The Art of Pricing (and the Heart of the War)

The fight for transparency in the financial markets is gaining traction.

Even maverick Judge Rakoff, in his SEC v. Citi settlement ruling, got in on the act with commentary that resonates: “In any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth.”

The recent media coverage on the transparency issue is particularly acute as it pertains to asset pricing transparency, which is becoming ever more important as the market seeks alternatives to ratings-based capital allocations, per the requirements of Dodd-Frank.

The problem is that while each asset has only one rating (from each rating agency), there’s no consistency of pricing from one bank to the next. We fear that absent a centralized or standardized solution, any mark-to-market pricing will continue to cause headaches in markets where assets aren’t actually traded (there’s no ready or visible price).

Floyd Norris explains in a recent piece that “[under] the [accounting] rules, banks have a choice of three ways to report the value of identical securities. Even if two banks are using the same valuation method for the same security, they can come up with different values, and it is very difficult for an investor to get any feel at all for just how optimistic, or pessimistic, a bank’s estimates might be.”

He also brings in a quote from former FASB member Ed Trott, explaining that “’we are moving back to the past’ by increasing the ability of banks to massage their numbers as they wish.”

This revelation (unfortunately) jibes well with Gretchen Morgenson’s commentary in her piece entitled Slipping Backward on Transparency for Swaps. Gretchen explains that “[right] now, many swaps are traded one-on-one, over the telephone. The price is usually whatever the dealer says it is.” (Recall in Michael Lewis’ The Big Short, when Scion Capital’s Michael Burry warns that “[whatever] the banks’ net position was would determine the mark,” and that “I don’t think they were looking to the market for their marks. I think they were looking to their needs.”)

And the problem isn’t limited to the comparability of asset valuations at the Big Banks. The Big Auditors are also coming a cropper in their audits of banks. Norris explains in a separate piece that analyzes the PCAOB’s oversight reports of KPMG and PricewaterhouseCoopers: “[one] virtually identical criticism of the two firms could be a sign of the way all the firms have been auditing how banks value hard-to-measure financial assets.”

“In three of these audits,” the board wrote in its report on KPMG’s audits done in 2010, “for certain financial instruments the firm obtained multiple prices and used the price closest to the issuer’s recorded price in testing its fair value measurements, without evaluating the significance of differences between the other prices obtained and the issuer’s prices.”

With the banks being able to extract greater margins from opaque markets, the war over asset price transparency is currently being won by the might-makes-right team.

But a more simple solution that levels the playing field for investors big and small, and reduces the burden (and cost) of each auditor having constantly to reinvent the wheel, is to create a central platform for pricing.

Confidence will increase in the adequacy, verifiability, and consistency of financial statements. Regulators would have a field day and investors would be better able to spot when they’re being fooled. Of course the Banks wouldn't be too happy.

Here’s an analysis we put together of the material benefits afforded by a centralized (and perhaps standardized) pricing solution.

Update Dec. 2: According to a Bloomberg article by Jesse Hamilton that came out this morning (SEC’s Data Crunchers Find Red Flags Leading to Hedge-Fund Cases), the SEC through a prorietary tool, has been increasingly been taking action against hedge funds for misconduct including "fraudulent valuations and misrepresenting fund investors."

Hamilton brings in a relevant quote from Bruce Karpati, co-chief of the SEC's asset management enforcement unit:

“Hedge-fund managers depend on valuation and performance for both their compensation and marketing,” ... “These managers have either manipulated performance or engaged in other falsehoods in order to line their own pockets at the expense of investors.”

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For a updated list of disputes around asset prices provided, click here.

Cross-Border Collateral Complexities

by PF2 consultant Rick Michalek

It's 11:59pm. Do you know where your collateral is?

The question of how to locate and ensure the realization of security is often asked, but rarely definitively answered, particularly in international complex derivative transactions. In an ever increasing number of cases, lenders - and counterparties and their insurers - have been forced to ask exactly this question.

The question is becoming increasingly relevant. Consider the following from a recent Press Release from the Office of the Trustee for the Liquidation of MF Global Inc. (published 11/21/2011)

"Further complicating matters, assets located in foreign depositories for customers that traded in foreign futures are now under the control of foreign bankruptcy trustees, and while the Trustee will pursue them vigorously, it has been his experience that recovery of these foreign assets may take more time. The Trustee's counsel has also stated in open court that the Trustee has only relatively nominal proprietary - that is non-customer - assets in his immediate control."

The "recovery of foreign assets may take more time...." is the key issue, and one that remains despite the wholehearted attempts by the regulatory bodies both in the US, the UK and elsewhere, to address the long standing challenge of rationalizing international and inter- jurisdictional processes for the realization of posted and pledged collateral.

Those experienced with derivative structured finance transactions will recall the litany of "assumptions" contained in the typical security interest opinion delivered by deal counsel and relied upon by the transacting parties. The utility and reliability of that legal opinion was conditioned on every single one of those assumptions being true at the time of delivery. The diligence required in verifying those assumptions was often "delegated down", and whether that diligence was fully and accurately performed - often under the pressure of a closing deadline - is critical to the ultimate outcome when pursuing collateral.

Mirroring those assumptions, the deal's legal opinions will also include critical "qualifications", including those related to the location of the collateral. Exceptions would inevitably be made to cover the possibility of collateral being moved out of relevant jurisdictions after the date of closing (particularly relevant to those secured by physical notes or other forms of indebtedness).

In multi-jurisdictional transactions, involving collateral originated in legal jurisdictions lacking well-developed protocols for settling competing interests of creditors residing in different jurisdictions, a trustee may be faced deciding which of the mutually inconsistent judgments it will recognize and honor. Creditors thinking of suing might want to delve deeply into the documentation - a decision that may make the difference between covering the costs of litigation or suffering the sting of a pyrrhic victory of having paid to prevail.

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To get in touch with the author of this piece, email Rick at rm@pf2se.com

Return of the TruPS CDO

The good news, for investors in TruPS CDOs, is that at least one rating agency has responded to our calls for upgrades.

Moody’s, in two separate actions over the last two weeks, upgraded three tranches of Trapeza CDO VI and two tranches of Alesco Preferred Funding CDO I.

All five of the upgraded Alesco and Trapeza bonds were previously downgraded on July 13, 2010.

When you analyze ratings migrations, you notice raters have a tendency to inflate the initial ratings on new structures (the “Type I” error). When things go wrong, rating agencies then tend to exaggerate their downgrades to avoid being caught looking foolish when AAA or AA securities default. But they then run the second risk, which is seldom monitored or advertised, of the “Type II” error – the rating too low of a security that pays off in full. Both of these errors have the potential to be damaging to investors: investors get insufficient coupon reward for taking outsized risks at the beginning, and then they pay too much, in ratings-based margin, for holding under-rated bonds after the magnified downgrades.

We felt we had noticed the exaggeration of downgrades for at least some TruPS CDO bonds. We expect certain of the bonds that have been downgraded, to as low as CCC, to pay off in full. We therefore called for upgrades, of at least certain of these bonds, after noticing a growing disconnect between the actual asset-level performance of TruPS CDOs and the ratings performance of the asset class.

Upgrading bonds is a good thing for TruPS CDO investors: it may provide the support needed to mark them up, or to reduce capital reserves (or margin) held against them. In the best case, for bonds expected to ultimately pay out in full, the upgrade provides “leverage” for small bank managers to justify holding these securities at par in hold-to-maturity accounts; or to combat regulatory pressure to mark them to fair value based on an OTTI write-down.

While Moody’s upgrading intentions are a healthy sign, they do not always precipitate a similar response from the other rating agencies in the short term:

- The upgrades are due, in no small part, to the generation of excess spread by the underlying assets. Fitch, for one, does not model these structures and so by definition cannot adequately capture, in their ratings, the effects of this excess spread. It may thus be reasonable to expect Fitch’s TruPS CDO ratings to linger in this regard, until they ultimately follow the direction of the other rating agencies. (To be fair to Fitch, Fitch did in its September review retroactively upgrade a single tranche when Fitch saw the tranche was being paid down – but it also downgraded seven tranches and affirmed the ratings of 488 tranches. The A2 tranche of PreTSL 8 was upgraded, wait for it, from CC to B, less than one year after it was downgraded from B to CC. The bond was originally rated AAA by Fitch.)

- Rating agencies also, understandably, have a natural tendency to want to avoid flip-flopping on their ratings. The CLO downgrade-turn-upgrades within a year have caused the raters significant embarrassment. How will they look if, so soon after downgrading these 30 year TruPS CDOS, they then re-upgrade them? The market may be led to believe that the raters’ economic models hold little predictive content.

Trading in TruPS CDOs presents serious money-making opportunities, heightened somewhat by the ratings arbitrage available: for example, the recently upgraded A1A tranche of Trapeza VI is now rated Aa3 by Moody's, A by Fitch, while rated CCC+ by S&P. This dynamic should also provide holders with all the encouragement they need to examine the “true” flow of funds of their TruPS CDOs, rather than relying purely on their ratings (and succumbing to associated regulatory pressure to boost reserves).

What Value the Rating?

I often ask myself how valuable any sell-side research can be, given the obvious conflicts being suffered through by a banks’ research team. The attributes that undermine the effectiveness of a banks’ research analysis are numerous – here are some:

1. the bank typically has many more buy recommendations than sell recommendations (The Big Short’s Vincent "Vinny" Daniel neatly captures the conflict when he says “You can be positive and wrong on the sell side,”… “[but] if you’re negative and wrong you get fired.”)

2. similar to the prior point, the uneven distribution of ratings renders the “buy” rating less meaningful

3. the accuracy of a rating isn’t easy to test, as its term and range isn’t always well-defined

4. the rating changes with regularity, and so never adjusts or converges to a final number, so the same analyst may appear right then wrong then right again. Were they right, overall? (see for example “S&P upgrades Google stock days after "sell" view”)


I remember chatting, a while back, to a former sell-side research analyst from a so-called Yankee Bank about what it was like rating stocks during the heat of the financial downturn (2007-2008).

He commented on the futility of his position: his predictions may just as easily be right as wrong, given the heavy influence of emotions, or market technicals, rather than any reliance on company fundamentals – which he was being asked to judge.

But he also described his position as awkward: in a market in which he truly expected almost everything to keep going down, he wasn't in a position to issue sell ratings on all his stocks. Why maintain a buy rating, or a hold, if you really think the client out to sell? But what effect would be produced if you put a sell rating on everything? Putting a sell rating is bad for business, and by way of the influence banks wield in providing ratings, serves only to increase the likelihood of a further decline, or to exacerbate that decline.

So in a down market, we have an influential bank analyst, who otherwise provides useful market color, feeling his position to be both awkward and futile.

I remember his remarks from time to time, especially when people ask me what I think of the US downgrade by S&P or the downgrading of other sovereigns like Italy or Spain.

While the downgrade may or may not be the right action, from a legal perspective based on the code of NRSRO ratings, one has to wonder what the benefit may be. If the downgrade action reflects the rater's perception that a sovereign entity may struggle to raise funds – as was the case in the Italy downgrade action – the actual downgrade itself only serves to heighten the sovereignty's difficulties in raising such funds. Economists often call this a self-fulfilling prophecy or a self-effectuating phenomenon.

As opposed to the threat of downgrade hanging like Damocles' sword above a finance minister, encouraging him/her to get the country's finances in order, the downgrade action serves little purpose - only making it harder to get one's finances in order.

And thus the duality of the position: can one credibly support an action that only serves to exacerbate a difficult situation, while helping nobody (aside, perhaps, from short sellers and political opponents to controlling regimes or parties).

The bank analyst felt his position to be futile and awkward. The rating analyst may struggle to sleep: his or her option is to defy the company's code, or to be destructive.

Will S&P's Wells Notice Change Their Behavior?

The role of the credit rating agencies in the recent financial crisis has been highlighted by numerous investigations including the Financial Crisis Commission and the Senate Permanent Subcommittee on Investigations (PSI). It therefore comes as no surprise that Standard & Poor’s receipt of a Wells Notice, indicating the SEC’s intention to sue, has garnered its fair share of attention. Challenges presented by the issuance of the so-called Wells Notice, and the circumstances surrounding it, will likely culminate in rating agencies and issuing entities having to adjust their approaches to the ratings process.

The various forms of media speculation have focused on Delphinus CDO, a crisis-era structure backed by subprime mortgage bonds, as the focal point of the SEC’s investigation. This transaction was highlighted by Senator Levin’s PSI report as a “striking example” of how banks and ratings firms branded mortgage-linked products safe even as the housing market worsened in 2007.

The implications of S&P’s internal emails, made public through the Senate’s investigative process, are that the rater may have known, at the time it was issuing its ratings on Delphinus, that the ratings being provided were inconsistent with its then-current methodology. In essence, S&P’s model and ratings were contingent on certain preliminary information made available to them by the underwriting bank. When that information changed at a late stage of the deal’s construction, S&P’s model was no longer able to produce results consistent with the desired rating.

That S&P nevertheless issued the originally-requested rating, despite its being incompatible with the new information, opens a line of questioning into whether S&P’s ultimate rating adequately reflected its own analysis. In issuing the Wells Notice, the SEC may at this juncture reasonably suspect S&P of committing a Rule 10b-5 violation.

The SEC would be pressed to show that S&P knew, at the time it was providing the rating, that the rating was ill-deserved (and thus misleading to investors). If the SEC is able to show that S&P intentionally provided a misleading rating, they would distinguish this case from several of the other rating agency complaints that have been dismissed.

Importantly, the SEC’s case would almost certainly survive the rating agency’s preferred defense motion that invokes their First Amendment rights to express an opinion. Floyd Abrams, S&P’s external counsel on First Amendment issues, himself confesses in his September 2009 testimony before the House that “[the] First Amendment provides no defense against sufficiently pled allegations that a rating agency intentionally misled or defrauded investors,” … “nor does it protect a rating agency if it issues a rating that does not reflect its actual opinion.” (emphasis added)

Aside from the abovementioned Wells Notice, the SEC is showing a keen focus on each rater’s application of its own public methodology: their annual rating agency examination report, released late last week, cites as an “essential finding” that “[one] of the larger NRSROs reported that it had failed to follow its methodology for rating certain asset-backed securities.”

The result of the Delphinus investigation notwithstanding, the mere threat of legal action alters a rater’s approach to issuing ratings and maintaining current ratings. We have already seen the fruits borne of pressure instilled by the new regulatory landscape. In late July of this year, S&P stunned the market by pulling away from rating a commercial mortgage-backed securities (CMBS) transaction, led by Goldman Sachs and Citigroup, on the evening prior to the deal’s closing. S&P reportedly needed to adjust its model to reflect “multiple technical changes,” ultimately leading to the deal being shelved.

The manner in which S&P dealt with a controversial and costly methodological change suggests a new-found sensitivity towards violating the 10b-5 legal standard. Such a drastic action, bringing significant embarrassment to S&P in addition to the loss of market share, would have been inconceivable in the prior, revenue-centric, competitive landscape.

With raters seeking at all costs to avoid a 10b-5 violation, we foresee them increasingly turning away bankers who pressure them with “last-minute” demands. Bankers, risking their deals falling through, will be driven to accommodate the rater’s requirements in providing their supporting data in a more timely fashion, well in advance of a deal’s closing. Perhaps we’ll have fewer deals done as a result; but perhaps those deals will be safer, supported by less-hurried analyses.

As we have seen before, it continues to be legal risk, and not reputational risk, that has encouraged oligopolistic rating agencies to re-focus their attentions on the quality of the product being provided. With Damocles’ sword swinging over-head, we can only hope for more objective ratings going forward – and fewer stale ones.

Complexity is a Cash Cow (but not for you)

“Fortuna's wheel had turned on humanity, crushing its collarbone, smashing its skull, twisting its torso, puncturing its pelvis, sorrowing its soul. Having once been so high, humanity fell so low. What had once been dedicated to the soul was now dedicated to the sale.” – from John Kennedy Toole’s A Confederacy of Dunces

Frank Partnoy, in his recent Financial Times commentary, makes the bold point that while “[most] for-profit companies are run for the benefit of shareholders … banks have been run more for the benefit of employees.”

Partnoy doesn’t delve too deeply into the basis for his claim, but he may well be alluding to the fact that traders were being financially rewarded for executing trades that brought short-term profits at the expense of long-term pain.

We have all heard about the Abacus case, where the bank was accused of siding with one client at the expense of others. (Goldman settled with the SEC for $550mm). In other cases it is argued that banks actually positioned themselves in direct opposition to their clients. Needless to say it doesn’t augur well from a long-term, shareholder value perspective for a bank to be adverse to its clients. Either the bank will suffer or its client will suffer.

From a corporate governance perspective one might argue that senior management failed to the extent its traders were not being compensated based on the long-term quality of their decisions, but rather on their short-term profits. In such a scenario, the traders would not have been incentivized, or forced, to consider the long-term benefits of strong client relationships. They would simply want to execute high margin, million dollar trades.

And hence the layering on of complexity, and the disappearance of transparency.

Complexity

Complex, opaque, private trades afford broker-dealing banks numerous short-term money-making opportunities.

First up, the lack of asset transparency (inability to see through to the asset’s support) and trading transparency (inability, due to the private nature of certain markets, to follow the money or the trading levels) makes it easier for banks to get away with manufacturing prices to their advantage, or taking advantage of comparatively unsophisticated (trusting) clients.

Jim Grant (founder of Grant’s Interest Rate Observer) posited in a recent Bloomberg interview that the world we live in “is a world of fake prices and of manipulated prices.” For liquid, traded securities like municipal bonds or US Treasuries, it is understandably quite difficult to massage the numbers; but for lesser-traded, or illiquid, assets price discovery can be cumbersome if not impossible, making price manipulation all the more feasible.

In Michael Lewis’ The Big Short, Scion Capital’s Michael Burry warns that “[whatever] the banks’ net position was would determine the mark,” and that “I don’t think they were looking to the market for their marks. I think they were looking to their needs.”

The lack of transparency, too, is entirely convenient to banks in the know: it creates numerous opportunities to profit at the expense of those with less information. We call this imbalance an "informational asymmetry." It may be very difficult to sell Apple stock at an above-market price to even the least sophisticated of investors: they can readily tell that the security ought to be valued lower. But when the security is complex and privately traded, and when the comparatively unsophisticated investors do not have the market know-how or savvy to model the deals, it can be much easier for a bank to "pull one over" on them. The Fed ponders the severity of this very advantage in its aptly titled report "Could Asymmetric Information Alone Have Caused the Collapse of Private-Label Securitization?"

Complexity also undermines the potential for investigative journalism (they cannot get access to the data or make a complex deal sound too interesting) and, more importantly, the ability for regulators to oversee the markets they regulate. The IMF in 2006 warned that “[while] structured credit products provide a wealth of market information, there remains a paucity of data available for public authorities to more quantitatively assess the degree of risk reduction among banks and to monitor where credit risk has gone.”

Investors would do well to acknowledge the incongruent incentives banks may have to add their complexity to their products. But as buyers, complex deals can be difficult – and expensive – to analyze, and cumbersome if not impossible to trade (out of) during times of heightened volatility.

Investors can push back when offered complex deals that don’t meet their interests – and they can strive to ensure that their rights to high quality information and transparent disclosures are upheld.

Complexity allows for high margin trades that elicit high profits, but sometimes on terms that are not commercially reasonable. And in times of high volatility, they tend to be accompanied by high bid-offer spreads. As always, it’s buyer beware.

The Downgrade Cometh

The concept of conflicted opinions is dear to us. When a conflict is more than a conflict it has the power to put the conflicted party in a false position; the conflict doesn’t act simply as a distracting factor which may throw doubt upon the opinions rendered – but it brings with it an uncanny ability to intrude on the precision of the supporting analysis, and the delicacy with which it is handled.

We have written before of potential conflicts inherent in the ratings model; today our guest author Marc Joffe brings the conflicts question closer to home in the context of S&P’s much debated US downgrade. While at PF2 we’re agnostic on the value added by the downgrade at this late stage, we are happy to host his views to encourage meaningful debate around the importance and implementation of sovereign ratings – and we welcome your comments.


The Downgrade Cometh

By Marc Joffe*

S&P took the right action last Friday. The timing may have been unfortunate. And while Treasury’s announcement of a calculation error was embarrassing, the fact is that $2 trillion is little more than a rounding error in relation to the $211 trillion overall fiscal gap calculated by Lawrence Kotlikoff. But rather than crucifying S&P, the media should be asking other rating agencies what numerical analysis they have done – if any – to justify their decision to maintain status quo.

The persistence of the US AAA rating in the face of high debt ratios and political paralysis was becoming an embarrassment for the rating industry. The ratings disconnect reminded one of the Enron saga, or the subprime misratings, which were sorely lacking in any intellectual basis. Let’s hope that the S&P downgrade begins the long march back to credibility.

Faulty ratings should be viewed in a much larger context of biased equity research during the internet bubble (Who is Jack Grubman?), Arthur Anderson’s failure to effectively audit Enron and more recently the phony appraisals and poor underwriting practices that triggered the foreclosure crisis.

Credit evaluation (whether by lenders or rating agencies), equity analysis, auditing and appraising are intimately related. All four of these disciplines affect the flow of capital, and professionals working in these fields are torn between cutting corners and ignoring professional protocol when conducting their analysis. Those of us who work in these professions face a stark choice: either (1) submit to management, public or client pressure to do a lousy job, or (2) perform thorough, unimpeded analyses that produces the most objective answer. If too many take the first option, funds are mismanaged, investors lose money and savings are curtailed. After all, if you can’t trust financial statements or credit analyses, what confidence can one have in her investment? A society in which the first choice dominates rapidly degenerates from a transparent advanced economy to a corrupt banana republic. This is the risk faced by the US today.

I see in the S&P Sovereign Group’s rating announcement that they had the courage to say what many of us already knew, and were willing to face public criticism when no money was on the line in the name of professional integrity. S&P’s action should remind all of us who assess debt, assets and financial reports to summon up the courage to speak the truth on a regular basis. The short term consequences may be difficult, but the benefits of an appropriate analysis include a clear conscience and a good night’s sleep. If all of us maintain our standards, we can create stronger financial markets and a healthier society.

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* Marc Joffe (joffemd@yahoo.com) is a consultant in the credit assessment field. He previously worked as a Senior Director at Moody’s Analytics. This article reflects his personal opinion of sovereign rating practice. Although previously employed by Moody’s Analytics, the author no longer works at Moody’s and, when he did work there, his area of professional responsibility was software development and data collection. He had no professional experience as a ratings analyst, and no knowledge of Moody’s ratings practices beyond what is in the public record.

A New Approach to Sovereign Ratings

The debt ceiling debacle has rejuvenated the discussion about the adequacy and effectiveness of sovereign credit ratings, as they're currently being provided.

We remain agnostic on the value added of a US downgrade today – does anybody really benefit from a downgrade at this stage? The objective of a downgrade watch notification, or a downgrade itself, is to encourage governmental concern, which precipitates action. We already have international concern. A downgrade at this stage seems only to cause further turmoil.

We are additionally skeptical of the adequacy of sovereign ratings being provided today: we wonder at the raters' ability to determine what they refer to as “willingness to pay.” Are they any better than anybody else at estimating this highly subjective measure? And if so, why is it they cannot provide to users the separate outcomes of each of these two components of the credit rating - the ability to pay and the willingness?** (Note also distinguished researcher Arturo Cifuentes’ timely suggestion of a third component: permission to pay.)

Sadly it seems a crisis has to occur before we resolve flawed systems. Since we believe sovereign ratings ought to be more consistently applied and more transparent, if worthwhile at all, we are happy to host guest author Marc Joffe's posts. We hope his views continue to encourage meaningful debate around the importance and implementation of sovereign ratings, and we welcome your comments.

A New Approach to Sovereign Ratings

By Marc Joffe*

A couple of my friends in the Moody’s diaspora have argued that rating agencies should not assign sovereign ratings due to difficulties in managing conflicts. I disagree for a couple of reasons. First, to the best of my knowledge, sovereign ratings have performed fairly well over the past few decades. While rating changes could have been faster, I have not seen evidence of systematic bias – except perhaps in the maintenance of the home country AAA rating.

Second, sovereign ratings provide a type of government accountability not unlike that offered by an independent press. For this reason, I am actually sympathetic to the idea that ratings warrant First Amendment protection. The best sovereign rating analysis is politically aware without being politically opinionated. As S&P and Moody’s have repeatedly stated during the current debt ceiling debate, they have no view about which fiscal measures should be employed to adjust the nation’s fiscal trajectory, they just believe that inaction or minimal action is no longer consistent with the highest rating.

Although the prevailing sovereign rating methodology may not actually display bias, it is certainly being subjected to accusations of bias, especially in Europe. Also, the present qualitative approach necessitates delays in rating changes unless the rating group is heavily staffed. In last week’s Congressional testimony, S&P President Deven Sharma said that his agency’s sovereign group consists of roughly 100 analysts rating 126 countries – less than 1 full time equivalent per issuer.

Thus, the biggest opportunity for improvement in sovereign rating performance is the application of transparent, quantitative modeling technology fueled by frequently updated data for exogenous variables. Model driven ratings can be calculated daily, weekly or monthly and then reviewed by analysts prior to release. And models don’t worry about being criticized for a lack of patriotism or for affecting interest rates.

Quantitative credit assessment techniques have been successfully applied to consumers, public firms and private firms. Bloomberg and Morningstar have already implemented ratings based on Merton-style public firm models first popularized by KMV Corporation, while RapidRatings uses financial statement data to automatically rate both public and private firms.[1]

Sovereign risk modeling is newer and less developed. The most interesting work I have seen in this area has come from Nouriel Roubini and colleagues, from Dale Gray and colleagues, and from Kamakura Corporation (full disclosure: Kamakura is a client and also has a public firm model). These efforts are generally focused on emerging market issuers, since that is where just about all recent default observations are available. Data for advanced economy sovereign defaults (or, more precisely, defaults by nations that went on to become advanced economies) is older, hard to gather and may require restatement to be meaningful in modern terms. Reinhart and Rogoff have assembled this data for their book and related IMF papers, lowering the data collection barrier.

I propose a different modeling approach for advanced economies that focuses on their primary risk factor: the impact of population aging on social insurance spending. The approach leverages the wealth of budget, economic and demographic data and forecasts available for these countries. While the remainder of the discussion focuses on the US, it should be equally applicable to major European economies.

In the US, the Congressional Budget Office and other government agencies (including OMB and GAO), periodically issue long term budget forecasts. Typical lengths of these forecasts are 10 and 75 years. For Treasury investors, the longest relevant time horizon is 30 years, which also happens to be the length of the longest term macroeconomic forecasts provided by IHS Global Insight and Moody’s Analytics.

The CBO forecasts include projected Debt-to-GDP ratios. It is also possible to derive Interest Expense to Revenue ratios from the CBO outlooks. This latter ratio may be more predictive of default than Debt-to-GDP because it embeds information about the government’s ability to tax economic activity and the level of its Treasury interest rates. (This ratio effectively ignores principal repayment schedules – an exclusion that could be justified by the assumption of continued liquidity and absence of rollover risk for advanced economy sovereign debt.)

Consequently, the CBO data provides expectations for key ratios at the maturity date of long term Treasuries. These expectations are based on policy and macroeconomic forecasts. If different policy and macroeconomic parameters are used, different projected ratios can be generated. If we provide a range of possible scenarios to a Monte Carlo simulation engine, we could generate a distribution of ratio outcomes.

Next, we can use historical data to identify ratios that are associated with default. A nice property of interest expense to government revenue is that, with rare and extremely idiosyncratic exceptions, it is always in the range of zero (absolute certainty of non-default) to 100% (absolute certainty of default). This relationship prevails across all countries and through time. For purposes of this discussion, let’s assume that an interest expense to revenue ratio of 30% is determined to be a reasonable default point. This would mean that a government would be unwilling to pay interest beyond this threshold, because the political pain associated with further crowding out other kinds of spending exceeds that stemming from a default. Admittedly limited post-Reconstruction experience in the US suggests that the critical value of this ratio, i.e. the default point, is 30% (see my earlier blog post entitled Correction: The US Has Defaulted Before and it Can Default Again).

With a distribution of ratio realizations and critical point both in hand, rating the issuer is then simply a matter of calculating the proportion of the distribution beyond the default point. If this proportion is very low (perhaps 0.25% for a thirty year Treasury), the issuer is AAA. If the proportion of “default-indicative” realizations is higher, then a lower rating is appropriate.

What would such a model conclude about the US? Since the model only exists in the form of the rough outline above, I can’t be certain – but I have a pretty good idea. In April, I calculated a projected interest expense to revenue ratio based on an adjusted version of the June 2010 CBO Long Term outlook. The adjustments mostly reflected some inputs from CBO’s more recent March 2011 10-year forecast. This calculation yielded a ratio of 37.82% in FY 2041. (Although the debt ceiling deal lowers this figure somewhat, CBO may also have to make an offsetting adjustment due to the disappointing GDP numbers published last week). Assuming that the 30% ratio is indeed the default point, the implied default probability is quite substantial.

This rough calculation is based on a number of assumptions, most important of which is that the CBO forecast provides a reasonable expected value. While CBO’s economic forecasts are well within the mainstream, CBO more controversially assumes no substantive policy change. If major tax increases or entitlement reforms are implemented, the expected ratio could be far lower. But the recent debt ceiling debate has shown just how difficult major policy change is in an environment of divided government and party polarization (the concept of Congressional polarization can be quantified as Political Scientist Keith Poole regularly does at VoteView).

Contrary to what we hear from politicians and the media, I do not see much reason to expect this situation to be resolved by the 2012 election. The likelihood that divided government will continue can be estimated by consulting political markets, such as InTrade, which reflects the expectation that Obama will be President and that the Republicans will control the House and Senate in 2013. Also, the further we get into the cycle of baby boomer retirements, which started in 2008, the more difficult entitlement changes will become given the economic inflexibility and heightened voting participation of seniors.

One assumption in the CBO projections that could be questioned is the reversion of interest rates to modern historical averages over the next few years. If, instead, the US has entered a period of sustained low interest rates a la Japan, the terminal interest expense to revenue ratio would be far lower.

Regardless of which interest rate, policy or growth assumptions are used, the simulation model outlined above provides a formal way of evaluating the implications of a range of political and economic scenarios for sovereign creditors. Further, if rating agencies make the simulation model and their assumptions publicly available, investors could substitute their own exogenous variables and form their own conclusions. The benefit is that evaluations of US and other advanced sovereign credits become more rigorous and more transparent. Quantitative approaches do not guarantee objectivity because the choice of assumptions can itself be biased, but any bias and its effect on the rating becomes more apparent and much easier to address.

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[1] Application of models to structured products has proven more controversial, but I would argue that the problems of 2007-2008 are not an indictment of quantitative assessment in general. Instead, the crisis is an indictment of the specific modeling procedures and assumptions employed. Just because models based on Gaussian Copulas failed to adequately weight tail risk does not mean that models relying on more empirically appropriate distributions will not work. And just because RMBS models failed to consider negative Housing Price Appreciation in 2006 is not evidence that models that included a proper set of HPA scenarios would not have been effective.

* Marc Joffe (joffemd@yahoo.com) is a consultant in the credit assessment field. He previously worked as a Senior Director at Moody’s Analytics. This article reflects his personal opinion of sovereign rating practice. Although previously employed by Moody’s Analytics, the author no longer works at Moody’s and, when he did work there, his area of professional responsibility was software development and data collection. He had no professional experience as a ratings analyst, and no knowledge of Moody’s ratings practices beyond what is in the public record.

** It is worthwhile to note that rating agency BMI, though not an SEC-licenced NRSRO, divulges each of the two components separately in its rating analysis.

Correction: The US Has Defaulted Before and It Can Default Again

This is a second piece on the topic of sovereign debt and ratings, by guest author Marc Joffe*. You can access his prior piece here: US Debt Ceiling Crisis: Rating the Rating Agencies.


One troubling aspect of the political debate over the debt ceiling is the constant repetition of the statement that “the US has never defaulted on its debt”. On the grounds that those who fail to learn from history are due to repeat it, I would like to set the record straight. I welcome readers to share this with colleagues with or without attribution. Fellow risk professionals and the general public deserve to know the facts. During its 235 years as a sovereign entity the United States has defaulted on three separate occasions - two of which are reported by Rinehart & Rogoff (2009) - and has also intentionally liquidated debt via inflation.

In 1782, the Treasury failed to pay interest on Revolutionary War debt. Following ratification of the Constitution, Treasury Secretary Alexander Hamilton resumed regular debt service in 1790, but deferred some interest payments for ten years (Riley, 1978).

For several decades prior to 1933, holders of Treasury securities were contractually entitled to receive interest and principal payments in either dollars or gold. At the time, many contracts contained a “gold clause”, which enabled payees to receive proceeds in the form of gold. During the 1933 banking holiday declared by President Franklin Roosevelt immediately after his March 4 inauguration, the federal government refused requests for interest payments in gold, remitting only currency instead. Congress later ratified this action by formally invalidating gold clauses in a "Joint Resolution to Assure Uniform Value to the Coins and Currencies of the United States," passed on June 5, 1933. In 1934, President Roosevelt officially devalued the dollar by increasing the price of gold from $20.67 to $35.00. Although contemporary press accounts characterized the government’s actions as an abrogation (Wall Street Journal, 1933, May 4), Treasury securities issued in June and August of 1933 were oversubscribed and a February 1935 Supreme Court decision upheld the government’s actions. While these actions were generally portrayed today as an attempt to halt gold hoarding or end price deflation, they also appear to have had a fiscal motivation. In FY 1933, the ratio of interest expense to federal revenues reached 33.15%, the only time this ratio has exceeded 30% since the post-Civil War era. The Roosevelt administration needed more funds to implement New Deal programs and wanted the flexibility to issue new Treasury securities unimpeded by gold convertibility (Wall Street Journal, 1933, May 27). On a cautionary note, Moody’s Municipal and Government Bond Manuals from 1933 and 1934, show that all US Treasury bonds carried Aaa ratings both before and after this default (Mergent, 1933-1934).

The United States Debt-to-GDP ratio reached its modern peak of 112.7% in 1945, primarily due to war-time borrowing. Interest rates at the time were relatively low, while tax rates were relatively high. Thus interest expense accounted for only 7.79% FY 1945 federal revenues – compared to a proportion of 9.88% in FY 2010 – suggesting that this high level of debt could be serviced without great difficulty. The Debt-to-GDP ratio fell rapidly after the end of World War II, largely as a result of high inflation that followed the relaxation of wartime price controls and Federal Reserve purchases of Liberty Bonds. Thornton (1984) reports that the Federal Reserve tripled its holdings of government debt between 1943 and 1946 by agreement with the Treasury. Consumer prices rose 18.1% in calendar year 1946 and 8.8% in 1947 (Bureau of Labor Statistics, 2011). By FY 1948, the Debt-to-GDP ratio had dropped to 79.9%. The ratio continued to fall through the early 1970s as economic growth outpaced the accumulation of debt. The ratio stabilized in the mid-1970s and then – after being temporarily suppressed by another round of inflation – climbed through the 1980s and early 1990s. This period was also characterized by high interest rates, increasing the Treasury’s debt service costs.

Meanwhile, as reported in The Economist (2011, June 23), the US Treasury failed to redeem $122 million of Treasury bills on time after another debt ceiling debate in 1979. This episode was purely a technical default, arising from systems issues.

The ratio of interest expense to revenues achieved a recent peak of 18.43% in FY 1991. Tax increases and spending cuts in the early 1990s, followed by rapid economic growth in the late 1990s substantially improved US debt ratios. By FY 2002, interest expense had dropped below 10% of federal revenues, while publicly held debt fell to less than 35% of GDP. Persistent large deficits over the last nine years have substantially increased the nations’ Debt-to-GDP ratio, while interest payments as a proportion of revenues have remained relatively stable due to low interest rates.

In 1933, an interest to revenue ratio exceeding 30% preceded a change in the terms of Treasury securities widely regarded as a default. After World War II, the record high Debt-to-GDP ratio of 112.7% was reduced in large measure through price inflation. Budget projections from various sources suggest that these two ratios will return to their historic highs during the late 2020s and 2030s in the absence of major policy changes. If these projections are realized, history suggests that holders of Treasury instruments will be subject to substantial risk.

While inflation would undoubtedly be the politically preferred method of restoring debt ratios to sustainable levels, outright default is also possible. Since the Federal Reserve chair’s term is not aligned with that of the President or Congress, it is possible that a chair politically disconnected from elected leadership may not succumb to pressure to monetize the debt. Further, regardless of political alignment, a Federal Reserve chair may decide that the price inflationary consequences of monetizing debt are worse than the consequences of a forced restructuring of Treasury debt. Jeff Hummel (2009), the first economist to predict a Treasury default, makes some more elaborate arguments as to why the federal government might choose default over inflation.

Conclusion: The US Treasury has defaulted in the past and it has a material risk of doing so again. Absent substantive budget reforms in the current debate, it is hard to see any justification for leaving the US at AAA.

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* Marc Joffe (joffemd@yahoo.com) is a consultant in the credit assessment field. He previously worked as a Senior Director at Moody’s Analytics. This article reflects his personal opinion of sovereign rating practice. Although previously employed by Moody’s Analytics, the author no longer works at Moody’s and, when he did work there, his area of professional responsibility was software development and data collection. He had no professional experience as a ratings analyst, and no knowledge of Moody’s ratings practices beyond what is in the public record.

References

Bureau of Labor Statistics (2011). Table Containing History of CPI-U U.S. All Items Indexes and Annual Percent Changes From 1913 to Present. ftp://ftp.bls.gov/pub/special.requests/cpi/cpiai.txt.

Economist (2011, June 23). The mother of all tail risks. http://www.economist.com/node/18866851.

Hummel, J. R. (2009). Why default on U.S. Treasuries is likely. Library of Economics and Liberty. Retrieved from http://www.econlib.org/library/Columns/y2009/Hummeltbills.html.

Mergent Corporation (1933, 1934). Moody’s Manual of Municipal and Government Bonds. Available online by subscription from Mergent Corporation, Fort Mill, SC.

Riley, J. C. (1978). Foreign Credit and Fiscal Stability: Dutch Investment in the United States, 1781-1794. The Journal of American History (65), 654-678.

Reinhart, C. M. & Rogoff, K. S. (2009). This Time is Different: Eight Centuries of Financial Folly. Princeton: Princeton University Press. Pages 112-113.

Thornton, D. L. (1984). Monetizing the Debt. The Federal Reserve Bank of St. Louis Review, 66(12), 30-43. Retrieved from http://research.stlouisfed.org/publications/review/84/12/Monetizing_Dec1984.pdf.

Wall Street Journal (1933, May 4). Editorial: No Payment in Gold. Page 6.

Wall Street Journal (1933, May 27). Acts to Cancel Gold Clause: Administration Bill in Both Houses Seen as Move Toward Long Term Bond Issue. Page 1.

US Debt Ceiling Crisis: Rating the Rating Agencies

By guest author Marc Joffe*

News reports and punditry reveal a shocking ignorance of the role played by rating agencies in the US deficit debate. Depending on the commentator’s bias, rating agency actions have been either lionized or demonized, often inappropriately. After dispelling some unfortunate myths about rating agencies, I will offer the reader a more informed assessment of how the three dominant rating agencies are handling the debt ceiling crisis.

Commentators often confuse a credit downgrade with a prediction of default. If a rating agency downgrades an issuer from AAA to AA+, it is not predicting that the issuer will default. The rating change simply expresses the view that a default or a loss of principal/interest is more likely. Since rating scales typically have about 18 different grades, a transition from the highest rating to the second highest rating does not reflect an enormous change in risk. A downgrade from AAA to AA+ simply reflects a rating agency’s view that the credit risk of the US has gone from de minimis to very low. Thus, if a rating agency were to downgrade the Treasury to AA+ and a US bond default did not immediately follow, it would not be appropriate to say that the rating agency made an error. On the other hand, if rating agencies leave the US at AAA and it does default, that would be indicative of an error – similar to assigning AAA ratings to structured instruments that later missed payments.

While it is true that the rating agencies commenting on US creditworthiness are the same firms that assigned inaccurate ratings to mortgage backed securities a few years ago, this fact is not especially meaningful. The analysts who assign ratings to structured finance instruments and those that assess sovereign bonds are different people, working in different groups, using different methodologies. More importantly, the commercial considerations that might bias sovereign ratings are totally different from those that impact assessments of structured assets.

Ratings for mortgage backed securities, collateralized debt obligations and other asset backed instruments are purchased by a relatively small number of issuers. If a rating agency provides an “unsatisfactory” rating for a deal structured by a given issuer, the agency risks losing a sizable fee for the deal in question as well as revenue from all future deals marketed by that issuer. Thus, in the structured finance area, the reactions of a few issuers can materially affect the rating agency’s revenue.

This is not the case with sovereign ratings. Advanced economy sovereigns, such as the United States, pay little if anything for their ratings. Thus, all the concerns about the so-called issuer pays model do not apply to sovereign ratings. At the same time, other commercial considerations might impact them. For example, since rating agencies are regulated by the United States, European Union and other sovereign authorities, they may have reason to fear retaliation from their regulators. While such fears appear to have a basis in Europe where official criticism of the agencies has been frequent, we have yet to see a similar problem in the United States.

Second, sovereign rating changes may impact other ratings in ways that create commercial challenges for rating agencies and investors. Given the dependence of numerous bond-issuing entities on the US government, a Treasury downgrade may trigger a large number of municipal, corporate and structured finance issuer downgrades as well. This cascade of downgrades would impose challenges on a rating agency’s internal systems, staff research skills and relationships with affected issuers.

To the extent that certain institutional investors are restricted to investing in AAA securities, a Treasury downgrade would result in the forced liquidation of many assets. Institutional investors – who often purchase research, data and analytics from ratings firms – may react negatively to such a scenario. Moreover, such portfolio changes could substantially impact interest rates. If these interest rate changes are blamed on the rating agencies, they may suffer reputational consequences.

Such concerns may unduly retard rating changes that appear justified by the issuer’s credit status. In this connection, I am reminded of the Enron situation in late 2001. Back then, the concern was that downgrading Enron to a speculative grade rating would effectively shut the firm out of the credit market and thereby force it into bankruptcy – which is precisely what happened when the belated downgrades were announced.

I characterize the Enron downgrades as “belated” because they occurred long after the firm was identified as a “junk” issuer by quantitative credit models, like the one marketed by KMV Corporation –now owned by Moody’s. Since computer models do not worry about commercial implications of their calculations, they promise to provide more instantaneous and less biased credit assessments than human rating analysts can. While quantitative models for corporate and structured instruments are quite common, relatively little progress has been made in modeling municipal and sovereign risk. (One notable exception is Kamakura Corporation’s sovereign model, released in 2008.)

As with Enron, major rating agency admonitions about US Treasury creditworthiness have been late. Official warnings about the long term sustainability of the federal budget due to population aging date back to the early 1990s. In 2006, Boston University economist Laurence J. Kotlikoff warned that the US was headed toward bankruptcy. In 2009, SR Rating, a Brazilian rating agency assigned the US a rating of AA. This was followed in 2010 by Dagong, a Chinese rating agency, which downgraded the US from AA to A+ last November. Earlier this month, Egan Jones, a small US-based rating agency that employs an investor pays model downgraded the US from AAA to AA+.

Within the last few years, US debt ratios have clearly diverged from comparable AAA sovereigns such as Canada and Australia. For example, the CIA World Fact book shows that in 2010 the ratio of publicly held debt to GDP was 59% in the US, compared to 34% in Canada and 22% in Australia. These other two countries are also less exposed to the consequences of population aging issues and they shoulder a smaller military burden than the United States, so it is difficult to see why all three countries merit the same rating in systems that have 18 distinct credit grades.

Finally, the parliamentary system employed by other Western democracies is better equipped to address fiscal stress than the divided government we have in the US. In a parliamentary system like that of the UK, a single party or a coalition can more readily obtain full control of all the levers of power and use them to implement unpopular changes at the beginning of its term (this is less true in parliamentary democracies that have large numbers of significant parties and thus weaker governing coalitions). In the US, with its more frequent elections, division of responsibility between two houses of Congress and an Executive branch often held by opposing parties and the risk of Senate filibusters, fiscal consolidation is far more difficult. This disadvantage has been exacerbated in recent decades as bipartisanship on many issues has given way to party polarization. These issues of governmental effectiveness should be a part of any comprehensive credit assessment of US Treasury securities.

One justification for maintaining the US AAA rating in spite of these concerns has been refuted by the current crisis. The argument is that since the US manages the world’s reserve currency it is somehow insulated from default. Unfortunately, the US dollar’s reserve status has been under attack for several years, and is not guaranteed to persist over the 30-year term of the longest dated Treasury instruments. Further, the reserve currency argument implicitly assumes that the Federal Reserve would monetize Treasury debts should default risk appear. This argument ignores Fed independence, as well as the fact that the CPI indexing of many Federal benefits would impede the government’s ability to liquidate debt by printing money. Finally, I have not heard any responsible commentator suggest that the government address a failure to raise the debt ceiling by paying creditors with newly created money, so clearly reserve currency status provides no refuge in the current scenario.

While all three major rating agencies have been late to the downgrade party, there are notable differences among them in their handling of recent events. In my view, S&P has performed the best. They were first to take any action, assigning a negative outlook to US Treasury securities on April 18, 2011. Further, S&P has correctly maintained that a debt ceiling increase without meaningful budget reforms would still merit a downgrade. As suggested earlier, the long term US fiscal imbalance has been known to policymakers for 20 years. If a political crisis like the one we are currently experiencing is unable to motivate elected officials to substantially reduce the gap between out-year revenues and expenditures, it is hard to see what will, thus leaving a future default as a significant risk.

Moody’s recent pronouncements have also been largely on target, but the agency was slower off the mark. On February 24, 2011, Moody’s predicted that the debt limit would be raised before the ceiling was reached - on May 16. On June 2, the agency observed that the risk of default due to a failure to raise the debt limit was a rising but still very small risk. Finally, on July 13, Moody’s placed the US credit rating on watch for possible downgrade and also noted that it would assign a negative outlook if substantive deficit reductions were not implemented together with a debt ceiling increase. Although welcome, Moody’s stance is not as strong as that taken by S&P. While Moody’s is threatening to maintain a negative outlook in the absence of substantive action, S&P has warned of an outright downgrade.

Another worry about Moody’s position is that the firm is frequently represented in the media by economists from Moody’s Analytics, such as Mark Zandi. Moody’s Analytics is a distinct subsidiary within Moody’s Corporation from the rating issuing entity, Moody’s Investors Service. Consequently, Zandi and others at Moody’s Analytics are not involved in the sovereign ratings process, a fact often lost on interviewers. Further, Moody’s Analytics economists have previously been on record as supporting fiscal stimulus measures including the recent temporary reduction in the Social Security tax rate. While Keynesian policies may be justified on other grounds, they are not consistent with maximizing a sovereign issuer’s creditworthiness at least in the short run. It is thus unfortunate when the public gets the impression that Moody’s Analytics economists are somehow representing the views of the rating agency.

Finally, it has been disappointing to see the third rating agency joining the discussion so late. In a report dated June 8, 2011, Fitch stated that it would place the US on negative watch on August 2nd if the debt ceiling was not raised and suggested that outright downgrades would occur only in the event of an actual failure to pay scheduled interest or principal. The idea that a default would be needed to trigger a downgrade negates the value of credit ratings. If credit ratings are not supposed to hold predictive content, it is hard to see why investors would need them.

In short, the leading credit rating agencies are belatedly awakening to the fact that a dysfunctional political system and long term fiscal imbalances have created significant risks for Treasury investors. Now these agencies, led by S&P, are beginning to provide investors with insight into the unfolding situation, largely free of the biases that affected them during the 2007-2008 credit crisis. That said, investors would ultimately be better served by measures of advanced economy sovereign risk that react more quickly and are less burdened by potential conflicts.

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* Marc Joffe (joffemd@yahoo.com) is a consultant in the credit assessment field. He previously worked as a Senior Director at Moody’s Analytics. This article reflects his personal opinion of sovereign rating practice. Although previously employed by Moody’s Analytics, the author no longer works at Moody’s and, when he did work there, his area of professional responsibility was software development and data collection. He had no professional experience as a ratings analyst, and no knowledge of Moody’s ratings practices beyond what is in the public record.

Covering and Uncovering the World of TruPS CDOs

The Philadelphia Fed’s June 2011 working paper provides a welcome addition to the conspicuously deficient body of literature on the topic of TruPS CDOs.

The researchers were quite thorough in detailing the creation of these notoriously opaque, private vehicles. They also tackled the valuation of these deals in an effort to estimate foreseeable losses on the tranches issued. This is no mean feat, but rather an academic exercise which helps readers and researchers better appreciate the limitations suffered by outside parties, like regulators, who are trying to get a handle on this market. For example, the researchers were limited to “[working] with information trustees make public to potential investors (or researchers like us).”

The authors nevertheless honed in on several key aspects of the market, some of which haven’t been adequately addressed in prior publications.

In terms of the creation of these instruments, they note the multidimensional roles being played by market participants who constructed these deals. They remark that several “dealers also serve as collateral managers and consult with banks on valuations” and they comment on the curious role of rating agencies whose “primary motive is to generate business.”

The researchers were also alive to the fact that “early TruPS CDO investors were relying largely on rating agency ratings and surveillance from the dealers responsible for issuing TruPS CDOs.” (Oddly, they too fall back on Moody’s data as the sole point of comparison for validating their own model – seemingly indicative of the situation many are and were faced with, in which one is forced to rely heavily on the rating agencies given their heightened access to data, and the presumed advantage rendered by this informational asymmetry. Unfortunately, given the lack of predictive content of ratings in this realm, it is perhaps difficult to find comfort in the fact that their model's outputs are similar to those produced by Moody’s.)

The researchers were also critical of the rating agencies’ assumptions and methodological changes, especially on the correlation side. They point out that “the model used to justify the zero inter-regional correlation assumption, apparently critical to the development of the single industry TruPS CDO market, was based on a model developed for an unrelated class of securities.”

They also track the increasing correlation between underlying banks over time, and admit their concern that despite the realization and disclosure of the increased concentrations, “rating agencies made few, if any, adjustments for this fact nor did we find evidence that issuers or other analysts expressed any concerns until after the TruPS CDO market came undone.” We would have liked to have seen them analyze, more critically, the validity of changes made in recovery rate assumptions over time.

Analytically, their model puts forth a number of interesting data points, not the least of which is a deferral-to-default cure rate of 2.3%. We believe this is lower than the current market rate, but it certainly runs counter to some of the punitive assumptions being applied elsewhere when analyzing these CDOs, where deferrals are often assumed to always default, with no recovery. (See The Tripping Point for more on this.)

Importantly, the lack of accessibility to certain information hinders the quality of their projections – something the researchers appreciated and candidly disclosed. They recognize that “unfortunately, we do not have information to analyze the risk profile of small banks issuing TruPS into TruPS CDOs versus those that did not. A more thorough analysis of risks at these small banks will have to wait until more information is disclosed.”

They were also cognizant of the inherent difficulties on the data side, given the “[limited] historical performance for TruPS, particularly in a stress environment, [making] forecasting future [deferrals and defaults] more an art than a science.”

Their lack of access to the underlying names leaves them at a significant disadvantage to most investors and players in this market, who have direct access to these names. Unfortunately, they also comment that they were unable to see through to the pool level assets, leaving them unable to distinguish between deferring and defaulted assets. Their inability to look through to the asset level means they must treat all pools identically, based on their overall opinion of the future of banks. This approach leaves them open to significantly underestimating or overestimating the differences between the banks included in different pools. (The FDIC’s Supervisory Insights on winter 2010 was particularly forthcoming on the reasons why banks included in TruPS significantly underperformed other banks in this crisis. We graphed this dynamic in Adverse Selection? No Problem!)

Having advocated heavily for a Central Pricing Solution for TruPS CDOs, we warmed particularly to one part of their important conclusion, which proposed that:

"Banks should also all be disclosing their securities holdings in their investment portfolios to regulators each quarter. For these, bank regulators should follow the model adopted by the National Association of Insurance Commissioners (NAIC), which receives from members CUSIPs and other information on investment portfolios so that regulators can do a full evaluation of all holdings in insurers’ investment portfolios. Applying models like the one we developed to all banks’ TruPS CDO holdings would offer a consistent, independent assessment to compare with banks’ internal analyses. Exactly this type of exercise was conducted as part of the 2008 Supervisory Capital Assessment Program (SCAP), commonly referred to as the “stress tests,” and the 2011 Comprehensive Capital Analysis and Review (CCAR) exercise for the largest banks. With a simple NAIC-style schedule, this type of analysis could be extended to smaller banks’ investment portfolios, with enormous gains in information and the quality and consistency of regulatory supervision."

Built to Fail CDOs 101: How Well Do You Know Your CDS Counterparty?

The Abacus CDO story of 2010 brought to the fore a worrisome scenario in which it could be argued that the arranging bank (Goldman Sachs) played two different roles at once, potentially serving one particular client (Paulson) at the expense of other clients (investors in the Abacus CDO). Goldman settled the case with the SEC for $550mm. What could be worse than participating in such a conflicted scenario? We are concerned that in a number of deals the arranging bank may have positioned itself directly against the CDO investors. In other words, the bank, like Paulson, may have been betting against its clients.


But first, let’s take a step back to explain how this all works…

A CDO is called a “synthetic CDO” when the underlying assets are “synthetically” referenced, rather than being held like physical corporate bonds. The underlying assets are often referenced by way of credit default swaps, or CDSs, and are called “reference obligations.” These CDSs may reference several types of asset classes, but in the synthetic CDO setting they typically reference either corporate debt or structured finance securities, such as commercial mortgage-backed securities (CMBS), residential mortgage-backed securities (RMBS), or even other CDO tranches. In the Abacus deal, the reference obligations were credit default swaps struck on RMBS.

Instead of buying physical assets that pay coupons (when current), the synthetic CDO sells protection on a portfolio of reference obligations. Much like insurance contracts, the buyers of protection on each underlying CDS make periodic “premium” payments to the CDO in exchange for compensation if and when a default, or credit event, occurs with respect to the obligation being referenced.

The CDO’s immediate counterparty on each CDS – typically the arranging bank – often plays an intermediary role between the CDO and each of its CDS transactions. It buys protection from the CDO and sells protection to the end buyer. This layout allows for the CDO to focus solely on the counterparty risk (i.e., the risk that a party will fail to fulfill its obligations under the CDS agreement) of a single party – in this case the arranging bank – as opposed to that of each end buyer (of protection).



Ideally, this dynamic ought to create an environment in which the immediate CDS counterparty (the arranging bank) is neutral to the performance of the CDO as the bank is fully hedged (as long as end buyers do not default).[1]

The imposition of an intermediary CDS counterparty often masks the identity of the end buyers from those who invest in CDO notes, potentially rendering CDO investors unable to discern which parties are ultimately short their portfolio.

Goldman Sachs’s now famous Abacus CDO illustrates a serious danger that can arise from the above confusion. The argument could be made that had investors known that Paulson was the end buyer of protection on a significant portion of Abacus’ CDS portfolio, they may have reconsidered the prudence of their investment, and potentially shunned it.


Built to Fail, Profitably

But what happens if the arranging bank chooses not to off-load all positions to an end buyer? In other words, what happens if the bank retains some or all of the short exposures to the underlying reference obligations? Here, the end buyer of protection, and the immediate CDS counterparty are one and the same: the arranging bank. The bank is now effectively short the CDO.

For example, the plaintiff in re: Space Coast Credit Union vs. Barclays Capital et al argues that:

“[the] facts here leave no doubt there was clear intent to create a very large short bet through Markov against Mezzanine CDO risk”

and that:

the “Defendants were extraordinarily determined to stuff Markov [CDO] with Mezzanine CDO risk.”

Plaintiff argues that:

“most stunning of all, [the Defendant] was so intent on Mezzanine CDO failure that it custom-built $300 million of built-to-fail Mezzanine CDOs … that [the Defendant], through Markov, could then bet against.”

While we do not seek to verify the accuracy of their contention, we are keenly aware of the material conflict such a scenario would present: the arranging bank is short the securities, meaning it would be financially rewarded if those securities were to plunder. The bank would benefit from selecting poor-quality assets. At the same time, the arranging bank is selling CDO notes, supported by these assets, to its clients. If the assets fail, the bank profits at the expense of the CDO noteholders – its clients. If the assets perform well, the bank would suffer financially.

From a higher level fiduciary perspective, the bank’s financial motive would not be aligned with the well-being of its client. Nor would the bank be even indifferent to the performance of its client. Rather, the bank’s profitability would be in direct opposition to that of its client.


While their clients were losing money on the trade, how much were bank profiting?

Removing the time value of money and the default timing as inputs to the model, we can create a simple model to estimate the bank’s profits from this trade. The model assumes that 100% of the assets are synthetically referenced.

Suppose the total premiums being paid were P, and that a bank held the super senior swap, with attachment point AP. The higher the attachment point, the greater the potential for the bank to make money: if losses exceed AP, the bank's profits are capped, as the profits from its short positions mimic identically the losses from its super-senior position.





In dollar terms, suppose the deal is of size $1bn, with an average 1% credit premium (P) on the reference obligations and a super-senior attachment point (AP) of 50%.

Suppose for simplicity that all losses occur within the first year.

If losses (AL) are lower than 1%, say they’re 0%, the bank loses 1% x $1bn = $10mm. Thus, if the portfolio is well selected, the bank stands to loses up to $10mm.

But if the portfolio is poorly selected, and suffers losses over 1%, the bank cashes in handsomely. At 5% losses, the bank makes 4% of $1bn, or $40mm. At 50% losses, the super senior attachment point, the bank caps out at 49% of $1bn, or $490mm. (Profits are maxed out at the 50% AL level as, in this example, the bank holds the super senior swap.)

A bank can either lose up to $10mm for doing a really good job of diligently selecting good assets, or the bank can make as much as $490mm for selecting really bad assets. Would you expect any bank to do the former?

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[1] If anything, the CDS counterparty ought to have a slight preference for the continued performance of each CDS contract, as a default would cause settlement and thereby cut short any intermediation fees it may be earning as a middle-man.

A TruPS UPdate

The TruPS CDO market has shown renewed signs of life over the last six or so months, for the first time really since 2007.

While the rating agencies continue to downgrade these bonds, and while certain serious risks remain to their performance, the market is (finally?) reacting to a number of positive developments in the underlying bank market. Several TruPS CDO securities, we believe, are now grossly mis-rated by the rating agencies. Our analysis suggests that many securities rated CCC or below will pay off in excess of their ratings-implied losses; some are likely to pay off in full.

Default Risk

A key risk for TruPS CDOs remains the default rate on smaller banking institutions. (Aside from banks strictly being pulled into receivership, TruPS CDO noteholders remain exposed to losses that may result on their preferreds to the extent troubled banks restructure, recapitalize or file voluntary petitions for relief under Ch. 11 of the Bankruptcy Code – see for example the cases of AmericanWest, or Builders Bank.)

On the plus side, the rate of bank failures has gone down from 2010. Adjusting for the cohort size – depending on the number of institutions reporting – we’re down from a default rate of approximately 2.05% last year to 1.37% annualized this year, based on the FDIC’s most recent quarterly report (March-end 2011).

This difference is substantial. From the looks of it, one of the key components of this reduction was that bank regulators were more successful in having banks absorbed through a merger process, evading failure: if we consider mergers plus failures, the sum is little different, from 4.62% in 2010 to 4.33% annualized for Q1 2011. But the distribution is now heavier towards the merger side of this equation, implying in the reduced bank failure rate.

The staving off of default, through the merger process or otherwise, almost always proves advantageous to TruPS CDO noteholders.

Balance Sheet Conditions & Outlook

The FDIC notes that “[more] than half of all institutions (56.2 percent) reported improved earnings, and fewer institutions were unprofitable (15.4 percent, compared to 19.3 percent in first quarter 2010),” and that net loan charge-offs (NCOs) have declined for the third consecutive quarter, resulting in an overall 37.5% reduction since March-end 2010. Deposit growth remains strong and the net operating revenues reductions were concentrated at the larger institutions – less of a concern for the average TruPS CDOs which are more heavily exposed to smaller rather than larger banks.

Banks' balance sheets, too, are in better condition: the ratio of noncurrent assets plus other real estate owned assets to assets decreased from 3.44% in 2010 to 2.95%. Also, while the overall employment of derivatives has increased almost 13% over the last year, the heightened exposure is more heavily concentrated among the larger banks. Based on PF2's calculations, if you exclude banks with more than $10bn in assets, you’ll notice a reduction of almost 30% in derivatives exposure over the last year.

These numbers are still much worse than pre-crisis numbers. Historically banks defaulted at an annual rate of approximately 0.36%, on a count basis. We’re at roughly four times that number now. Back in ’06, fewer than 8% of reporting institutions were unprofitable. We’re still at double that number. The ratio of noncurrent assets plus OREO assets to assets was slightly below 0.5% in 2006. We’re sitting at six times that level. But the trends are moving in the right direction – certainly if you’re an investor in the average TruPS CDO.

On the downside, the FDIC’s problem bank list has grown by a not-insignificant amount, from 775 banks (or 10.12% of the cohort) in 2010 to 888 banks (11.72% of cohort) as of March 31, 2011. TruPS CDO noteholders will doubtless hope that these troubled institutions turn around, or are merged or resolved in any other fashion that circumvents default on their trust preferred securities. (For TruPS CDO noteholders exposed to deferring underlying preferreds, the acquisition or merging of the deferring bank by or with a better-capitalized bank brings with it the possibility of the deferral’s cure.)

With the downward trend of bank default rates (and the possibility of deferrals curing), some of the more Draconian bank default probability assumptions can be relaxed, boosting values on TruPS CDO tranches.

We think the market is starting to appreciate this additional "value."

An Aversion to Mean Reversion

Last Wednesday’s Financial Times hosted a scathing column by Luke Johnson, which questions the usefulness of economists, as a whole (see “The dismal science is bereft of good ideas.”)

The column’s title is misleading: Johnson focuses his frustrations only on economists – not economics. Importantly, it is the application of the science, not the science itself, which seems to have caused Johnson's concern.

Indeed the purity of all mathematical sciences can be spoiled by its application. Johnson comments that he “[fails] to see the point of professional economists,” that economists “pronounce on capitalism for a living, yet do not participate in private enterprise, which is its underlying engine.” He ends off his piece by prescribing “[the] best move for the world’s economists would be to each start their own business. Then they would experience at first hand the challenges of capitalism on the front line.”

To be fair, the direct application of economic theory was never intended to satisfy the depths of the dynamic puzzle we put before them, a puzzle for which the answer lay not in the data but in the incentives. [1]

We cannot pretend not to have known that economic models work best in reductionist environments, and that the introduction of complications (like off-balance sheet derivatives) tend to reduce the effectiveness of economic models. Conceptually, once models start to consider too many inter-related variables, or degrees of freedom as statisticians call them, they become so rich and sensitive that no empirical observation can either support or refute them. And so any failures of economists to spot the housing bubble or predict the credit crisis, as Johnson mentions, become our failures too. We would have done better to equip our economists (or academics) with the tools necessary to perform the “down and dirty” analyses that take into account the complex and changing nature of our economy. [2]

Seeing no reason why they ought to have succeeded, we’re perhaps a little more forgiving (than Mr. Johnson) of economists’ shortcomings. But we share his concerns that mathematical sciences are being too directly applied, that the practices and the incentives are being largely ignored.

On Endlessly Assuming “Mean Reversion”
Rather, we ought to encourage our researchers to go into the proverbial field – and to learn to think, and study dynamics, differently.

We can no longer allow ourselves to be informed purely by static analyses of historical data and trends, without seeking a keener appreciation for the underlying dynamics at play. The lazy assumption of mean reversion is simply an assumption, not a rule. When the fundamentals are out of whack – and a direct analysis of data alone cannot tell you that – the market can and will act very differently from a mean-reverting economic model.

Thinking Differently

Given that many market participants have emotions (one could argue that computer algorithms are to an extent emotionless), the tendency for panic or at least the capacity for panic ought to make the direct application of mean reversion models less appealing – and their results less informative, predictive or meaningful.

Ask not “is this a buying opportunity” based on a simple historical trend. But what are the underlying fundamentals? If the game changed based on underlying issues, have they been resolved? Or were they underestimated or overestimated. If the latter is determined after sufficient exploration, one could recommend a "buy." If the former, initiate a "sell." To do otherwise - to simply present a graph and suggest an idea, is folly – it's simply a guess.


Mean reverting economic forecast models continue to be constructed to this day without the thought necessary to support their assumptions (despite the realization that we’re in a very different world).

The outputs, unfortunately, are never better than the inputs.


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[1] See our earlier commentary “The Data Reside in the Field”

[2] In light of this fact, it is perhaps troublesome that when questioned by JP Morgan CEO Jamie Dimon as to the extent of the government's investigation of the effect of its banking regulations, Bernanke purportedly responded "has anybody done a comprehensive analysis of the impact on -- on credit? I can't pretend that anybody really has," ... "You know, it's -- it's just too complicated. We don't really have the quantitative tools to do that." Source

Is Wall Street Guilty?

“If Wall Street is bilking Main Street on such simple deals–basic trade execution-and yet the only way to recover is to sue, what real chance do individual investors have of getting a fair shake in the financial markets? And what if you add sophisticated computer models, derivatives structuring technology, and secret Cayman Island companies to the mix? Do we have any chance at all?” — Frank Partnoy (1998) in his postscript to F.I.A.S.C.O.

A couple of weeks ago, Bloomberg BusinessWeek ran a story by Roger Lowenstein, entitled “Wall Street: Not Guilty,” that largely absolves Wall Street of criminal culpability for the financial crisis. 


This courageous conclusion—and if nothing else one must concede it is courageous—runs counter to popular opinion that malfeasance on Wall Street was an integral cause of the crisis, if not the chief cause. The story widens the debate at a time when a number of vocal critics (including Inside Job director Charles Ferguson and New York Times contributor Jesse Eisinger) are calling for criminal prosecutions.

Putting aside the accuracy of Mr. Lowenstein’s supporting arguments[1], we find it interesting to consider Mr. Lowenstein’s argument against criminal prosecutions from a legal, economic and philosophical perspective.

Society criminalizes conduct to achieve many policy goals, above all, prevention and punishment. (Of course, punishment should have a deterrent effect but it retains significance without regard to its deterrent effect.) Juridically, the primary goals of punishment center on the protection of society from criminal conduct, the stigmatizing of the conduct and the serving of justice to the victim(s).

The economic argument is simple, as it relates to the protection of society. From an economist’s viewpoint, punishment can be described as the “price” a criminal must pay to society for breaking the law, for criminal conduct. This “price” has two elements: the severity of the punishment on the books and the likelihood of its imposition in practice. In proper balance, they work together as deterrents to criminal activity, reducing its incidence. But what happens if we introduce an imbalance between these elements, if our laws create stiff penalties that are never imposed? We already know the answer to this question: when potential criminals believe ex ante that misconduct will not be punished, the marginal wrongdoer is incentivized to seek economic rents from misconduct.

Mr. Lowenstein agrees that “[t]o prosecute white-collar crime is right and proper, and a necessary aspect of deterrence.” However, in the current crisis, he sees a wrong but no wrongdoer: “[T]rials are meant to deter crime—not to deter home foreclosures or economic downturns. And to look for criminality as the supposed source of the crisis is to misread its origins badly.” But the hunt for wrongdoers in this crisis is no mere quest for a scapegoat. Rather, it proceeds from the need to protect society from future crises. This will only happen if punishment deters (or incapacitates) the specific wrongdoer from repeated misconduct and deters the general public from similar misconduct by the example of the punishment of the wrongdoer.

The philosophical analysis is more complex—but worth exploring in a wider context. It forces us to examine how well our present regulatory system is capable of dealing with the special types of problems presented by the complex and opaque world of derivatives dealing, problems with which is it is repeatedly and increasingly being required to cope.

Mr. Lowenstein doesn’t quite make the best philosophical argument against criminal prosecutions in this crisis, but he might have suggested the following: any criminal conduct in this crisis was so wide-spread that no wrongdoer’s action stands alone. If any one wrongdoer had not acted improperly another one would have. In other words, where everyone is guilty, no one is.

In other words, while well-constructed derivatives provided certain wholesome benefits, the opportunity to benefit from abusing derivatives was not limited to a single bank or even a single type of financial institution. Rather it transcended the banks and hedge funds and included all types of market participants, from the buy-side to sell-side to the rating agencies and beyond, and all types of individuals working for those participants. In the end, the entire profit maximization motive and the human nature from which it proceeds must be put on trial, so that ultimately we all find ourselves sitting right next to every other defendant in the dock.

Thus, a defense might argue that the “system” seems to have encouraged (and rewarded) wide-spread misconduct and that, given the existence of such a dysfunctional dynamic, one ought to excuse a defendant's acting as a willing participant (or instrument) in this unjust system, if for no other reason than to advance his or her self interests, or lofty ambitions.

The philosophical response may simply be this: an abyss exists between actual wrongdoing and potential wrongdoing. Those who kill while part of a mob really are different from those who are just part of the mob.

But while philosophically that response might appear to suffice, legally there remain certain challenges. Among other things, a prosecutor has to prove both components of a criminal act: criminal conduct and the requisite mental state. The requisite mental states—intentional, knowing, reckless or even negligent conduct—may vary by jurisdiction and they may pose a barrier to the extent they require a determination of the defendant’s level of deviation from that of the ordinary person in a similar environment. (The similarly improper conduct of many or all parties surrounding the defendant may obscure the analysis of a “punishable mental state.”)

But they should not prevent prosecution: the critical question is not “Shall we prosecute?” but “Whom shall we prosecute?”

Nor does the argument hold weight that a subordinate can excuse her role as a mere functionary carrying out the role of her superior. Whether the defendant was only a tiny cog in the machinery, or the motor driving the faulty operation, the relative importance to the resulting order of magnitude of the misconduct serves only to help define the gravity of the sentence imposed—not the probability of its imposition.

17th century Dutch jurist and statesman Hugo Grotius, paraphrasing an earlier Roman authority, explained that "punishment is necessary to defend the honor or the authority of him who was hurt by the offence so that the failure to punish may not cause his degradation."

Given the continued proliferation of improper derivatives dealing, it is punishment alone that can protect our society for future wrongdoing—through stigmatizing the improper acts and by serving as a material deterrence for potential wrongdoers. In this way, restitution will meet the material concerns of the victims of these crimes—the tax-payers.

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[1] The facts have been argued by, among others, Ryan Chittum and Prof. William Black.