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.


simmons said...

loans have come back because they're fundamentally a strong product. Nice pick up though. Wonder if raters think their downgrades actually help anybody if next is simply upgrade when wrong.

Accredited Investor said...

Regulators, ask not whether the credit agencies should be monitored, but ask only how actively they should be monitored and by whom!