Tuesday, December 21, 2010

The Psychological Biases of Holding Downgraded Bonds

The early days of this economic slowdown brought to our attention a plethora of examples of investors choosing to hold on to downgraded bonds in the belief that “they will come back again,” and that “it is only a temporary market dislocation.”

(Incidentally, it is not traders alone who fall prey to the “return-to-normalcy” ideology. Many of us carry the internal belief, for example, that all will be well immediately a blundering institution recognizes its folly. Being exposed to one’s folly, and fixing it, however are two different things. Thus, history tends to be allowed to repeat itself.)

From a strict utility function perspective, opting to hold on ought probably to prove the inferior choice: downgraded bonds tend to be more likely to be downgraded (again) versus comparably-rated bonds that have yet to be downgraded; moreover, the risk of an associated exponential increase to reg. capital radically changes the risk-return profile of the investment.

But there are a number of psychological forces in play that make investors particularly vulnerable to the need to hold downgraded securities whose market value is quickly diminishing.

Psychological Biases

First is the obvious — that investors exhibit risk-seeking behavior in the face of losses while being risk-averse in the face of gains.

Next, investors originally held some derivative of an innate belief that the rating agencies possessed magical capabilities and material non-public information which resulted in their original ratings being correct and any subsequent rating changes posing mere caveats before the return to normalcy. This “everything will come back again” mentality demonstrates at least two behavioral biases: (i) representativeness, the willingness of investors to base their decisions of superficial (or artificial) characteristics as opposed to underlying probabilities, and (ii) conservatism, the willingness to cling to a prior belief despite the receipt of new information.

Were They Right?

The answer is... sometimes.

Here are certain factors that should be taken into account, followed by a solution to the quandary:

First, rating agencies’ actions are often retroactive: the rating action only occurs well after the fact. In some cases, that means that as an investor you can look directly at the current situation to gauge whether subsequent upgrades are imminent.

Example: according to information we have been provided, one rating agency began downgrading collateralized loan obligation (CLO) securities between September 2009 and May 2010, well after the market shock had ended, with loan prices generally having begun returning to “normal” levels in December 2008. Depending on what indices you examine, loan prices generally went up roughly 40% during calendar year 2009, and this trend has continued in 2010. CLO prices improved too, as have their underlying portfolios. So while the rating agency was aggressively downgrading almost 3,000 bonds during this time period, the underlying loan market and the CLOs themselves were markedly improving.

According to JPMorgan data, the spread levels on 5yr LCDX tightened from 556 basis points to 377 basis points over the relevant Sep. ’09 to May ’10 period, demonstrating the market’s interpretation of decreased credit risk on similar loans to the ones in CLOs. Next, Wells Fargo data show that whereas almost half (49.3%) of CLOs were failing their junior par coverage test as of mid Sept. 09, less than one fifth (18.86%) were still failing as of early May 2010. This key ratio perhaps best describes the improved performance of CLO securities.

Thus, in a market when the rating agency should have been upgrading bonds on a net basis, it (perhaps retroactively) downgraded more than 75% of all CLO bonds rated by them, including 76.27% of all triple A securities they rated, the market was already well into its turnaround and continued to improve. Those downgraded bonds are now being swiftly upgraded.

In other cases the “hold-to-normalcy” trade hasn’t worked as well: trust preferred (TruPS) CDOs seem continuously to be downgraded, as bank failures and bank deferrals continue to plague this market. While in certain markets default rates were significantly lower in 2010 than 2009, there has been an approximately 20% increase in bank defaults this year (annualized) versus in 2009. The credit performance of certain tranches, unfortunately, may never return to their pre-crisis levels.

In it in this light that S&P’s announcement last week was so interesting to us. S&P placed 1196 bonds on CreditWatch negative as they “incorrectly analyzed the timely interest payments, and did not incorporate an analysis of the effect of interest paid pro rata on the senior securities (that, all else being equal, inherently contain lower credit protection than those in which the interest is paid sequentially) for those transactions that have this structural feature. Approximately two-thirds of the classes affected by this CreditWatch action are from transactions issued in 2010 and approximately one-quarter were issued in 2009.”

(To be clear, their misrating of RMBS re-REMICs was not the interesting element. A week prior to this announcement we submitted to the Financial Times a comment letter that described the continued misrating of these securities, click here www.ft.com/cms/s/0/c51bb428-072c-11e0-94f1-00144feabdc0.html. We cite a Re-REMIC rated AAA in 2008 that currently languishes in the CC region.)

The magnitude is certainly severe, but the confession is the focal point, as it allows investors to immediately recognize that, wait, these bonds were incorrectly rated and contain risk in excess of that originally estimated by S&P. In publicly admitting to their error, a true “investor service” was provided to the investors by S&P. Naturally, one might be less enthusiastic about this announcement if one were to own a to-be-downgraded bond.

The next question, of course, is who else rated these bonds? And which rating agencies chose not to rate the bonds as a result of their model not being able to achieve the high ratings S&P's model produced?

The Solution

If you’re an investor, we suggest due diligence. Look into the assets being downgraded. If reg. capital is a question for you as a bank or insurance companies — or margin for leveraged funds — build a model to capture probabilities of being right versus wrong, pre-decision. Work out the probability that a large downgrade is to be followed by an upgrade, versus subsequent downgrades, asset-class by asset-class.

Welcome to the brave new world of investor due diligence.

Friday, November 19, 2010

Meredith Whitney and the Future of Credit Rating Agencies

The popular media are harping on the wrong issue in respect of the future of the credit rating agencies. They say that despite financial overhaul aimed at reducing their influence, “credit raters keep their power” (WSJ Nov. 16) and that “[for] potential newcomers, … , it is difficult to compete against established agencies [like Moody’s and S&P].” (FT Nov. 19)

Rather, the regulatory proposals in both the U.S. and Europe have been quite severe on the rating agencies, demanding both improved transparency and enhancing transparency, which increasing the potential for legal liability; and the very reason that players like Kroll and Meredith Whitney are entering the rating environment is that the established agencies are particularly vulnerable to competition.

To be fair, it is always a challenge to compete against a well-established company. But Kroll and Whitney are seizing the opportunity while the raters are weakened by poor ratings performance, and distracted by the significant increase in both the “volume and cost of defending such [related] litigation.” - from Moody’s (MCO) 10Q

Ratings, as we all know, are interwoven throughout our financial framework. It takes time to remove references to them and there remains a modicum of inertia among market participants in moving away from the Big Three or away from credit raters in general. But there has been a tangible change in momentum, with raters like Canada’s DBRS having already secured a large (majority) share of the U.S. residential mortgage-backed securities (RMBS) market — hardly a sign of “difficulty competing.” (WSJ May 2010)

Rather than being anxious about seeing immediate changes despite the lengthy history, and deeply embedded nature, of credit ratings, we urge the media to rather applaud the substantial regulatory improvements that have been made in respect of reducing reliance on ratings and heightening the integrity of the ratings process. We caution, however, that a material increase in the number of rating agencies leads to greater competition and not to higher quality ratings. More accurately, the readier the supply of ratings, the higher the inflation of ratings provided.

(1) Aside from the 11 SEC approved NRSROs, there are already according to our calculations 108 other debt rating companies worldwide, 18 of which are affiliated in some way or other with one of the NRSROs.
(2) To visit submissions to the SEC, including our submission, on the credit rating reform proposals put forth in the Dodd-Frank Act, click here.

Wednesday, October 20, 2010

The Importance of Being Investment Grade

While references to credit ratings are being removed from statutes and federal regulations (effective July 2012) their position in our existing investment framework remains secure.

We have discussed previously how credit rating downgrades might negatively influence a security's price by decreasing investor demand (some funds and companies, for example, can only buy debt of a certain credit quality) and increasing funding costs (collateral/margin requirements), which may lead to the inevitable vicious cycle.

The deeply embedded nature of ratings in financial contracts is even more apparent when we look at the ramifications of a downgrade on H&R Block's corporate debt (CUSIP 093662AD6), which has been the recent focus of negative attention from the rating agencies. If the debt is downgraded by Moody's to Ba1 or below and/or by S&P to BB+ or below, the coupon on these notes will increase, and the debt will thereby become more expensive to HRB. In other words, if a downgrade is an indication that a company is struggling to meet its obligations, the downgrade in its enactment (by construction) might make said obligations more expensive, which precipitates further difficulty in meeting them. As such, the rating provided is integral to, and certainly not de-linked from, the performance of the security being rated.

These bonds are currently Baa or BBB, investment-grade bonds. However, as the table illustrates, if either rating agency alone downgrades the debt to the Ba1 or BB+ level, the coupon on the bond will increase by 25bps from 7.875% to 8.125%. If both rating agencies downgrade the debt to this level, the result will be a 50bps increase to 8.375%. The interest rate increase is capped at 2%, which will be effectuated if Moody's downgrades the bond to B1 or below and S&P downgrades it to B+ or below.

The (unfortunate) consequence: a downgrade immediately increases the coupon on the bond, which decreases the price. That's in addition to the decreased demand for the bond, the heightened illiquidity, and the increased funding costs for holding the bond. If downgraded, a devaluation of the bond is inevitable, irrespective of the market's opinion of the accuracy of the rating agencies' opinions.

Tuesday, October 5, 2010

Phantom Pricing

Mario Draghi, head of the Financial Stability Board, is making a splash about the loosely regulated “shadow banking system.” While estimates of the size of the system are tough to come by (the FRBNY report suggests $16 trillion) what makes this system a “shadow” system is not its size, but the location of the assets. Who owns what, where?

The provisions of off-balance-sheet accounting made it very difficult to know the exposures of your counterparties, one of the reasons Mr. Draghi felt the shadow banking system to be a key contributor to the crisis: if you don’t know what else your counterparty’s holding, you won’t lend to it in a time of crisis. The lending freeze, then, only serves to exacerbate the crisis for those parties in need of short-term liquidity. A minor disconnect in a small part of the market can therefore lead to panic, bank runs, and mass deleveraging. The scenario painted exaggerates what happened in our financial downturn, but the elements remain true.

The challenge becomes how best to cure this lack of transparency. Unfortunately there are at least three parts at play in this multidimensional version of Heisenberg’s uncertainty principle: we cannot measure the exposure because we cannot see it (questionable balance sheet transparency), we know not what it is (questionable asset transparency) and we cannot rely on the value being associated with it (questionable pricing transparency).

If we could cure the “balance sheet transparency” element, the difficulty would by definition be removed from the shadow banking system. Enhancing asset transparency practices is a regulatory initiative that has begun. The process toward improving pricing transparency, however, remains in its infancy.

Why the lack of transparency? The answer: a lack of transparency in the market creates a money-making opportunity for those parties in the know. The informational asymmetries in the market allow the better-informed market participants to take advantage of those who are guessing at certain characteristics. From The Big Short:

[Yale professor] Gary Gorton guessed that the piles were no more than 10 percent subprime. [Gene Park] asked a risk analyst in London, who guessed 20 percent. “None of them knew it was 95 percent,” says one trader. “And I’m sure that [AIG’s Joe Cassano] didn’t either.” In retrospect their ignorance seems incredible—but, then, an entire financial system was premised on their not knowing, and paying them for this talent.
Absent the ability to perform due diligence internally, market participants grew increasingly dependent on the soundness of advice being offered to them by their broker-dealers, a situation which has created forum for BD litigation. From Confidence Game:

Meanwhile, [MBIA’s lawsuit against Merrill Lynch alleged that] because MBIA “did not and could not perform a cost-effective loan-level valuation analysis of the ML-series CDOs, it relied on and trusted Merrill Lynch’s statements about the quality of the underlying loans.”
Pricing transparency is similarly powerful and problematic. In the deeply veiled world of broker-dealer intermediation, the buyer and seller seldom know each other. The bidder (for example a regional bank or a hedge fund trader) doesn’t know the offerer, nor the offer itself, nor the number of offerers out there, and vice versa.

In other words, neither party knows the bid-offer spread being made by the broker-dealer and they don’t know whether there are many bids or just a few. Buyers and sellers are guessing at the price and the liquidity.

The larger problem, of course, is that for leveraged funds your margin is being dictated by the seller’s price, and that price is not necessarily an independent, unbiased opinion. Back to The Big Short:

“Whatever the banks’ net position was would determine the mark,” [Scion Capital’s Michael Burry] said. “I don’t think they were looking to the market for their marks. I think they were looking to their needs.”
One solution, thus, is to centralize the pricing operations among one or more independent bodies — perhaps among existing regulatory bodies to the extent we can avoid conflicts of interests between their supervisory agenda and their pricing power. Else, why not create a new agency that creates various economies of scale in promoting pricing transparency and consistency in the name of, wait for it, consumer protection.

Monday, September 27, 2010

Credit Ratings Reversals

The debate continues over the usefulness of credit default swaps (CDS) spreads as alternatives to ratings.

Today, Moody’s Corporation announced that its Analytics division – separate from its ratings group – has improved the ability of its EDF (expected default frequency) model to estimate default probability as a result of the incorporation of CDS spreads to the platform.

Moody’s Analytics clearly agrees that CDS spreads provide useful predictive content. So did a fellow panelist of ours at a distressed debt conference on Friday.

Jerome Fons, EVP of Kroll Bond Rating Agency, included the following slide in his presentation (click here to download the presentation in its entirety).

Among other things, it shows CDS spreads to be better predictors of default probability (see the higher Accuracy Ratio).

The slide also displays the lower frequency with which credit ratings are reversed by rating analysts, versus the regularity with which CDS spreads can move from one bucket to another as per the market’s whims.

This feature, as displayed by Ratings Reversals and Rating Changes, reminds us of the human nature of rating agency analysts and in particular their psychological predisposition against reversing a prior rating action. The obvious upside is ratings stability – at the expense of volatility -- to the extent we care for it. Would we want our regulatory capital ratios to move on a daily or secondly basis, as a stock price may trade on the news, or on gossip?

For example, consider the case of Arlington CDO tranche A3. Moody’s and S&P both started off at Aa2/AA ratings, respectively, in the year 2000. In 2002, Moody’s downgraded it more aggressively than S&P, a situation which lasted until 2006, at which stage Moody’s upgraded the bond to A3, which was the then-current equivalent of S&P’s rating of A-. 2009 arrives and Moody’s drops to Caa3, before upgrading to B3 in early 2010 and then Ba3 last week. Moody’s is now just short of S&P’s current equivalent rating of BB+.

While certain market participants might benefit from more regular rating actions, others no doubt value ratings stability above all else. But either way, it seems entirely unlikely that rating stability and ratings accuracy go hand-in-hand.

We remain very interested in the topics of ratings alternatives and the comparison of ratings performance. Let us know if you have a similar interest in these topics.

For more on CDS spreads as alternatives to ratings, click here; to visit our submission to the Fed, OCC, OTS and FDIC on this topic, click here.

Wednesday, September 22, 2010

Basel Dazzle

Jean: Don't you know that it is dangerous to play with
Julie: Not for me. I am insured.”

— from August Strindberg's Miss Julie

Basel III’s newly announced bank capital requirements have received their fair share of criticism from the public media. Many of the opinions shared center on the (expected) limited effectiveness of the increased capital standards.

Indeed it is basic approach to simply bolster the reserve requirement. It has its downsides — stemming growth and lending activities — while also failing to strictly eliminate an eventual default: higher reserves might in certain cases simply allow a troubled bank to linger as a going concern before defaulting, without necessarily staving off the default.

How else to protect against another system-wide financial institution failure?

The first question to answer is whether capital reserves that were in place were being correctly applied and adhered to. If not, it leads one to question whether it is the capital reserves that need increasing or whether it is their application that begs tightening.

Prior capital reserve and accounting requirements encouraged banks to game the system by, among other things:

(1) obscuring their balance sheets and taking as many assets as possible off their balance sheet (see for example the infamous Repo 105; the negative basis trade; Madoff’s supposed year-end movements into Treasuries to thwart auditor supervision; and the various mechanisms uncovered for hiding assets and insurance policies, such as is being alleged in the case of the SEC vs. Sentinel); and

(2) creating, through securitization, phantom diversification benefits that were rewarded by the risk-based capital regimes then in effect.

Thus the converse would be to endorse a system that encourages true diversification on the vanilla asset level — not on complex structured finance and portfolio investment vehicles where diversification is gamed and over-rated (no pun intended). We ought to reward transparency, as well as the usage of up-to-date, reliable, complete and comprehensive data and models, or punish the converse.

To protect against systemic risk concerns, we can further require that the rating agencies, too, remain current on their ratings. This will create a useful buffer against large downgrades, the coup de grâce for many leveraged financial institutions.

From a high-level point of view, one may argue that to avoid a crisis similar to the current one, one has to ensure the incentives that led to our current crisis are adjusted towards promoting active risk management and prudent risk taking. Let’s channel our energies towards fostering an investment environment, a culture of proactive risk, reward and responsibility.

Friday, September 3, 2010

Warning: Insurance TruPS

In an atypical, ominous maneuver, rating agency A.M. Best has today placed on negative watch the ratings of (we believe) all tranches of all trust preferred CDOs rated by them. From the most junior notes to the most senior notes, all in one fell swoop.

The insurance trust preferred CDO securities -- the area in which A.M. Best focused -- have thus far outperformed their bank or REIT TruPS counterparts, which is one of the reasons behind the comparatively stronger performance of A.M. Best's ratings versus others in the TruPS CDO space, thus far (click here for details).

The reason for the negative attention according to A.M. Best?

The rating actions reflect concerns in a number of areas including (1) the growing number of “defaulted securities” and capital securities whose periodic interest payments are in a deferral mode in the various pools; (2) capital securities redemption activity occurring in the pools; (3) increased stress upon the various credit support/enhancement mechanisms; and (4) deterioration in the issuer credit ratings of individual insurance companies and deposit taking institutions within the transaction pools.

Monday, August 30, 2010

Credit Rating Alternatives

At a time of increased tension in and among the larger credit rating agencies, Frank Partnoy, Mark Flannery and Joel Houston have submitted a suitably-titled research piece that addresses "Credit Default Swap Spreads as Viable Substitutes for Credit Ratings."

Inconveniently they have chosen 15 highly liquid financial names for comparison purposes, which unfortunately means their conclusions do not address our concerns that credit default swaps (CDS) spreads remain questionable estimates when the CDS and the rated underlying itself have vastly different trading volumes, or for illiquid or unrated securities (visit our April piece "Credit Ratings vs. Credit Default Swaps").

As the banking regulators consider following the NAIC's lead in finding alternative solutions to relying on credit rating agencies for regulatory capital reserve considerations, another key features to consider is their respective predictive content: do ratings or CDS spreads have any long term opinion associated with them, or are they purely back-looking or point-in-time estimates. The authors attend directly to the search for regulatory scrutiny alternative and the possibility of relying on CDS for this purpose (emphasis added by us):

"More generally, it is apparent that CDS spreads reflect available information, which makes them useful for regulatory and risk management purposes, even if they are not necessarily suitable for forecasting."


"At a minimum, our analysis supports the conclusion that CDS spreads reflect information more quickly and accurately than credit ratings. Specifically, we find that as information about the subprime mortgage exposure of financial institutions was disclosed during 2007 and 2008, CDS spreads reflected that information, whereas credit ratings remained relatively unchanged.

If regulators and investors had looked to CDS spreads to assess the riskiness of financial institutions during this period, they would have found as early as April 2007 that such risks were significant and increasing. By early 2008, CDS spreads reflected a significant likelihood of default by one or more investment banks. In contrast, credit ratings reflected little or none of this information."

Monday, August 9, 2010

FDIC Esoterica – It's Capital

The FDIC is following the NAIC's lead in considering alternatives to credit rating agencies in determining capital reserve standards for their underlying banks. According to the WSJ's "Regulators Plan First Steps on Credit Rating:"

[among] the options being discussed is a greater use of credit spreads, having supervisors develop their own risk metrics and a reliance on existing internal models...
The other option likely to be mulled is the use of service providers and rating agencies outside of the Big Four (Moody's, S&P, Fitch and DBRS). We have contemplated some of the elements of rating operational agency due diligence, here, but ultimately this process would require an understanding of the varying levels of expertise within each rating agency, it's level of accuracy and stability, and the various limitations of its model. (For example, this morning's WSJ reports on Morningstar research that concludes oddly that "using low fees as a guide [to a mutual fund's future success] would give investors better results than even Morningstar's own star-rating system...[because while] the stars system has typically guided investors to better results, it isn't as effective in predicting future returns at times of big market swings.")

The movement towards relying fully on credit default swaps, as contemplated above, seems to us a distant longing: first, CDS liquidity (not to mention maturity) isn't always comparable to that of the securities being referenced resulting in an imperfect spread-to-risk mapping; next, we are yet to witness substantial research evidencing the predictive content of CDS spreads on unrated securities; last, it remains questionable to what extent CDS spreads directly mimick the underlying's fundamental credit risk. (See Credit Ratings vs. Credit Default Swaps for more on this.)

There are at least three reasons why we would welcome the FDIC's direct participation by analyzing the securities interally:

1 - If the FDIC decides to create its own models, they'll be better equipped to appreciate the risks inherent in the securities being purchased by the banks they're to an extent insuring. Not only will they be less reliant on credit rating agencies, but also on broker-dealers' and third-party providers' differing opinions.

2 - With investor sophistication levels having (unfortunately) softened from a legal perspective, it augurs well to have a regulator play an active role in overseeing the investments being allowed by its underlying members. They would be better positioned to push back on riskier investment activities, or to encourage improved hedging or risk mitigation techniques on the bank or system level.

3 - Aside from the obvious advantages of treating all banks equally, the other benefit of having regulators play a more active role in examining capital adequacy reserves is the informational advantage they bring to the table:

For a real-life example, consider the $60bn world of trust preferred securities CDOs (or TruPS CDOs), whose performance depends on the performance of its underlying banks. Who would be better positioned than the FDIC to have an accurate handle on future bank defaults? With a model to support them, the FDIC can estimate the effect of default of all banks they consider to be poorly-positioned or undercapitalized. As it happens, in somewhat circular a fashion, banks (like Zions Bancorp) often also hold TruPS CDOs, which are themselves supported by other banks. Thus, the FDIC will be able to model the exact public utility of allowing a bank to prepay on its preferred securities at a discount, as they'll be able to measure the overall affect of that bank's prepayment on all TruPS CDOs holding that bank's preferreds; and they'll know how much each other bank holds of those TruPS CDOs which hold the original bank's preferreds. Ah, the beauty of information!

As an alternative, banks holding TruPS CDOs have been subjected to abysmal ratings performance which has come in tremendous waves of downgrades by rating agencies that in some cases are not rating the underlying banks and in other cases are guessing at how the models will perform.

From a recent American Banker article entitled "TruPS Leave Buyers in CDO Limbo:"

According to Fitch's Derek Miller, the agency is "in the process of reviewing all our assumptions" on trust-preferred CDO defaults and deferrals. For recent rating actions, he said, Fitch did not do precise cash-flow modeling, because it felt that the nuances of the capital structure have been drowned out by the sheer volume of defaults and deferrals that determine payouts.
Knowing just how sensitive some banks are to ratings changes en masse, we're excited at the prospect of the FDIC becoming more hands-on, and potentially smoothing the shocks. In this way, not every ratings failure need precipitate a liquidity crunch, a lending freeze, or a public-sector intervention.

Thursday, July 1, 2010

Trust Preferred CDO Update

We ended last year with a special report on what we saw as the changing nature of banks’ “choice” to defer. Our piece, entitled “The Tripping Point” concluded as follows:

“…while data remain scarce for the illiquid, opaque world of bank trust preferred securities in TruPS CDOs, our preliminary analyses tend to support the theory that not all deferring banks are poorly positioned, under-capitalized institutions. As we monitor the situation and continue to gather further evidence to either support or reject this argument, we eagerly anticipate a conclusion that not all deferring banks are doomed to fail.”
Since January 1, 2010, we have an increasing DEFAULT rate on banks in general. Using the FDIC’s cohort of 8,012 FDIC-insured financial institutions as of 12/31/09, we calculate a roughly 2.24% annualized default rate as of June 18, 2010. This default rate constitutes a 46% increase since the September 30, 2009 annualized default rate of approximately 1.53%, which was based off a 12/31/08 cohort of 8,305 FDIC-insured financial institutions.

(PF2’s base projections anticipated a roughly 50% weighted average increase of this 1.53% default probability over the forthcoming two years. Having realized this 46% increase, and from our various conversations with market participants and regulators, our best guess estimate is to anticipate another weighted average increase of 35%, over the forthcoming two year period. Thus, over the coming period, we attach an expected default probability of 3.02% to the average performing bank in our analysis of TruPS CDOs.)

We also encourage you to visit some of the excellent investigative journalism that’s been covering the TruPS market this year. Here follow some key pieces that provide insights into the differing pressures on and by banks, CDO investors, and external market participants. Amongst other things, the two June articles throw further light on the possibility that certain banks are opting to defer simply as a ploy to encourage investors to allow them to pre-pay their preferred securities at a discounted. (Of course this is not always the case, and banks certainly have the right to defer on their preferreds.)

June 11, 2010; American Banker: Blocking Rescues, or Challenging Bum Deals?

June 8, 2010; Bloomberg: Banks in `Downward Spiral' Buying Capital in CDOs

March 19, 2010; Bloomberg BusinessWeek: CDO ‘Samaritan’ Hildene Duels Funds Over Collateral

April 27, 2010; American Banker: TruPS Leave Buyers in CDO Limbo;

Thursday, June 24, 2010

In Due Diligence We Trust

Guildenstern: We only know what we’re told, and that’s little
enough. And for all we know it isn’t even true.

Player: For all anyone knows, nothing is. Everything has to be taken on trust; truth is only that which is taken to be true. It’s the currency of living. There may be nothing behind it, but it doesn’t make any difference so long as it is honoured. One acts on assumptions. What do you assume?”

- Tom Stoppard’s Rozencrantz and Guildenstern are Dead

As we battle a crisis among crises, the informational asymmetry between sophisticated and unsophisticated investors becomes all the more striking.

The so-called sophistication level requirements have conveniently lingered despite the increasing complexities brought on by financial innovation: the dollar amount of income or net worth for natural persons to be considered “Accredited Investors,” for example, has not been adjusted for inflation in the almost 30 years since it was originally adopted; similarly investments in auction rate securities (ARS) were initially limited to institutional investors with minimums of $250,000. In recent years the minimum level has been brought down to $25,000 in an effort to lure as many market participants as possible, and more worryingly to make ARS available to the general public.

(“Accredited Investor” is defined to include natural persons having an annual income of $200,000 -- or $300k with spouse -- over specified periods or a net worth of $1mm or more. ARS typically refers to either municipal or corporate debt securities or preferred stocks which pay interest at rates set at periodic auctions. The market for ARS, prior to the collapse of the auction market, purportedly stood at around $350 billion.)

As such, Accredit Investors have over time become far less “accredited.” More importantly, the less “accredited” investors were being allowed to purchase increasingly complex securities. Investors, not wanting to look bad, chose to trust others rather than give voice to their lack of understanding. They place their trust in their lawyers, accountants, financial advisers and brokers. And the rating agencies.

They trust these parties differently: they trust their lawyers, financial advisers and brokers to act in their best interests and to be mindful of their risks. They trust them based on their credentials, the lengthy relationship they’ve had with them in the past and the fact that they have supervisory boards (e.g., FINRA, FASB and the SEC) tasked with ensuring they behave properly. They trust the rating agencies to provide an independent, objective opinion that has no party’s ulterior motives at heart and accuracy as its only goal.

Unable to perform their internal analysis, investors increasingly had to blindly trust the rating agencies’ ratings, from both a modeling perspective, and from an unbiased credit risk opinion perspective. Less sophisticated investors tended to rely more heavily on analyses performed by the rating agencies. More sophisticated investors, like Paulson, worked day and night to take advantage of their analytical advantage, by finding and betting against those bonds whose ratings least reflected their true credit quality.

The opaque, private securitization market provided a handy tool for poorly incentivized parties to take advantage of less sophisticated parties: the immature securitization market is noted for its lack of transparency and disclosure. More recently it has been marked by its misrepresentations. Battles continue to be fought over who owns the rights to the mortgages underlying the mortgage-backed securities vehicles; the bankruptcy process for off-shore vehicles remains underdeveloped relative to the United States; off-shore legal counsel seems nowhere to be found; and the complexity of some of the special purpose entities (and the number of different interests being represented) creates havoc for our litigious society.

In sum, the securitization market was particularly susceptible to being abused. And it was abused. The SEC vs. ICP case, seems only the tip of the iceberg as we begin to examine the repercussions that come from the several incentive misalignments that are apparent throughout the securitization vehicle. We are abounding with conflicts of interest while informational asymmetries, resulting in various forms of moral hazard, proliferate.

Economy-wide, we have realized that we need to encourage, if not force, the investor to perform necessary levels of due diligence both pre and post investing in complex securities. We need to impose adequate safe-guards on these vehicles to ensure that they are not mismanaged, and that managers are incentivized to manage across the capital structures, in the spirit of the deals. We also ought to encourage regulator responsibility, and permit them the authority necessary to step in sooner – to act before the problems become insurmountable. The recent, indefatigable, examiner activity seems too little too late. But it is crucial that the standard be set.

Friday, June 11, 2010

TruPS CDO Ratings Performance

Click on the diagram to enlarge it


(1) Performance includes bank, insurance and REIT TruPS CDOs.

(2) The data show no upgrades on any tranches by any of the rating agencies.

(3) The migration tables indicate an average downgrade in the region of 12 rating subcategories; downgrades are continuing to this day.

(4) Often the same tranche is rated by more than one rating agency.

(5) The tranche ratings exhibited, in some instances, continue to benefit from the rating of the insurer, to the extent the insurer's rating remains stronger than that of the underlying tranche.

(6) The vast majority (91.76%) of the deals closed in the region between 2003 and late 2007.

(7) Please visit cdodatabase.com for more information on TruPS CDOs.

(8) Data on TruPS CDO issuance can be found here.

Monday, May 10, 2010

The Carry Trade from Off-Balance-Sheet Heaven

The Citigroup-structured CDO, Adams Square Funding II, Ltd., closed in March 2007 with the $600mm Class A1 Floating Rate Notes (Due 2047) not being offered by Citi; rather the A1 notes were being insured by a swap counterparty by way of the then-convenient-and-now-infamous negative basis trade.

By insuring this A1 tranche trade (Ambac Assurance was reportedly the ultimate swap counterparty), Citi was able to lock in substantial up-front “profits” on the trade in addition to their significant underwriting fee. FASB’s accounting regime (1) enabled the so-called profits on the trade to be recognized immediately, by way of “sale accounting,” and (2) allowed the trade to disappear into off-balance-sheet oblivion, away from Citigroup shareholder verification.

The negative basis trade was perpetuated by several banks for many reasons, as described more comprehensively here. The forthcoming chart provides what we believe to be a thorough breakdown of the minimum estimated up-front profit -- of approximately $9.8mm -- Citigroup would have been able to achieve in having the A1 wrapped by a monoline guarantor.

Indeed UBS’s shareholder report explains that

[UBS’s] CDO desk viewed retaining the Super Senior tranche of CDOs as an attractive source of profit, with the funded positions yielding a positive carry (i.e. return) above the internal UBS funding rate …


Day1 P&L treatment of many of the transactions meant that employee remuneration (including bonuses) was not directly impacted by the longer term development of positions created…

UBS may have made larger sums on the deals they had wrapped: UBS’s cost of credit default swap (CDS) protection was on average as low as 11 bps, or 0.11%.

The ability to lock in such enormous, fictitious, gains (and potentially distribute some of these gains immediately in the form of bonuses to investment bankers) proved to be a major contributor to the financial crisis. With the under-capitalized monolines – such as ACA, AIG, Ambac, CIFG, FGIC, FSA, MBIA, Radian and XL -- struggling or failing to support the credit protection contracts they had over-sold, several of the TBTF banks were forced to rely on the government’s (and taxpayers’) aid to fund the ultimate return to their balance sheets of what we estimate to be $300 billion of off-balance-sheet negative basis trade securities.

Other resources: a diagram describing the trade more generally, in its context relative to the CDO, can be found here.

Wednesday, April 28, 2010

Credit Ratings vs. Credit Default Swaps

As an alternative to relying overly on ratings produced by credit rating agencies, several ratings reform proposals offer the usage of bond or credit default swap (CDS) prices or spreads as a more plausible option. Some of these proposals are positively suggestive of the fact that market prices are both more accurate and more predictive than credit ratings.

I’m not convinced.

Firstly, with ratings being so deeply embedded throughout our financial structure, the ratings of the assets themselves become an integral component of the market-implied risk assessment. For example, even when analyzing securitized products Vink and Fabozzi (2009) show credit ratings to be a major factor accounting for the movement of primary market spreads. Thus, for any proposal to be convincing it would have to test the accuracy and reliability of CDS spreads on unrated bonds or companies. Alternatively, a study would need to compare the performance of traded securities whose ratings are not publicly known (also known as shadow ratings) to the performance of those shadow ratings.

Secondly, bond yields (or spreads-to-swaps) and credit default swap premiums are largely incomparable to credit ratings for many reasons. These differences will have to be tackled in a separate piece, but at the very least there’s that non-insignificant concept of liquidity. Both CDS premiums and bond yields include the various risks – not just credit risks – that come with investing in, or buying protection on, a security. Credit ratings speak solely to long-term credit risks.

One may argue that the ratings were far less accurate than CDS spreads during the crisis, and that this (i.e., during a market dislocation) is the only time we depend on accurate default projections and we should therefore abolish rating agencies in general. While I don’t wish to complain of these proposals, I fear that they complain unfairly of the rating agencies.

Yes the CDS spreads may better reflect default probability during a crisis. By definition they’re more adaptive to changing market conditions, versus the ratings which are long-term predictors. But would you want ratings to change in as volatile a fashion as CDS spreads? Would you want ratings to depend on headline news, or on audited (or lightly audited) financial data? Also, one shouldn’t forget that CDS spreads on CDOs and RMBS tranches were just as poor reflections of market-perceived asset quality before the crisis. The crisis could only occur, in part, because the banks were able to buy protection so cheaply from the monolines, by way of being long the CDS -- the infamous negative basis trades.

But even if these proposals made sense and even if their hypotheses were correct, they would be missing at least one crucial point: we need ratings. Meaningful ratings are essential – certainly now. Let me explain why, albeit by way of a long-winded explanation.

For financial reform to be successful it needs ultimately to deal with the flaws in our banks’ risk management procedures – and to deal with them in an environment in which the very serious practice of risk mitigation is left by senior management to risk managers, just as the serious business of growing revenues while attending to shareholder pressure is left by risk managers to upper management.

That these two functions are more adversarial than independent in nature is a concept not to be lost on us. Overly cautious risk management might hinder the implementation of growth opportunities, or the extent thereof. At times, indeed, they may be thought by the skeptic to be mutually exclusive.

Indeed the overpowering pressures that come with business initiatives can influence even the most judicious risk manager’s ability to perform her function in an objective manner, even though her function ought to be both separate from and independent of the business strategies. (See for example “Lehman’s Worst Offense: Risk Management.”)

With both traders and management being compensated for revenue generation, and with prudent risk managers acting only as a hindrance to the initiation and exploitation of growth opportunities, there remains little incentive for senior managers to maintain a healthy risk management environment. Instead of cultivating an environment in which risk managers are educated in monitoring the real risks (which requires expensive resources including personnel, data and systems) they are seen rather as a burden and a cost center, and are therefore starved of the resources necessary to question traders, trades, and trading strategies.

In sum, we remain in the infancy of creating a functioning risk control practice in place at our major banks. We are yet to promote adequate business-peer challenge processes and our price verification processes remain immature. Credit ratings, if created and applied properly, can provide a healthy starting point for internal skepticism; they can provide the independent credit risk assessment that supplements an analysis performed by the front-office or by the back-office.


CDS spreads are untested as a predictor of long-term default probability on unrated securities. Perhaps the reliability of CDS spreads depends on the underlying referenced entity being rated. There’s no doubt that CDS spreads are useful indicators – but I seriously doubt that they’re anywhere near as useful as ratings in predicting long-term default probabilities or losses.

I remain convinced there's an important place in our market for one or more independent agencies to provide their objective opinions in the form of a rating. For ratings reform to be successful, however, requires that the necessary measures be put in place to ensure that rating analysts are unfettered by market share concerns, and are incentivized only by ratings quality and accuracy. If we can achieve these objectives, ratings will return to providing a meaningful utility.

Monday, April 19, 2010

The SEC v. Goldman Sachs

The civil suit filed by the Securities and Exchange Commission against Goldman Sachs revolves around a combination of three patterns we have seen recently:

(1) the ability of external parties to adversely influence the portfolios that support securitized vehicles (see for example the Magnetar trade or the TPG trade);

(2) the harmful effects of the negative basis trade (according to the New York Times article, seven of Goldman’s Abacus deals were wrapped by AIG); and consequently

(3) the capacity for ratings to be “gamed.”

Ultimately, the complexity and opacity of the structured finance product make it susceptible to abuse by poorly incentivized parties. Securitization is abounding with conflicts of interest while informational asymmetries, resulting in various forms of moral hazard, proliferate.

But none of these problems would exist if ratings were always perfect: the negative basis trade would never have existed and the Abacus deal’s reportedly poorly-selected portfolio would never have received the ratings it was able to achieve.

And so we must deal with the very serious business of underwriters “gaming” the ratings system, which jeopardizes both the accuracy and the integrity of ratings and the ratings process.

But first we need to understand the observer effect.

The Observer Effect

In the social sciences any framework or methodology is subject to what is called the observer effect. The observer effect deals broadly with the process by which subjects alter their behavioral patterns on becoming aware of a test’s objectives.

Consequently, behavior induced by the methodology can be different from that on which the historical data was based. The subjects’ response varies based on the incentives of the subjects and the potential complexity of the underlying product.

The problems for ratings become most apparent when the incentives of the subjects (e.g. mortgage bankers) vary significantly from those of the creators of the methodology (i.e. rating agencies). The assumption, or hope, that models and careful study of the historical data can overcome the misalignment of incentives has been shown to be a fallacy: poorly incentivized market participants were able to create products and scenarios never contemplated by historical analysis.

How? Suppose we have a duopoly of rating agencies X and Y. Rating agency X decides that according to its internal calculations, it will more heavily scrutinize a particular quantitative factor – the borrower’s FICO score – when considering the quality of a mortgage for the purposes of its ratings methodology. Rating agency Y, however, discloses that its methodology predominantly hinges on the loan-to-value (LTV) ratio of each mortgage.

As an originator of mortgage loans (or structurer of RMBS securities) if you have a package of loans possessing high FICO scores, capitalistic tendencies will encourage you to approach rating agency X for your rating.

This is known as ratings arbitrage, or “gaming the system.” A more realistic scenario may be that once rating agency X publicly discloses that it considers FICO to be the key driver of mortgage performance, mortgage originators or structurers, will seek to put together a bunch of comparatively cheap mortgages representing high FICO score borrowers but with very poor other qualities and bundle those together in an RMBS to be rated by rating agency X. Originators might specifically target high-FICO individuals, knowing they’ll be able to off-load these mortgages by way of an RMBS to be rated by rating agency X, almost irrespective of the other qualities pertaining to the borrower (e.g. salary) or the mortgage itself (e.g. documentation level). While FICO score may have originally been a key driver of mortgage performance, all else equal, these high-FICO pools now significantly underperform.

Thus, due to what we call customization — or active adverse selection – rating agency X’s RMBS analysis turns out to have been inaccurate or compromised. (The “problem” of customization is not limited to the selection of the portfolio, but may include adverse selection of the securitized vehicle itself, or counterparties to the structure. Like the product itself, the problem is multidimensional.)

If the rating agencies continue to publicly disclose their procedures they will need to be increasingly adaptive and accurate in our computationally-intensive market, lest their rating models be otherwise gamed. They will have to be nimble and swift, like investment banks: they will need to be everything they currently are not.

The regulatory drive towards creating multiple rating agencies presumes that increased competition encourages higher standards. Niels Bohr noted that “the opposite of a great truth is also true.” In this situation, perhaps the flip-side is a greater truth: that as far as creating rating agencies goes, less is more.

Ratings competition was a key driver in the decline in standards, with rating agencies competing on ratings for market share: higher ratings translate into increased market share, which is crucial for publicly-traded companies.

The more models and options available, the easier it is to arbitrage the system, finding the least conservative rating agency to rate each particular pool of assets.

Monday, February 8, 2010

Choose Your Own Adventure

In good times anything is possible. Second class managers can raise capital for new funds; corporate debt managers suddenly become experts in structured finance; and trust proliferates.

In good times risk-averse pension funds invest in ABS CDO equity and traditional managers go for the exotics, be they weather derivatives, airline securitizations or bonds secured by the future royalties from David Bowie’s music. In good times small managers win bids to manage multi-layered complex CDO-squared portfolios supported by actively-managed leveraged loan funds, ABS CDOs, CDOs supported by commercial real estate, bond funds, trust preferred CDOs and other CDO-squareds, collectively; and structurers can sell anything, everything. Oh, in good times

… anything is possible. And if it shouldn’t be possible, it can be hidden away behind all the growth that we are seeing -- and we can be easily distracted by, and forgiving due to, all the peripheral positives.


In bad times everything is illiquid. Those same managers no longer have the experts around who made them believe their forays into alternative exotics would pay off. Those exotics lie in side pockets, either unanalyzed or constantly scrutinized -- but no longer ignored.

Oh in bad times the too-big-to-fail become too-big-to-succeed and have to be trimmed to take advantage of overlaps and economies of scales.

... in good times we overcome our animalistic instincts to preserve. Utility theory trumps our innate loss aversion and for a short while the concept of risk leaves the dictionary.

Then we blink, take a good look around and troubled times have come
to My Hometown.

Friday, January 29, 2010

Counterparty Risk

In 2009 we discussed in great depth many of the risks relating to both CDO structures and to their underlying securities. We'll continue to explore these nuances in 2010, but first we'll kick off with one of the risks we only covered lightly in '09 - counterparty risk.

Stepping back for a second here: the key concept is that in the complex, opaque and illiquid world of CDOs, at each credit rating level you were being paid more -- higher coupon or spread -- to assume additional risks, other than credit risks. These include but are not limited to illiquidity risks, model risk, operational, legal and counterparty risk.

We commented in a NYSSA article that: "We desperately need to move away from a culture in which investors, sophisticated or not, would buy the highest-yielding asset at each rating level, irrespective of its other-than-credit risks and without having performed an adequate analysis (or even possessing the tools or skills to perform such an analysis)."

The recent U.S. Bankruptcy Court ruling in the Dante CDO lawsuit captures several of these key risks: complexity, model risk, counterparty risk and legal risk. For an immature product (synthetic CDOs) supported by an imperfectly defined-or-tested bankruptcy process, the several layers of risks and dependencies inevitably give way when the unexpected occurs: in this case, the default of Lehman Brothers. (Lehman was single-A rated, not AAA, and so it raises an additional eyebrow that its default should impinge upon the performance of a tranche whose AAA ratings were designed to have been removed from any such dependencies.)


Here follow some choice extracts from the ruling:

"This is a matter arising out of a complex financial structure that includes an added layer of complexity due to the pendency of parallel and potentially conflicting legal proceedings in this Court and the United Kingdom. The litigation in England (the “English Litigation”) was first commenced in the High Court of Justice, Chancery Division (the “High Court”) followed by an appeal to the Court of Appeal, Civil Division (the “Court of Appeal” and, together with the High Court, the “English Courts”). At issue both here and in the English Courts is the priority of payment to beneficiaries (one a noteholder and the other a swap counterparty) that hold competing interests in collateral securing certain credit-linked synthetic portfolio notes. The swap counterparty is Lehman Brothers Special Financing Inc. (“LBSF”), one of the Lehman entities whose chapter 11 case is before this Court.

... After a trial, the High Court issued a judgment in which it held, inter alia, that LBSF’s interest in the collateral securing the Swap Agreements (the “Collateral”) was “always limited and conditional,” and, therefore, payment pursuant to Noteholder Priority did not violate the so-called “anti-deprivation principle” under English law.

... the Court has learned that the Debtors are perhaps the most complex and multi-faceted business ventures ever to seek the protection of chapter 11. Their various corporate entities comprise an “integrated enterprise” and, as a general matter, “the financial condition of one affiliate affects the others.”

... The issues presented in this litigation are, as far as the Court can tell, unique to the Lehman bankruptcy cases and unprecedented. The Court is not aware of any other case that has construed the ipso facto provisions of the Bankruptcy Code under circumstances comparable to those presented here. No case has ever declared that the operative bankruptcy filing is not limited to the commencement of a bankruptcy case by the debtor-counterparty itself but may be a case filed by a related entity -- in this instance the counterparty's parent corporation as credit support provider. Because this is the first such interpretation of the ipso facto language, the Court anticipates that the current ruling may be a controversial one, especially due to the resulting conflict with the decisions of the English Courts.

One of the distinguishing characteristics of the Lehman bankruptcy cases is the complexity of the underlying financial structures many of which are being analyzed for the first time from a real world bankruptcy perspective. It is to be expected, as a result, that the cases of LBHI and LBSF on occasion would break new ground as to unsettled subject matter. This is one such occasion.

This decision places BNY in a difficult position in light of the contrary determination of the English Courts confirming that Noteholder Priority applies to claims made against it in England by Perpetual. This is a situation that calls for the parties, this Court and the English Courts to work in a coordinated and cooperative way to identify means to reconcile the conflicting

For more on counterparty risk in CDOs, see: Hedged Trades: Lessons from the Crisis (slide 9)

If you haven't already joined us at our Ratings Reform website, please visit http://ratingsreform.wordpress.com/. We look forward to your comments and suggestions throughout 2010, and beyond!