Friday, April 22, 2011

Ratings Reversals

Back in our December 2010 piece (The Psychological Biases of Holding Downgraded Bonds) we commented on what was to us a rather unusual trend in the collateralize loan obligation space, where these bonds were being downgraded at a time when their fundamentals were already (generally) rebounding.

“[One] rating agency began downgrading collateralized loan obligation (CLO)securities between September 2009 and May 2010, well after the market shock had ended, with loan prices generally having begun returning to 'normal' levels in December 2008. Depending on what indices you examine, loan prices generally went up roughly 40% during calendar year 2009, and this trend has continued in 2010. CLO prices improved too, as have their underlying portfolios. So while the rating agency was aggressively downgrading almost 3,000 bonds during this time period, the underlying loan market and the CLOs themselves were markedly improving.”
Moody’s recently produced some very informative data on their ratings reversal rates in structured finance. Not surprisingly – at least to to us and the avid readers of our blog – CLOs lead the list of ratings reversals, at a rate of approximately 5 times that of other CDOs (excluding CLOs) and more than 6 times the rate of all global structured finance ratings provided by Moody’s.

The downgrading (if it is premature) of a long-term bond only to subsequently upgrade it falls broadly within what is referred to as a “Type II” ratings error.

Holding lower-rated bonds can be more expensive for investors. This may encourage holders to sell the bonds to the extent the cost of funding the lower-rated bonds is too high, or they may even become forced sellers to the extent the lower ratings fall outside of their investment guidelines or their vehicles’ eligibility criteria. Thus, in addition to the (rather unfortunate) increased cost of funding on a downgraded bond, one may be forced to sell the bond at an inopportune time, only to see the bond subsequently re-upgraded.

Ratings reversals can include downgrades followed soon after by upgrades, or upgrades accompanied by subsequent downgrades.

Examples of Moody’s ratings reversals:

1 - Gresham Street CDO Funding 2003 class B notes (CUSIP 39777PAB9): Originally rated Aaa in 2003. Downgraded (Moody’s) to A1 in Aug. 2009. Upgraded to Aaa in May 2010. (S&P maintained rating at AAA throughout.)

2 - Halcyon Loan Investors tranche B (CUSIP 40536YAJ3): Downgraded from A2 to Ba1 (March ’09) to B3 (June ‘09); upgraded back to Ba3 (May ’10) and Ba1 (Dec. ’10).

Happy Easter everybody!
- PF2

For more on this topic, click here.

Wednesday, April 13, 2011

Split Ratings

Given the high correlation between security prices and their ratings, we wanted to follow up on some of our prior pieces that contemplated the wide discrepancies between ratings opinions provided on certain securities (see for example here and here). Split ratings, of course, present trading opportunities.

Our analysis considered securities that were acted upon by a single rating agency between June and August of 2009. We then had a look at the average ratings split as of March 28 this year: one and a half years later. The outcome was quite astonishing.

While at inception the rating agencies seem typically to achieve the same rating, down the line they tend to substantially disagree with one another. (We have broken the differential down depending on how many rating agencies rated each security. If all three of Moody's, Fitch and S&P rated the security, we'll show both a max split and a minimum split. If only two raters rated the security as of March 28, 2011, the max split equals the min split.) The average max differential: 4.23 rating subcategories (or "notches"). The median differential - 3 notches. One rating subcategory would be the difference between a AAA and a AA+.

This table shows examples of the 748 structured finance securities considered in our database at each ratings split level, including one of the 20 securities on which there was a ratings differential of between 14 and 18 ratings subcategories.

For the purposes of this analysis, securities were only considered to the extent they had ratings outstanding from at least two of the Big Three credit rating agencies as of March 28, 2011.

Thursday, April 7, 2011

Contested Pricings List

The capacity for price manipulation or price inflation presents a major challenge for the market to overcome, especially in the illiquid markets where live trading data are seldom made available to the general public. Like "ratings shopping," investors may be incentivized towards seeking the highest price, or most accomodating price provider, for their securities.

We will continue to maintain this growing database of situations in which parties disagree as to the prices used, or pricing practices employed.

  1. Dec. 2017: SEC Probes If Banks Helped Hedge Funds Inflate Returns: "The U.S. Securities and Exchange Commission is now investigating whether some banks crossed the line to win business by offering hedge funds bogus price quotes on hard-to-value bonds, said two people familiar with the matter. The SEC’s concern: As a reward for helping hedge funds make money -- by submitting quotes at requested levels -- banks got trades steered their way."

  2. Dec. 2017: Intrepid writes down mining properties: "ASIC notes the decision by Intrepid Mines Limited (Intrepid) to make a $16.1 million impairment charge against its Zambian mining properties in its financial report for the half-year ended 30 June 2017. ... Intrepid announced a subsequent sale of its Zambian assets for $4.75 million plus $1 million deferred contingent payments on 12 December 2017, resulting in a further loss."

  3. Oct. 2017: Rio Tinto, Former Top Executives Charged With Fraud: "The Securities and Exchange Commission today charged mining company Rio Tinto and two former top executives with fraud for inflating the value of coal assets acquired for $3.7 billion and sold a few years later for $50 million."

  4. Oct. 2017: Ex-Third Point Partner’s Bond Trades Focus of SEC Probe: "U.S. regulators are investigating whether a top trader who left Dan Loeb’s Third Point hedge fund earlier this year contributed to the mispricing of hard-to-value mortgage bonds, two people familiar with the matter said. The Securities and Exchange Commission is probing whether former Third Point partner Keri Findley caused the thinly traded bonds to be undervalued, said the people who asked not to be named because the probe isn’t public. Findley, 35, left the $18 billion firm in February, telling people who had direct communications with her that she was retiring and moving to California."

  5. Oct. 2017: RBS to pay $44 million to settle U.S. charges it defrauded customers: "RBS will pay a $35 million fine, plus at least $9.09 million to more than 30 customers, including Pacific Investment Management Co, Soros Fund Management and affiliates of Bank of America, Barclays, Citigroup, Goldman Sachs and Morgan Stanley. Prosecutors said that from 2008 to 2013, RBS cheated customers by lying about bond prices, charging commissions it did not earn and concealing the fraud in an effort to boost profit at the customers’ expense."

  6. Aug. 2017: SEC Order: In the Matter of KPMG LLP AND JOHN RIORDAN, CPA: "This case involves improper professional conduct and securities law violations by KPMG and Riordan relating to a review and audit of the financial statements of Miller Energy Resources, Inc. (“Miller Energy”). During its fiscal 2010, Miller Energy acquired certain oil and gas interests located in Alaska (the “Alaska Assets”) for an amount the company estimated at $4.5 million and then subsequently reported those assets at an inflated value of $480 million in its fiscal 2010 financial statements. This asset valuation violated generally accepted accounting principles (“GAAP”) and overstated the fair value of the assets by hundreds of millions of dollars."

  7. Aug. 2017: One of Canada’s largest private-equity firms accused of fraud: "Canadian securities regulators received four independent whistleblower complaints against a multibillion-dollar investment firm Catalyst Capital Group Inc., The Wall Street Journal reported ... The case was brought to the country’s leading securities regulator — Ontario Securities Commission. According to the complaints it was artificially inflating the value of some of its assets and deceiving borrowers about the terms of loans it made."

  8. May 2017: Hedge Funds Are Facing a U.S. Criminal Probe Over Bond Valuations: "The witness, a former broker named Frank DiNucci Jr., said under oath that he provided bogus quotes to a trader at a mortgage bond fund, Premium Point Investments LP. DiNucci agreed to plead guilty last month in Manhattan federal court to conspiracy and fraud and says he has been cooperating with a criminal probe by New York prosecutors into Premium Point." ...“I would extend marks to make them seem like they were my own,” DiNucci told the federal jury in Hartford. The goal was to “increase the number of trades we would do with this particular client,” he said.

  9. Apr. 2017: Lehman Suit Seeks Return of $2 Billion in 'Phantom' Citi Fees: "The trial opens a rare window into the frenzied weekend before Lehman’s bankruptcy filing on Sept. 15, 2008. Banks were supposed to use a Sunday trading session to mitigate damage to the financial system by reducing their exposure to the bank. Lehman, which first sued over the $2 billion in 2012, claims that Citigroup efficiently hedged its risks, but went on to inflate its claim by marking its books to its benefit." ... "Marc Pagano, who ran Citigroup’s emerging-markets business at the time and was involved in closing out some of his group’s trades, was asked in a phone conversation -- a recording of which was played in court Wednesday -- whether traders were supposed to mark their books under a different methodology than usual. “Yeah, one night. One night only,” Pagano said in the call. “We only deviated one night.” 

  10. Feb. 2017: Mortgage investor Premium Point discloses SEC probe: Premium Point Investments LP is under investigation by the U.S. Securities and Exchange Commission over the valuation of structured products and other assets held by its funds, according to a letter sent to clients of the New York-based investment firm.

  11. Jan. 2017: SEC Reviews Bond Trades by Hedge Funds, Devaney’s Firm: At issue, the people said, are trades between hedge funds -- including Candlewood Investment Group -- and United Capital Markets, a brokerage owned by John Devaney. Investigators at the U.S. Securities and Exchange Commission are trying to determine if the prices in small transactions were reasonable or were inflated to allow the parties to record gains on bigger holdings of the securities, according to the people. Devaney said there has been no suggestion by regulators that his firm engaged in misconduct.

  12. Dec. 2016: ECB Found Deutsche Bank Risk Management Weakness: "A European Central Bank inspection of Deutsche Bank AG’s risk controls found deficiencies in derivatives and complicated financial bets that raise questions about pricing processes at the German lender, Il Sole 24 Ore reported."

  13. Dec. 2016: Wall Street Cop Asks Money Managers To Reveal Silicon Valley Valuations: "Federal securities regulators are intensifying efforts to determine how large U.S. money managers value some of the best-known private technology companies, such as Uber Technologies Inc. and Airbnb Inc. In recent weeks, the Securities and Exchange Commission sent letters to or spoke with several mutual fund firms including T. Rowe Price Group Inc. and Fidelity Investments, according to people familiar with the matter."

  14. Oct. 2016: Deutsche Bank Said to Review Valuations of Inflation Swaps: "The bank is looking at valuations on a type of derivative known as zero-coupon inflation swaps, said the people, who asked not to be identified because the matter is confidential. After finding valuations that diverged from internal models, it began questioning traders, the people said."

  15. Aug. 2016: Legal Fight Escalates Over Tech Startup’s Financials: "Mr. Biederman holds 64,166 Domo shares that would be worth $540,919 at the $8.43-per-share price where Domo sold stock to investors last year. But some mutual-fund investors have since marked down their Domo shares, according to The Wall Street Journal’s Startup Stock Tracker. Morgan Stanley said Domo shares were worth $5.04 a share as of May."

  16. Aug. 2016: Former Deutsche Bank Trader Fined $50,000 by SEC Over Valuations: "A former Deutsche Bank AG trader agreed to settle a U.S. regulator’s allegations that he mis-marked loans tied to commercial-mortgage-backed securities to boost his profits" ... "The SEC has made policing bond valuations a priority. The agency and the Justice Department have brought civil and criminal cases against traders for lying about bond prices to customers. The SEC is using algorithms to comb through bond trading and has found billions of dollars worth of problematic transactions."

  17. Aug. 2016: U.S. mutual funds boost own performance with unicorn mark-ups: "The Securities and Exchange Commission (SEC) has been asking mutual fund companies how they value their stakes in companies like Uber, Pinterest Inc and Airbnb. The regulator is worried investors could get hurt in case of a sharp tech downturn, according to two people familiar with the SEC's queries."

  18. July 2016: Fraud Probe Ricochets Through Platinum Partners: "Among questions investigators seek to answer is whether Platinum misstated values of some holdings, the people familiar with the probe said. Platinum spokesman ... defended the firm’s auditing and valuation methods and said it stands behind its performance record."

  19. July 2016: LendingClub Fund Has Its Version of June Swoon: "LendingClub also said in the filing that LC Advisors hadn't followed standard accounting rules when it was determining the value of the loans in its portfolio as well as their monthly returns. Investors affected by the adjustments would be reimbursed around $800,000,...."

  20. June 2016: CMBS Servicers Sued in Fair-Value Option Case for 'Flawed' Appraisal: An investor in a 2007 CMBS transaction has sued the deal's master and special servicers, arguing that they breached their obligations under the deal's pooling and servicing agreement when they allowed a collateral $84.8 million loan to be sold using a fair-value purchase option.  

  21. June 2016: ASIC calls on directors to apply realism and clarity to financial reports. "ASIC continues to find impairment calculations based on unrealistic cash flows and assumptions, as well as material mismatches between the cash flows used and the assets being tested for impairment.... Fair values attributed to financial assets should also be based on appropriate models, assumptions and inputs."

  22. May 2016: Wall Street Cops to Hedge Funds: Treat Investors Better: "Regulators are looking into whether a firm employed by RD Legal as its independent valuation agent, Pluris Valuation Advisors LLC, ever contested any of the firm’s preferred valuations, people familiar said."

  23. May 2016: Banks Sued by Investor Over Agency-Bond Rigging Claims. "The lawsuit... accuses traders of colluding with one another to fix prices at which they bought and sold SSA bonds in the secondary market. It adds the threat of possible triple damages available under U.S. antitrust law for investors harmed by any illegal price-fixing."

  24. Mar. 2016: A $7 billion hedge fund says it's being investigated by the SEC and the US Department of Justice: "They have requested information from several years ago regarding the valuation of certain securities in the firm's credit fund which was closed in 2013,..."

  25. Feb. 2016: Loan Valuations Draw Scrutiny: Some firms are marking down securities faster than others

  26. Nov. 2015: Regulators Look Into Mutual Funds’ Procedures for Valuing Startups
  27. Sept. 2015: Canadian Pension Fund Says It Was Cheated By Boaz Weinstein's Saba Capital

  28. May 2015: SEC Charges Deutsche Bank With Misstating Financial Reports During Financial Crisis: “An SEC investigation found that Deutsche Bank overvalued a portfolio of derivatives consisting of “Leveraged Super Senior” (LSS) trades through which the bank purchased protection against credit default losses."

  29. May 2015: Alleged Fund Fraud Exposes Cracks in Securities Pricing: “The trustees have determined that the valuation of the fund’s assets may not be reliable,” the board wrote in a letter to shareholders after [manager] Thibeault’s arrest that month.

  30. May 2015: We Tried to Re-Create JPMorgan’s Mutual Fund Returns and Gave Up: The bank’s impressive mutual-fund-group performance figures come with little explanation

  31. Mar. 2015: SEC Announces Fraud Charges Against Investment Adviser Accused of Concealing Poor Performance of Fund Assets From Investors: The SEC’s Enforcement Division alleges that Lynn Tilton and her Patriarch Partners firms have breached their fiduciary duties and defrauded clients by failing to value assets using the methodology described to investors in offering documents for the CLO funds, which have portfolios comprised of loans to distressed companies.

  32. Sept. 2014: SEC Finds Deficiencies at Hedge Funds: Shortcomings Include Valuation 'Flip Flopping'

  33. Sept. 2014: Pimco ETF Draws Probe by SEC: Regulators Are Probing Whether Returns Were Artificially Inflated

  34. Aug. 2014: FINRA Fines Citigroup Global Markets: "Citigroup priced more than 7,200 customer transactions inferior to the NBBO because the firm's proprietary BondsDirect order execution system (BondsDirect) used a faulty pricing logic"

  35. June 2014: Ex-Millennium Fund Manager Gets Four Years in Prison: "Former Millennium Global Investments portfolio manager Michael Balboa was sentenced to four years in prison for defrauding investors by inflating the value of Nigerian sovereign debt by $80 million." ... "Balboa, a London-based investment manager, was convicted of providing fake valuations to inflate month-end market prices on Nigerian warrants. The scheme generated millions of dollars in management and performance fees for which he earned as much as $6.5 million, prosecutors said."

  36. Feb. 2014: SEC Looking at How Alternative Funds Value Investments

  37. Feb. 2014: Danske Bank Faces Broader Probe of Bond Price Fixing in 2009: "The trades, conducted in February and March 2009, raised mortgage bond prices in a way that “harmed customers at Realkredit Danmark A/S,” Danske’s home-loan unit, the crime squad said."

  38. Jan. 2014: Federal Probe Targets Banks Over Bonds: Inquiry Looks for Deliberate Mispricing of Mortgage Bonds Key to Financial Crisis

  39. Dec. 2013: SEC charged a London-based hedge fund adviser GLG Partners with internal controls failures that led to the overvaluation of a fund’s assets and inflated fee revenue for the firms.  

  40. Aug. 2013: 2 more targeted in JPMorgan's London Whale case: "Prosecutors in the office of U.S. Attorney Preet Bharara in the Southern District said Martin-Artajo and Grout manipulated and inflated the value of position marks in the Synthetic Credit Portfolio, or SCP, which the government said had been very profitable for the bank's chief investment office."

  41. Dec. 2012: Deutsche hid up to $12bn losses, say staff

  42. Nov. 2012: KCAP fund, execs settle charges of overstating assets.

  43. Oct. 2012: SEC Charges Formerly $1 Billion Yorkville Advisors Hedge Fund With Fraud and Bogus Valuations

  44. May 2012: FINRA Fines Citigroup Global Markets $3.5 Million for Providing Inaccurate Performance Data Related to Subprime Securitizations: "Citigroup failed to supervise mortgage-backed securities pricing because it lacked procedures to verify the pricing of these securities and did not sufficiently document the steps taken to assess the reasonableness of traders' prices."

  45. May 2012: JPMorgan CIO Swaps Pricing Said To Differ From Bank

  46. May 2012: Ex-UBS Trader Sues After Firing for Mispricing Securities

  47. Feb. 2012: SEC Looking Into PE Firms’ Valuation of Assets

  48. Feb. 2012: Massachusetts Subpoenas Bank of America Over CLOs: examining whether Bank of America knowingly overvalued the assets in the portfolios in order to get the loans off its books

  49. Feb. 2012: Ex-Credit Suisse traders face US charges: Case relates to alleged CDO mispricing

  50. Jan. 2012: SEC Charges UBS Global Asset Management for Pricing Violations in Mutual Fund Portfolios)

  51. Dec. 2011: SEC Charges Multiple Hedge Fund Managers with Fraud in Inquiry Targeting Suspicious Investment Returns 

  52. Nov. 2011: PwC and KPMG criticised over audits (of their clients' valuations of mortgage-related securities)

  53. Oct. 2011: Oversight board faults Deloitte audits

  54. July 2011: Polygon Faces Accusations It Used Tetragon For Cash

  55. April 2011: Report says Goldman duped clients on CDO prices

  56. April 2011: Wachovia cheated investors by inflating markups, SEC says

  57. March 2011: Buffett’s Berkshire Questioned on Accounting

  58. Feb. 2011: What Vikram Pandit Knew, and When He Knew It

  59. Feb. 2011: Mutual Funds' Muni-Debt Prices Are Questioned

  60. Oct. 2010: SEC Continues Crackdown on Overvaluations of Hedge Fund Assets

  61. Aug. 2010: Merrill's Risk Disclosure Dodges Are Unearthed

  62. May 2010: HK watchdog slaps fine on Merrill units

  63. April 2010: Legal Woes for Regions Financial

  64. Nov. 2009: Ambac Misstates Financials to Meet Minimums

  65. July 2009: Under Fire, NIR Group Switches Valuation Firms

  66. June 2009: Evergreen Pays Over $40 Million to Settle SEC Charges that it Overvalued Mortgage-Backed Investments

  67. April 2009: FHLB Executive Who Left Cites Securities Valuations

  68. Aug. 2008: "Large Number" of Banks Miss-Marked Assets, U.K. Regulator Says

  69. Aug. 2008: Financial Services Authority’s "Dear CEO: Valuation and Product Control" Letter

  70. July 2008: The Subprime Cleanup Intensifies: Did UBS Improperly Book Mortgage Prices? Several Probes Expand

  71. Feb. 2008: IN RE REGIONS MORGAN KEEGAN SECURITIES, DERIVATIVE and ERISA LITIGATION:"(g) The Fund's Board of Directors was not discharging its legal responsibilities with respect to “fair valuation” of the Fund's assets and had abdicated these responsibilities to the Fund's investment advisor, which had an inherent and undisclosed conflict of interest because its compensation was based on the amount at which which the Fund's assets were valued"

  72. Feb. 2008: AIG's bad accounting day

  73. Feb. 2008: OCC Supervisory Letter to Citi (identifies as one of two key concerns "CDO Valuation and Risk Management in the Capital Markets & Banking Group")

  74. Oct. 2007: Ex-RBC trader says colleagues mismarked bonds

  75. Oct. 2007: Pricing Tactics Of Hedge Funds Under Spotlight

  76. Aug. 2007: BNP Paribas halted withdrawals from three investment funds because it couldn't "fairly" value their holdings

  77. Aug. 2007: Goldman Disputes AIG Valuations and Office of Thrift Supervision Instructs AIG to Revisit Modeling Assumptions

  78. Jan. 2006: Deutsche suspends trader over £30 million 'cover-up’

  79. June 2002: An Analysis of Allied Capital:Questions of Valuation Technique

  80. Aug. 1994: Behind the Kidder Scandal: How Profit Was Created on Paper

  81. Let us know if there are any we're missing.