Tuesday, August 25, 2009

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."

Wednesday, August 19, 2009

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)

Thursday, August 6, 2009

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.

Monday, August 3, 2009

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.


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