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.