline analysts for unethical behavior."


Mark's complete testimony can be viewed here.

A Practical Proposal for Rating Agency Reform

The premise behind most proposed regulatory regimes for rating agencies – managing conflicts of interests between issuers and investors – is misguided. The conflicts of interest faced by rating agencies are not qualitatively different than those faced by many other industries, such as the accounting or brokerage industries. The problem is actually more pedestrian – product quality versus profit. Regulating outside influences will not work if the source of the problem is internal.

The conflict stems directly from the concentration of power at the rating agencies. They create rating methodologies, assign ratings based on the same and then judge their own performance. There is no “separation of powers” in the credit rating world – the agencies act as judge, jury and executioner, and are not required to justify their actions to any regulator or other third party. This concentration of power, combined with regulatory demand for ratings, makes it too tempting to alter methodologies and procedures to maximize revenue.

Imagine, for example, if accountants could be the sole arbiters of what counts as income or expenses for a company’s financial statements. Imagine further that their word was final and not even the authorities could appeal the verdict. No one would be surprised by the resulting decline in accounting standards.

My solution is to reduce the concentration of power within the agencies. The proposed template would be based on the regulatory apparatus for other third party information providers in the capital markets – accountants and attorneys.

Like credit rating agencies, accountants and attorneys are private parties competing for business in the capital markets. While no one would argue that these parties are paragons of virtue, their ability to generate profits through manipulation of analyses and opinions is limited. One key safeguard is that neither party sets its own methodological standards. Accountants take their cue from national or international standards and the relevant regulators. Lawyers likewise only interpret and offer advice on legal standards set by authorities.

Standardized Methodology

Rating agencies should follow a standard set of methodologies as well. A body similar to the FASB could be empowered to set various standards for the rating agencies. These could initially include some credit basics such as the definition of ratings (e.g. what is the default probability of a AAA at 5 years), the frequency of surveillance updates and the types of data required to be presented for ratings.

The proposed central credit policy body would have two major effects in improving credit quality:

First, the central approach would stop the methodological “race to the bottom” that was at least partially responsible for today’s credit crisis. Mistakes will still be made, but rating agencies will no longer have to the incentive to play “one-upmanship” in order to maintain their market share.

Second, a standard methodology can be used to actually match the ratings with their regulatory usage. For example, the risk profile of a given rating should match the capital weight assigned to it – this is not the case today. Likewise, if the Federal Reserve requests that only securities rated AAA be allowed in a financing program, the quantitative (e.g. probability of default) measures will have a consistent meaning across the agencies. This is not the case today.

The rating agencies will argue that standardizing methodologies will lead to a loss of independent opinion. This is simply not true; despite the differences in methodologies, the bankers made sure that the ratings issued in structured finance were nearly identical. Moreover, the supposedly different methodologies used by the rating agencies prior to the crisis did nothing to prevent it. If a rating agency had actually proffered a different methodology, especially a more grounded, more conservative analysis, it would have been run out of business.

In fact, the rating agencies do not have to give up their current methodologies and approaches. What they can be asked to provide is a new “regulatory rating” which fits the needs of regulators. This would be no different from having different accounting standards for different tasks. For example, GAAP accounting and tax accounting. Each can produce different results, but is tailored to the needs of the requisite purpose. Lawyers, too, deal with a multitude of jurisdictions and conflicting laws. Ratings should be no different.

Central Ethics Body

Another function that is currently in the sole control of the rating agencies is the adjudication of ethics and professional codes. The International Organization of Securities Commissions has promulgated a code of conduct for the ratings industry. While it is a very good code, the enforcement of its principles is left entirely to the rating agency itself. There are no appeals or penalties for non-enforcement. This is another example of concentration of power within the rating industry. Other professionals in the capital markets (stockbrokers, accountants and lawyers) are subject to ethical standards which can be and are enforced beyond the employer itself. In my personal experience the lack of enforceability leads to precisely the result one would expect – loose or non-existent enforcement.

A central ethics body needs to be established with the authority to adjudicate violations of the IOSCO or any other code of ethics for the ratings industry. The proceedings of this body need not be public, but they should be known to the regulatory bodies with proper jurisdiction such as the SEC.

In order to empower this body to fairly enforce its rulings, a fine-tuned remedy is required. I propose that rating agency analysts be licensed individually to provide “regulatory ratings” only. A licensing requirement would put rating analysts on par with their colleagues in the securities industry. Removal of an individual’s ability to provide ratings is a sufficient punishment for most violations of conduct within the ratings agencies. The knowledge that one may lose her livelihood will increase the incentives for analysts to behave ethically.

One additional benefit of licensing would be increased understanding of regulatory requirements within the rating agency. I have been surprised and frustrated by analysts’ lack of knowledge of applicable regulation or even securities laws. Other regulatory licensing standards (e.g. Registered Representative) require the candidate to have a basic understanding of the legal environment surrounding her profession.

Conclusion

I believe that the two proposals above, the creation of standardized methodologies and the use of ethics bodies, would significantly improve the quality of the work performed by rating agencies. They would also allow regulators to more efficiently discharge their responsibilities. Additionally, these proposals would also be simple to implement and would cause a minimal amount of capital market dislocation.


- Former rating agency analyst

Critique of Impure Reason: CDO Anyone? I'll Take Two, Please!

In a perfect world CDOs would have been the perfect investment: for the same level of risk (as distinguished purely by rating, of course) you get more reward, by way of the additional spread or yield on your investment.

Where certain investors -- including pension funds from the US to Europe to Australia -- saw the word "ARBITRAGE" flash in bold red across their screens and quickly rushed to beat the market, others lingered and assessed the risks more closely.

Wisely and slow. They stumble that run fast.

In sum, some investors looked around to find the highest yielding asset that fits their fund's rating criterion (and so they'll necessarily outperform the market, at least for the short-term, and perhaps secure themselves a pat on the back and an increased bonus). Others asked themselves: "Well, even if I can come to terms with the rating agencies' approach to rating these assets -- that the have accurately measured default probability or expected loss, as the case may be -- what else am I paying for, say, relative to a corporate bond? And is it worth it?"

CDO Risks

Without further ado, here's what they're paying for, in terms of risks and expenses, over-and-above the vanilla corporate bond alternative:

• liquidity, or illiquidity risk;
• model risk and/or complexity risk;
• spread or yield risk (somewhat similar to that of a corporate bond);
• interest rate risk;
• payment timing risk (prepayment, extension risk, lumpy payment risk);
• tranche pricing volatility;
• rating methodology changes (given the "newness" of the asset class);
• a slew of operational costs (to monitor/model/mark your position); and
• a host of accounting risks and legal risks that we'll leave for another day

Additionally, certain CDOs brought with them foreign exchange risk, certain basis risks and portfolio market value risks. Leveraged accounts, buying CDOs, took the burdensome funding risk and rating downgrade risk. (This is all not to mention the risk that the rating agencies may be wrong in their assessments of default probability and loss given default.)

While you can't necessarily model the "cost" of each of these risks, and what you should be paid for absorbing each, individually, they are nevertheless quite tangible risks. Especially now.

Ideally, perhaps, a sophisticated investor with strong analytical capabilities might model the deal, run various sensitivity scenarios based on her internal opinion, interview the manager -- and decide that upon sufficient review of the documents and the various "dangers" they allow for, she is is willing to take the risks involved in the investment relative to the yield it provides. It would be suboptimal to say, well, "this looks good to me and geez it pays a whole lot of yield at that rating level, so let's buy it, close our eyes, and hope for the best."

Why? Well essentially you're being paid a hefty reward for being right in your modeling assessment of the deal and in your determination that you can, as a fund, stomach the collective risks of the instrument. If you don't perform the necessary credit analysis, you're not earning your wage: you're rolling the dice or guessing. Tough times, and the volatility they bring, have a sneaky way of separating the guessers from those who performed a thorough analysis, bringing to the fore any portfolio-level risk or support weaknesses, and thereby magnifying certain of the risks of OTC instruments:

• increased illiquidity particularly hurts those buyers who are holding their securities as available for sale (AFS);
• low interest rates decrease payments derived from bonds with LIBOR-based coupons; and
• payment uncertainties, model complexities, and accounting and legal risks and costs accentuate the imbalance between buyers and sellers, driving prices further down. (To compound the matter, lawsuits may discourage both the sale and the purchase of complex securities.)

"Unmodeled," almost qualitative, risks proliferate

- S&P has corrected its ratings on, among others, Founder Grove CLO Ltd., Archstone Synthetic CDO II SPC, and WISE 2006-1 PLC's CDO Notes. Their reason: modeling errors

- S&P has corrected its ratings on, among others, Lorally CDO 2006-2, Tranched Investment-Grade Enhanced Return Securities 2004-11, Longshore CDO Funding 2007-3 Ltd., and Quartz CDO (Ireland) PLC. Their reason: administrative errors

- Moody's and S&P have both confessed to finding errors in their CPDO models

Resources:

1. Arturo Cifuentes on modeling complexity
2. Professor Joseph Mason on the difference in default likelihood between CDOs and similarly-rated corporate bonds
3. On the level of analysis performed by pension funds and endownments prior to purchasing CDOs

(P.S. Feel free to share in the comments section below if you feel we've failed to mention any major risks.)

The KYSS Principle

We're coining a new phrase on this bright-n-sunny summer morning:

KYSS - Know Your Super Senior

Or Know Your Senior Secured. Either way, knowing who's above you in the capital structure can be immensely useful, particularly in the world of defaults.

We've been seeing this in ABS CDO space for a while now, as the contrasting interests and demands of the controlling class holders have determined whether defaulting CDOs were liquidated or accelerated.

And we recently spoke about this in the leveraged loan world too (click here for the full transcript) where banks and CLO managers have possibly different agendas in the corporate loan amendment process:

The big difference is when banks are the lenders the relationship between the borrower and the lender often goes back many, many years and may include businesses like bond underwriting and cash management and other types of solutions that the banks offer. And so the banks are going to be even more incentivized than usual to grant covenant relief and find a solution that allows for continued revenue generation. With institutional investors, on the other hand—and we’re talking CLOs, prime rate mutual funds and the like— they’re “transactional lenders.” In other words, their relationship doesn’t go any further back than the individual loan in question here and so their incentives will be naturally more immediately self‐serving.

Thus, as a prospective subordinated bondholder (i.e., purchaser) it might be wise to find out who is holding the senior secured loan. What would the amendment process look like? What sort of acquisition restrictions will be imposed on the borrower post amendment, and amendment fees and charges will leak to the senior lender. (See for example Richard Kellerhals' recent piece Investors Fume as Banks “Extend and Pretend.”)

So go ahead and KYSS - it may even change the way you see the bond you currently hold.

Impact of amendments on CLOs

Your good friend GP was recently interviewed on the state of corporate loans and CLOs amid the flurry of credit agreement amendments.

You can download the full podcast here.

Collateral Managers and Takeover Opportunities

Collateral managers banding together...here's a link to the report we sent out last week. Enjoy.

Collateral Managers and Takeover Opportunities

Is your CDO Leaking

CDO noteholders, pay close attention to your monthly trustee reports. These are complicated deals and trustees make mistakes. Most of the time, these mistakes cost you nothing but every now and then they'll cost you millions.

For example, a mistake we picked up today revolves around an incorrect implementation of the “CCC Haircut Amount.” It's responsible for leaking approximately $4 million to equity when that amount should have been used to pay down senior notes.

The details...

Here's the definition from the O.M :

Click to enlarge

In simpler words, if this CDO has too many poorly rated assets then it has to carry a portion of these (“The Excess”) at market value (vs. par) when computing the numerator of this CDO’s overcollateralization tests. (The ensuing lower numerator increases the likelihood of an overcollateralization test trip. If such a trip occurs, cashflows that would have otherwise gone to subordinated tranches are redirected to pay down more senior tranches.)

Additionally, the definition specifies that The Excess should consist of those poorly rated assets with the lowest market values (this is typical) but the trustee made a mistake and picked the ones with the highest…

WHAT HAPPENED / WHAT SHOULD HAVE HAPPENED?

Click to enlarge

This misapplication of the CCC Haircut Amount definition causes the class D overcollateralization test to pass when it should in fact fail. Because this test passes, cashflows are leaked out of the deal to equity when they should have been used to pay down the senior tranches in an effort to cure the failing test.

While this is the first distribution date during which the impact of this mistake is felt, chances are that the trustee will keep making it moving forward, ultimately sticking millions in losses to the wrong group of noteholders.

Here are the details of the CCC Haircut Amount calc.:

Click to enlarge

We’ve got a handful of these examples; we’ll try writing more of these in the future if there is an interest…

Assumptions Assumptions Assumptions

"During the recent foolish-extension-of-credit period, I think there was altogether too much reliance on black boxes. Something that comes out of the computer looks quite official; it looks quite precise down to all these little digits. But the fact is, any kind of computer-based model inherently has as its basic assumption that tomorrow will look quite a lot like yesterday. The unfortunate truth is that when you get to a major inflection point, it's precisely because tomorrow does not look very much yesterday." - Wilbur Ross

The rating agencies, among other market participants, have to walk a fine line between maintaining their "long-term" views on long-term securities and being overly adaptive to changing market conditions.

I certainly don't envy them their position: A false step in either direction, and they'll be criticized from Wall Street to Washington.

Before we investigate this double-edged sword, let's consider the original premise or thought process or unspoken truth at the time of the original rating of, say, a CDO tranche. It goes a little something like this:

• this rating is a long-term rating
• given the lengthy maturity (usually more than 10 years away) of the asset, we expect it will go through different economic cycles and so our assumptions should speak neither to the peaks nor the troughs, but to the averages (based on historical data) with some volatility -- i.e., stresses -- built into our assumptions
• as long as the manager behaves as she should relative to the constrictions of the indenture, and as long as the portfolio collateral quality remains within the bounds described, we shall not downgrade you!

Now we return to the question of changing assumptions. As you can imagine, any change in assumptions may precipitate a change in ratings, and so ought to be accompanied by transparency describing the methodological change. A change in rating affects, among other things, the regulatory capital that the holder needs to post against the rated asset and the ability of certain funds to continue to hold the asset. In other words, downgrades precipitate deleveraging. And supply. And price. And therefore recovery. And I could go on and on but this circle is vicious.

From their April 23 press release:

S&P: Criteria Changes And Stressed Collateral Performance Affect TruPS CDO Ratings

We have published several revisions to our ratings criteria for TruPS since the July 2008 trust preferred CDO CreditWatch placements as a result of our observations regarding performance trends and worsening economic conditions, and our view regarding the effect those conditions might have on the performance of TruPS CDOs:

-- "Criteria: Revised Correlation Assumptions For Rtng CDO/CDS Exposed To Financial Intermediaries" published Oct. 3, 2008; this modified the correlation assumptions used for financial institutions held within or referenced by CDO transactions, including bank TruPS CDOs.

-- "Criteria: Correlation Assumptions Revised For Rating Global CDOs/CDS Exposed To Insurance Cos.," published Nov. 6, 2008; this modified the correlation assumptions used for insurance companies held within or referenced by CDO transactions, including insurance TruPS CDOs.

-- "Criteria: Prob Of Default, Correlation Assumps Revise For Glbl CDOs/CDS Exposed To REITs/REOCs," published Nov. 6, 2008; this modified the default and correlation assumptions used by CDO Evaluator for REITs and real estate operating companies (REOCs) held within or referenced by CDO transactions, including REIT TruPS CDOs.

-- "Global Methodology For Rating Trust Preferred/Hybrid Securities Revised," published Nov. 21, 2008; this modified the assumptions Standard & Poor's uses when rating TruPS CDOs generally.

-- "Assumptions: Standard & Poor's Reclassifies Insurance Companies That Issue Debt Securities Owned Or Referenced By Rated CDOs And CDS," published Dec. 23, 2008; this modified the industry classifications used in CDO Evaluator for insurance companies held within or referenced by CDO transactions, including insurance TruPS CDOs.

Stepping back, we're seeing at least five assumption revisions since October 2008. Is this too much? Too little?

Back on April 14, on being downgraded yet again by Moody's, Ambac Assurance responded as follows:
- "While Ambac believes that Moody's is entitled to its opinion of Ambac's financial strength, it notes that this is the tenth such opinion change since January 2008."

As we've described with the current regulation environment, in Hegelian fashion, one tends to over-regulate as a means of "compensating" for under-regulation. Each can be harmful, and hitting the sweet middle-ground is the key. Here we're seeing the responsiveness to severe criticism relating to maintaining static assumptions in a changing environment. The response, naturally, is to proactively rate.

Damned if you do, damned if you don't.

Distress Testing

The Economist put out a piece on the psychology of trading in stressed environments, such as those facing floor traders.

The piece brings to the fore the idea that, in deciding between a low-probability major loss and a high-probability minor loss, the stressed conditions encouraged participants to roll the dice with the major loss.

This theory -- which culminates in traders taking profits too soon and being unwilling to realize losses while they're still manageable -- is consistent with the "loss-aversion winning over utility theory" pieces that stock-trading-psychologist-guru Phil Pearlman writes (see here and here for example).

The nuts and bolts: if a trader has a 100% probability of winning 1 unit, versus a 60% probability of winning 2 units, the theory suggests that the trader often chooses the former option, against the principle of utility theory (since 60% x 2 units = 1.2 units, which is greater than 1).

The alternative is, however, much more troubling especially as it relates to pension funds and government intervention implementation: the willingness to roll the dice and risk a major problem, rather than suffer a sure, minor blow now. On the government level, this "theory" may manifest in an unwillingness to cut rates or even to draw down on the credit line available from the IMF. The United States was a front-runner in cutting rates in early H2, 2007, but some even criticize the U.S for cutting too slowly, too late, with the downturn having begun in 2006. A more rash action may have qualmed fears sooner, and nipped the problem -- now massive -- in the bud.

This trend remains "watchworthy" as companies like Ford reap the rewards of raising capital sooner rather than later and the Japanese banks continue to resist their governments attempt to inject capital, despite their relatively massive exposure to the stock market. Post the G20 meeting, it will be interesting to see how the Balkan (and particularly Baltic) countries differ in their approach towards relying on the IMF.

While it may be acceptable for smaller hedge funds to play ball on the downside, it's incrementally detrimental if systemic-risk-issue-companies, and governments themselves, don't carefully avert losses on the downside.

UPDATE April 22 (Bloomberg): Fitch says Japanese banks may need, yet avoid, public funds

Japan’s biggest banks may need to accept funds from the government as bad debts increase and investors demand higher capital ratios, according to Fitch
Ratings Ltd.

“Capital pressures are growing,” David Marshall , a managing director at Fitch in Hong Kong, said in a Bloomberg Television interview today. Capital weakness and loan losses “might even pressure some of the bigger Japanese banks eventually to have to turn to the government,” he added. “That’s something they’ll resist as long as they can to avoid that stigma.”

UPDATE April 23: Despite wider-than-estimated fourth-quarter loss -- as bad loans spiraled and the global financial crisis cut the value of its investments -- Japan’s second-largest bank Mizuho Financial Group Inc. did not announce any plans to raise money.

From Lemmings to Lemons

"The market-sensitive risk models used by thousands of market participants work on the assumption that each user is the only person using them." - Avinash Persaud, April 2008.

This quote came to my attention via Felix Salmon's Market Movers via Reuters, and it encouraged me to develop our thought process from an earlier piece we put out, entitled Static Measures for a Dynamic Environment.
The point: in a changing environment, one has to proactively adapt modeling assumptions (such as recovery rates and correlations) to reflect those changes.

As Operation Securitization got underway, escalated and then came to an abrupt, sudden halt, each input into the model needed to have been updated due to the gargantuan size of the market -- and its subsequent influence and impact on trading levels -- and the systemic risk is brings with it. For example, the growth of the collateralized loan obligation market (CLOs) from 2001 through 2006 continued hand-in-hand with the growth of the leveraged loan market. With CLOs constituting the majority of demand for these (typically broadly-syndicated) bank loans (roughly 60-65%) the demand base grew in tandem with the supply source. But we saw no adjustment in either recovery rate assumptions (for loans or CLO-issued notes) or in correlation (between loans and CLOs or between loans or between CLO tranches) on the basis of, or necessitated by, this dual, dependent growth.

Surely if the CLOs stop buying, with the demand source halted, loan recovery rates must plunge downwards. And that's what's happened. Indeed performing leveraged loans have recently oscillated between trading levels of 50% and 65%, well below historically realized recovery rate levels for defaulted corporate loans! (70-80%)

We've described this phenomenon in more detail in The Corporate Loan Conundrum. Also, The Elephant in the Room describes our astonishment that certain recovery rate estimates to this day remain unchanged.

The system-wide (systemic) mass-production of securitized tranches helped undermine the value of each in the crisis. The greater the supply, the lower the recovery when things don't work out, and the more correlated they become. And so the banks -- the lemmings -- acting in unison for the most part, created lemons (there are notable exceptions who are still around).

Separately, while my "lemons" are securitized tranches, Brad Setser took the initiative back in 2007 of Turning lemons into lemonade. His lemons are different: they are mortgages; his lemonade being securitized notes.

His article is thought-provoking for many reasons. Here are two: (1) it brings to the fore the economic principle of lemons (think second-hand cars), a principle which relates nicely to the government's purchasing of "toxic assets," and (2) it reminds us of the correlation question: increased correlation improves the quality lower tranches. Why, then, in this market of increased correlation, are the lower tranches of securitized notes not being upgraded? Well, it's a loss-loss scenario for them: correlation, like volatility, increases precisely in the tough times, during which defaults are high. During these times the lower tranches die a quick or slow death in any event, depending on the deal. Superfluous then?