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."

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.