Monday, April 27, 2009

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.

Monday, April 20, 2009

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.

Tuesday, April 14, 2009

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?

Monday, April 13, 2009

Damaged Goods

With GM in the news on a daily basis, I found myself considering the burdensome scenario of leasing a car expecting to be able to resell it at $x when returned (at the end of the lease period), only to find out it can only be sold at $0.5x.

Well, this possibility (or, now, eventuality) -- not unique to cars -- got me thinking about key inputs to modeling resale value. Assuming these cars are not vintage sports cars, one has to assume they depreciate over time. If they're new cars, they likely depreciate the moment you sign on the dotted line.

My natural assumption would be that new cars would depreciate faster than used cars, from a higher base price, and at a steeper rate (duration and convexity). In other words, if the car acts as collateral for the auto loan, one would assume one would achieve lower loan rates on used vehicles.

To cut a long story short, apparently I was wrong. These auto rates for 48 month car loans available in San Diego are courtesy of

P.S. One other consideration may be the credit quality or behavioral patterns of people who buy new cars versus those who buy used cars. One thought, though, is that in this economy the used car purchaser may be the more conscientious. Having said that, I've ignored the possibility that returned used cars may have seen their day (tend to zero value, quickly) whereas some value may remain in returned used cars.

P.P.S. I'm noticing that US Bank agrees with me (re new vs. used car loan rates), but aren't providing this service in San Diego.