Thursday, March 31, 2011

Central Pricing Solution

It continues to worry us that asset prices can be, or are, subject to conflicts of interests and inflationary pressures.

As an independent valuation consultancy we’re naturally disagreeable about market participants seeking valuations from biased counterparties like asset managers or even the broker dealers who sold them the bonds or are funding their holding of the bond. Scion Capital’s Michael Burry explained in The Big Short: “Whatever the banks’ net position was would determine the mark.”

But even aside from potentially conflicted external parties, we’re acutely aware of the inflationary pressures independent parties such as ourselves may face when evaluating a security. Similar to “ratings shopping” opportunistic market participants often seek out the provider willing to give the highest prices.

The incentive is clear: higher asset prices translate into stronger performance. Stronger performance may directly benefit an executive or employee (to the extent performance fees or bonuses are based on returns) or even indirectly improve a fund’s prospects (heightened ability to raise capital or negotiate decreased margin requirements on the back of strong performance).

While prices have been regularly contested problems are starting to crop up more and more regularly, with questions about mutual funds’ municipal bond pricings and Berkshire Hathaway’s pricing and writedown practices finding their way into the news in the last two months.

There’s no easy solution, but one we feel strongly about is the creation of a centralized analytical (read pricing) solution.

The cost of creating such a system could be shared among its users. The advantages are numerous. Here are a few:

  • If all holders were required to hold the same security at the same price, the result would be greater balance sheet consistency (across funds, companies)

  • Regulators, auditors and examiners would have an easier time analyzing their constituents’ books: they would be able to rely on a single, consistent model that is widely used. (The prevailing, seemingly inefficient alternative is to have each regulator/ auditor/examiner familiarize herself with the methodologies employed by each and every pricing provider used by each company scrutinized. This is no mean feat, especially across different asset classes, and so naturally a lot will slip through the cracks.)

  • Pricing consistency helps reduce portfolio-level variability and also helps the market overcome some of the uncertainties that come with informational asymmetries and modeling complexities in today’s market. Consistency and confidence together help promote market liquidity.

Thursday, March 17, 2011

Looking for a Mis-Rated Subprime Bond?

As we combed through the latest list of subprime RMBS ratings downgrades, we found some astonishing actions, like AA ratings being reduced to CCC in one fell swoop. (Source: S&P's March 16 press release, entitled: S&P Lowers 172 Ratings On 39 '03-'04 US Subprime RMBS Deals, see for example Fremont Home Loan Trust 2004-3 Class M4.)

But one in particular caught our eye:

Welcome to Morgan Stanley ABS Capital I Inc. 2004-NC5 Class B4

Rated C by Moody's and CC by S&P (the lowest and second lowest ratings respectively), the bond paid off in full.

Click to enlarge

As the chart shows, this bond didn't suddenly pay off in full, catching the raters by surprise. Rather, it paid down ever so slowly, but consistently, especially over the period from February through November 2010. (The factor describes the percentage of the bond's par value outstanding at any time, as a percentage of its original face value. In this case, it went from 100%, or 1, down to approximately 20% in mid '07, and then down to 0%, ultimately, in November 2010.)

But wait, this gets better: while S&P simply denotes the CC rating as being withdrawn (as opposed to being paid off in full), as per their procedure, Moody's skips over the B4 class in its March 15, 2011 press release entitled: Moody's downgrades $2.75 billion of Subprime RMBS issued by Morgan Stanley in 2000 through 2004
We did a little checking. First we wanted to verify from the deal's trustee report that class B4 really did get all its payments. Turns out that not only did the B4 pay off in full (four months ago), but the C-rated B3 notes, still outstanding, are paying off handsomely too. Since Moody's downgraded the B3 notes (CUSIP 61746RGA3) to C in Feb. 2009, they've paid down more than 56% of their balance!

The bond continues to pay (as of Feb. distribution), and now has a factor of just under 11% remaining. It's currently rated C, CC and C by Moody's, S&P and Fitch, respectively.

Click to enlarge

Update: Feb. 2012: tranches B, C, D and E of Parkridge Lane Structured Finance Special Opportunities CDO I Ltd. were withdrawn after paying down in full. They paid down slowly over time. At the time of final payments, the B notes were rated Caa1 by Moody's and CCC+ by S&P. The E notes were rated Ca by Moody's and CCC- by S&P.

For similar funky findings, click here or here or here. For our coverage of weird (usually structured finance) model errors, click here.

Thursday, March 10, 2011

Christine Richard, on Confidence

Earlier this week, Expect[ed] Loss sat down with Christine Richard, author of Confidence Game. If you haven’t already read the book well firstly shame on you. The paperback’s due out next week so pick it up. It’s a vital story.

Briefly, the book tells of a hedge fund investor’s campaign to bring attention to what he felt to be material shortcomings within a AAA-rated, systemically important insurance company. He’s short their credit default swap, which means he stands to profit if other market participants, authorities, rating agencies or regulators can be convinced to agree with his take. Of course, he walks the line between good and evil: he provides a material public good in a way in warning of a systemic concern, but in doing so his warnings serve to cloud the viability of a systemically important public company, while creating a profit for him.

We’re not here to spoil the book for those of you who haven’t read it yet. But we’re going to provide you with a couple of snippets from our conversation. Any wisdom coming from the interview belongs to Christine. Any errors are ours.

EL: Christine your book describes activist investor Bill Ackman’s crusade, and really it’s quite a lonely crusade isn’t it, against an insurance company he believed to need reforming and perhaps a whole system he felt was broken. Having seen how reform and regulation has transpired since, how the world has moved on, well has it affected your perception of the value of your work. Was the book fulfilling to you?

CR: I'm pleased with the book and the response I've gotten from people who've read it. I think it succeeds in combining a very human story with the larger story about what went wrong on Wall Street. I do find it discouraging that the FCIC left the role of the bond insurers out of its 500-page-plus report. I think that the loss of confidence in the triple-A ratings of companies like MBIA was the beginning of the unraveling of everything. Most of the companies have crept quietly off the stage but still I think the story of their collapse is worth understanding. They were the first, really, to figure out that the triple-A rating was one of the most powerful brands in the world. Before the crisis, their collapse was unthinkable. Even the idea that they might be downgraded to AA from AAA was unimaginable. It shows you just how fragile and delusional the financial system had become.

EL: Companies can fail for all sorts of things, often trace-able to poor communication between management and the board and shareholders. But here that wasn’t really the problem – Ackman, like Harry Markopolos in a way, was all about communication. He went to regulators, to the attorney generals, to the executives at the ratings agencies. He wrote detailed reports, ran extensive analyses, produced an open source model at a time in which analytics were expensive and the market opaque. What can be taken from all his efforts? All these authorities he went to that were deaf to his comments - did they all just have a distortion field around them at the time?

CR: Some of the reasons people wouldn't listen to Bill were obvious. It wasn't in their interest to be critical of a company that could turn any bond into a top-rated security. For a while, the main business of Wall Street was manufacturing triple-A-rated securities. I also think there were psychological reasons that people didn't want to listen. No one wants to be told how to do their job or that they have it all wrong. Plus, Bill had this huge financial motivation to scare people about the bond insurers so that he could make money on his credit default swap position. It was hard to look beyond the self-interest and really think through the argument. Above all, the triple-A credit rating shielded the company from critics.

EL: When we read interviews of Inside Job director Charles Ferguson, they often ask him about the language barrier of finance. Overcoming the barrier might be quite difficult for some reporters who are not too familiar with finance. Now I know you’ve been covering the debt market for many years at Dow Jones from well before you were at Bloomberg. And you’ve written a page turner, you really have, it’s remarkable. But was there a, how do we say it, complexity barrier for you to overcome?

CR: The financial system became so unbelievably complex. And, bond insurance layered more complexity on top of complexity. I didn't want to shy away from writing about credit default swaps or collateralized debt obligations but I was always conscious that I needed to quickly offset the technical explanations with something a human being could relate to. Bill's willingness to share his personal experiences, to let me look through thousands of emails and to interview his friends and colleagues made it possible to write a story that's as much about human nature as it is about bonds or credit default swaps or collapsing mortgage securities. One of my favorite parts of the book is when Moody's finally puts MBIA under review and Bill is at his grandmother's 90th birthday at the Plaza Hotel. He's trying to piece together how a credit rating downgrade might unravel the whole company and how that is going to trigger payments of billions of dollars on his swaps. Meanwhile, the waiter is holding up a cake and his family is singing Happy Birthday and he's trying to sing and to read Bloomberg headlines and communicate with his trader on a Blackberry under the table.

EL: You mention even at Dow Jones that there wasn’t much patience for your investigative tendencies, your interest in digging deeper. And you’ve mentioned to me before the pressures to keep current – how nobody wants you going back and following up on stories of the past. Is this the new normal?

CR: It's a big part of what business journalism aspires to do -- to give people information to trade on, to move stocks, to make profitable predictions. Maybe it explains why the M&A reporters get so much of the attention. I've always enjoyed telling stories more than making forecasts. In the case of MBIA, I found the company's history of covering up losses so fascinating because it revealed its vulnerability. It had to be infallible or it was finished. That made going back and looking at the past important. The past held all the clues about what was going to happen.

EL: Christine before I let you go I want to ask you one thing – does Bill inspire you?

CR: I spoke with Bill for six years before I started writing the book. What I enjoyed most about our interactions was his enthusiasm for the research. He was fanatical about figuring out what made the company tick, and he seemed to have more fun reading financial statements than anyone I've ever met. He also just has this incredible optimism. He'd come back from a meeting with one of the credit rating agencies (back in the days when he was giving two-hour long presentations about why MBIA should be downgraded and he was being ignored) and an employee at Pershing Square would ask how it went. It was always the same response -- "On a scale of one-to-ten, the meeting was definitely a ten." Eventually, people didn't even bother to ask Bill about meetings, they just looked at each as he came through the door: "Ten out of ten?" "Yep, ten out of ten?" It's a great message about believing in yourself and persevering when the world thinks you're wrong.

To read more about the Confidence Game, click here.

Friday, March 4, 2011

The Curious Case of Carrington

With Carrington having been in the news of late, we thought we would investigate the performance of one of its bonds.

Today's bond is currently rated A2 by Moody's (MCO), CCC by Standard and Poor's (MHP), and CC by Fitch. (Carrington Mortgage Loan Trust, Series 2004-NC1 ; Class M2 ; CUSIP: 144531AF7)

This residential mortgage backed security (think "toxic asset") survived through to 2009 before first being downgraded by Fitch. Standard and Poor's followed suit in 2010. Moody's retains it at its original A2 rating.

Split ratings like these, in an ideal world, provide a trader with an ideal opportunity to profit if she can correctly express her opinion as to the credit quality of the bond. Of course, there's no simple mechanism for shorting a RMBS security that you think is over-rated -- but buying a bond you believe to be under-rated can provide handsome rewards, if you're right.