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.