Expect[ed] Loss

Illinois Attorney General Sues S&P – Initial Thoughts

2012-01-26T15:32:00.003-05:00

Credit risk ratings are becoming a risky business.

Yesterday’s filing of the complaint against S&P (MHP) centers, in essence, on the allegation of false advertising. Stepping in to this issue for a moment, one of the key defenses offered by the raters is that their ratings are protected under the First Amendment rights to express an opinion (their “speech”). But as law professor Eugene Volokh opines in his letter to the House Committee (May 2009) it is within the framework of commercial advertising that “speech aimed at proposing a commercial transaction – is much less constitutionally protected than other kinds of speech.”

In this case, the AG is not really focusing wholly on whether the ratings were wrong, as much as it’s saying that S&P advertised that it was following a certain code in ensuring the appropriate levels of independence and integrity were being brought to the ratings process.

A former SEC enforcement official, Pat Huddleston, once explained that "[when] I say the [financial] industry is dirty, I don't mean to imply everyone in the industry is dirty," … "[only] that the industry typically promises something it has no intention of delivering, which is a client-first way of operating." This is essentially what the complaint argues: that S&P “misrepresented its objectivity” while offering a service that was “materially different from what it purported to provide to the marketplace.”

This goes back, really, to the key reform measure Mark proposed before the Senate in 2009 – that rating agencies would do well to separate themselves from commercial interests, by building a formidable barrier around the ratings process.

First, put a “fire wall” around ratings analysis. The agencies have already separated their rating and non-rating businesses. This is fine but not enough. The agencies must also separate the rating business from rating analysis. Investors need to believe that rating analysis generates a pure opinion about credit quality, not one even potentially influenced by business goals (like building market share). Even if business goals have never corrupted a single rating, the potential for corruption demands a complete separation of rating analysis from bottom-line analysis. Investors should see that rating analysis is virtually barricaded into an “ivory tower,” and kept safe from interference by any agenda other than getting the answer right. The best reform proposal must exclude business managers from involvement in any aspect of rating analysis and, critically also, from any role in decisions about analyst pay, performance and promotions.

Two other elements jump out immediately from the complaint:

First, the complaint specifically argues that the rating agency “misrepresented the factors it considered when evaluating structured finance securities.” Next, the complaint tries to tie S&P’s actions to its publicly-advertised code of conduct, arguing that its actions were inconsistent with the advertised code.

In respect of actions being inconsistent with the code, certain of these arguments are common-place, such as the contention that the rating agencies did not allocate adequate personnel, in opposition to what’s advertised in the code. This of course becomes a contentious issue – you can see S&P coming back with copious evidence of situations in which they did “allocate adequate personnel and financial resources.” But the complaint hones in on the factors considered in producing a rating, and it focuses on two parts of the code:

Section 2.1 of S&P’s Code states: “[S&P] shall not forbear or refrain from taking a Rating Action, if appropriate, based on the potential effect (economic, political, or otherwise) of the Rating Action on [S&P], an issuer, an investor, or other market participant.”

and…

Section 2.1 of S&P’s Code states: “The determination of a rating by a rating committee shall be based only on factors known to the rating committee that are believed by it to be relevant to the credit analysis.”

This brings back to mind, disturbingly, a recent New York Times article (Ratings Firms Misread Signs of Greek Woes) which focuses on the deliberations within Moody’s (MCO) and their concerns about the deeper repercussions of downgrading Greece – rather than the specifics of credit analysis:

“The timing and size of subsequent downgrades depended on which position would dominate in rating committees — those that thought the situation had gotten out of control, and that sharp downgrades were necessary, versus those that thought that not helping Greece or assisting it in a way that would damage confidence would be suicidal for a financially interconnected area such as the euro zone,” Mr. Cailleteau wrote in an e-mail.”

The question then, is whether rating committees were focused on credit analysis, or whether other concerns were at play, aside even from typical business interests. The concerns for rating agencies, from a legal perspective, can become quite real when the debate centers not on ratings accuracy, but on whether the rating accurately reflected their then-current publicly available methodology. There may be substantial risks, therefore, in delaying a downgrade of a systemically important sovereignty or institution (such as a too-big-to-fail bank or a key insurance company) if such downgrade is appropriate per the financial condition of the company or sovereignty, or in providing favorable treatment to certain companies or sovereignties based on the relative level of interconnectedness.

The allegations of misrepresenting factors considered in their analysis opens another can of worms for rating agencies, as they’ll subsequently be increasingly focused on disclosing the sources of the information relied upon. There’s substantial concern, to the extent they’re relying on the issuing entity (in cases in which the issuing entity is itself the paying customer), that such reliance becomes a disclosure issue to the extent the investor may otherwise have assumed the rating agency was independently verifying such information. This was a frequent problem in the world of structured finance CDOs such as those described in the AG’s complaint.

Last, but not least, the complaint focuses on the effectiveness of ratings surveillance. This is a topic of importance to us, as we feel that proper surveillance, alone, may have substantially diminished the magnitude of the crisis. At the very least, certain securitizations that ultimately failed may not have been executed had underlying ratings been appropriately monitored, and several resecuritizations may have become impossible, limiting the the proliferation of so-called toxic assets. See for example: Barriers to Adequate Ratings Surveillance

That’s all for now. There’s a lot more to this complaint, so we suggest you check it out here.

The Mortgage Litigation Hangover (and who knew what, when)

2012-01-23T15:00:00.004-05:00

Aside from the relatively new foreclosure disputes, including those relating to MERS, the big banks continue to suffer the ill-effects of lawsuits relating to their original portfolio selection and sale of mortgage-backed securities (and derivatives thereof, like ABS CDOs).

A number of these cases were dismissed last year, as judges often failed to sympathesize with the plaintiff's arguments that they were "duped." On the back of Congressional and FCIC-related testimony, plaintiffs have been able to strengthen their arguments as they search for viable legal theories that satisfy these, potentially higher, pleading standards.

Today's two cases filed today focus on the what they believe were material informational asymmetries between the buyers and sellers, and possible scienter on the side of the sellers.

In John Hancock Life Insurance Co. v. JPMorgan Chase & Co., 650195/2012, New York state Supreme Court (Manhattan), the complaint argues that:

Defendants JPMorgan, Bear Stearns, WaMu, and Long Beach knew about the poor quality of the loans they securitized and sold to investors like Plaintiffs, because in order to continue to keep their scheme running, they completely vertically integrated their RMBS operations by having affiliated entities at every stage of the process. In addition, Defendants JPMorgan, Bear Stearns, WaMu, and Long Beach were aware of lending abuses on the part of the third party originators they purchased loans from due to, inter alia, their financial ties to the third party originators and their reviews of loan documentation and performance.

In Sealink Funding Ltd. v. Morgan Stanley, 650196/2012, New York state Supreme Court (Manhattan), the plaintiff contends that because the seller never disclosed certain of its practices to the investors, the "investors were not compensated for the additional risks that they unknowingly took on in purchasing those Morgan Stanley RMBS."

Morgan Stanley knew or recklessly disregarded that those lenders were issuing high-risk loans that did not conform to their respective underwriting standards. Morgan Stanley did, in fact, conduct extensive due diligence on the loans it purchased for securitization, as represented in the Offering Materials. In the course of that extensive due diligence process, which, in many instances, included an extensive re-underwriting review of the loans it purchased by an independent third-party due diligence provider, Clayton Holdings, Inc. (“Clayton”), Morgan Stanley learned that the originators routinely and flagrantly disregarded their own underwriting guidelines, originated loans based on wildly inflated appraisal values, and manipulated the underwriting process in order to issue loans to borrowers who had no plausible means to repay them. Indeed, both the President of Clayton and the head of Morgan Stanley’s own due diligence arm testified as to the extensive deficiencies identified through Morgan Stanley’s due diligence. Specifically, over one-third of the loans Morgan Stanley evaluated for purchase and securitization at the height of the mortgage boom (from 2006 through mid-2007) failed to meet the originators’ own underwriting guidelines.

We concentrated on the effectiveness of the Clayton due diligence sampling in ar piece late last year. (See Analysis of the Shortcomings of Statistical Sampling in the Mortgage Loan Due Diligence Process.)

But watch this space for more coverage on how legal teams representing investors seek to survive threshold challenges by showing that – even if their client is or was a sophisticated investor – they may not have been privy to the types of information available to the structuring banks.

A Fair (Value) Solution

2012-01-12T12:16:00.006-05:00

Hello readers, and a belated welcome to 2012!

In yesterday's FT Citigroup CEO Vikram Pandit advocates for heightened transparency across the banking system, enabling an apples to apples comparison that “[clears] some of the obscurity that causes people to believe the system is a game rigged against their interests.”

He is not alone. Late last year, Barclays' Group Finance Director Chris Lucas called for greater transparency in the financial reporting of liability valuations. The concept, of course, is that transparency is desired by investors, once bitten, before they can again get comfortable investing in banks.

Pandit proposes a solution that involves creating a benchmark portfolio against which banks can measure their relative risk.

Asset valuation itself has become the number one concern for the SEC in 2011: through mid-December the SEC had, according to the WSJ, issued a total of 874 “comment” letters to 802 distinct companies concerning their fair valuation and estimation of assets and contracts. Meanwhile, audit firms PwC, KPMG, Deloitte and others have been criticized as to their oversight of their clients' valuations and valuation processes (see Contested Pricing List). And so it is not surprising that banks are trying to overcome these substantial hurdles, though understandably in ways that suit them best.

The problem here is akin to the one faced by technology companies: the evaluation of their patent portfolios is no mean feat and is highly subjective – yet it is a crucial component of their stock price, especially in an acquisition or dismantling process.

Pandit’s solution is one solution. Another is more arduous, but overcomes the dual problems of inconsistency and subjectivity. It also combats the material regulatory arbitrage gaming business that has been created to minimize capital reserves. We would be able to say good-bye to a whole business of utility-free resecuritizations, structured solely to game the ratings models to achieve, or manufacture, lower reserves. It would be the end of certain Re-REMICs and perhaps even AAA-rated principal protected notes.

The solution, of course, is to evaluate each and every bond. This is already being done (to an extent) by the NAIC, and would add stability and assurance to our investor base.

Asset valuation may be more art than science, especially in the world of illiquid assets – but at least it's not a game. If well-performed, it can provide the cross-company valuation consistency even our bankers are calling for.

But it won’t be cheap.

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For our Central Pricing Solution, click here.

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

2011-12-01T14:00:00.008-05:00

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

2011-11-22T15:08:00.005-05:00

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

2011-11-07T10:12:00.004-05:00

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?

2011-10-28T11:38:00.005-04:00

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?

2011-10-10T14:03:00.002-04:00

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)

2011-08-23T15:47:00.003-04:00

“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 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

2011-08-10T16:43:00.002-04:00

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

2011-08-02T09:40:00.008-04:00

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

2011-07-27T17:35:00.003-04:00

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

2011-07-25T12:13:00.002-04:00

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

2011-07-20T15:27:00.004-04:00

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?

2011-07-06T12:38:00.015-04:00

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?

_________________________________________

[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

2011-06-16T15:06:00.004-04:00

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

2011-06-14T11:23:00.008-04:00

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 we’re 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.

---------
[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?

2011-06-08T13:33:00.003-04:00

“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.

A Telling Tale of Two Tables

2011-05-19T11:30:00.013-04:00

Just how difficult is it to measure ratings performance, and how useful are the measures, really?

There are certain difficulties we all know about – having to rely on the ratings data being given to you by the parties whose performance you’re measuring. So there is naaturally the potential for the sample to be biased or slanted, and that’s very difficult to uncover. (We’ve discussed this hurdle at great length here.)

The next issue we’ve written about is the inability to separate the defaulting assets from those that didn’t default. In our regulatory submission, we called for transparency as to what happened to each security BEFORE its ratings was withdrawn (see Transparency of Ratings Performance).

Let’s have a look at a stunning example today that brings together a few of the challenges, and leaves one with a few unanswered questions as to the meaningfulness of ratings performance, as it's being currently displayed, and the incentives rating agencies have to update their own ratings.

Here’s a Bloomberg screenshot for the rating actions on deal Stack 2006-1, tranche P.

Starting from the bottom up, it seems Moody’s first rated this bond in 2006 whereas Standard & Poor’s first rated it in 2007. If we try to verify this on S&P’s website for history, we come to realize how difficult it can be to verify:

So let’s suppose everything about the Bloomberg chart is accurate.

As verified on their website, Moody’s rated this bond Aaa in August ’06 and acted no further on this bond until it withdrew the rating in June 2010. (They don’t note whether the bond paid off in full, or whether it defaulted.)

S&P, meanwhile, shows its original AAA rating of 2007 being downgraded in 2008 (to BBB- and then to B-) and in 2009 to CC and again in 2010 to D, which means it defaulted (according to S&P).

For Moody’s, the first year for which the bond remains in the sample for a full year is 2007; thus, it wouldn’t be included in 2006 performance data. For S&P, the first complete year is 2008.

So if we consider how Moody’s would demonstrate its ratings performance on this bond, it would say:

Year 2007: Aaa remains Aaa
Year 2008: Aaa remains Aaa
Year 2009: Aaa remains Aaa
Year 2010: Aaa is withdrawn (WR)

No downgrades took place, according to Moody’s … while at the same time S&P shows it as having defaulted:

Year 2008: AAA downgraded to B-
Year 2009: B- downgraded to CC
Year 2010: CC downgraded to D

Here’s what their respective performance would look like, if one were to apply their procedures (at least as far as we understand them):

Adverse Selection? No Problem!

2011-05-13T12:48:00.003-04:00

A section from their rating methodology piece "Moody’s Approach To Rating U.S. Bank Trust Preferred Security CDOs" describes its procedures for ensuring the quality of bank preferreds being bought by CDO managers (S&P / Fitch have something similar). The section reads:

"In order to control for [adverse selection of banks by the arranger of CDOs], Moody's takes a four-step approach for banks that are not rated by Moody's.

First, each bank should satisfy the following prescreening attributes:
Financial Institution insured by the Bank Insurance Fund or Saving Association Insurance Fund.
Five years minimum of operating history.
Minimum asset size of $100 million.
Not under investigation by any regulatory body.
No restrictions placed on its operations by any regulatory body."
[additional steps omitted in the name of brevity]

Alas...

Pricing Transparency

2011-05-10T12:18:00.004-04:00

Professor Allan Meltzer argues, in yesterday’s WSJ article BlackRock's 'Geeky Guys' Business, that BlackRock Solutions’s pricing process “should all be open” and that “[they] may be doing things honestly and above board, but we won’t see that unless we see how they got the numbers.”

While legislators and supervisors scurry to plug the holes created by the absence of both balance sheet and asset transparency, the final piece of the puzzle – pricing transparency – remains largely unattended to.

It is this final element, the lack of pricing transparency, that concerns Prof. Meltzer. Right now, hedge funds, banks and insurance companies can all carry the same asset at a different price. In illiquid markets, the price differential between two price providers can be extraordinary, creating an opportunity for lesser-regulated financial institutions to profit handsomely from the regulatory arbitrage available, at the expense of their more heavily-regulated counterparts.

As with “ratings shopping” where market participants seek the highest ratings on their securities, investors are financially incentivized to seek out the highest value they can find for each security. Funds’ performance (and often their managers' bonuses) is directly determined from the valuations of their assets. Stronger performance, whether real or artificial, can even help a fund or company raise new capital.

Thus, there remains significant potential for derivatives mispricing. One could even argue that the potential for mispricing is heightened when the price provider offers additional advisory services to the client. Given the substantial fees and margins that may be earned on the advisory side, a conflicted price provider may be more open to accommodating a client’s price haggling to win or maintain it as a client.

Prof. Meltzer’s goal for pricing transparency would hone in on, perhaps eliminate, numerous possible sources for deliberate mispricing (see list of contested pricings here). While we fear it may be prove an insurmountable hurdle to require pricing providers to share transparency as to their methods, we feel strongly that an opportunity exists now for market regulators to ensure the consistency of prices used. (See Central Pricing Solution here.)

Absent complete pricing transparency, the usage of consistent prices would serve to increase investor confidence as to the adequacy of financial institutions’ balance sheets. A requirement for all constituents supervised by the same regulatory body to apply the same price can discourage price haggling, or price shopping.

The Data Reside in the Field

2011-05-02T12:32:00.002-04:00

In the New York Times' “Needed: A Clearer Crystal Ball” (Sunday Business pg. 4) professor Robert Shiller claims that if we sharpen our risk measurement tools we will better understand the risk of another financial shock. He argues that improved data collection can substantially increase the predictive power of our financial models.

As mathematicians we must agree with his sentiment: more complete data is always useful. But as market participants we wonder if professor Shiller has missed out on a valuable lesson to be learnt from this financial crisis.

One key lesson was that the source of the failure was neither data-driven nor model-driven, but rather a direct result of the expected behavior of poorly incentivized parties.

In fact, one could argue that for the large part the data were comprehensive. The models were highly sophisticated, perhaps too sophisticated. But what caused the crisis was that originating parties were financially rewarded for structuring and selling low quality mortgage loans. The incentive was clear and by mid-2005 the FBI was already commenting on the pervasive and growing nature of mortgage fraud.

Misrepresented financial documentation skews the data and cannot be spotted simply by poring over ever more abundant realms of data: you have to go into the field itself to follow the incentives.

The financial downturn was made worse by financial institutions’ lack of confidence in the creditworthiness of their counterparts. Absent a level of certainty as to the true nature of others’ balance sheets, a lending freeze precipitated an illiquidity crisis. But a more thorough examination of data won’t tell you what resides off-balance sheet: you have to understand the prevailing accounting environment (that led to the mechanical reproduction of the negative basis trade) and the fundamental nature of the opaque shadow banking system.

It is a concern that intellectuals and academics risk being lulled into a false sense of security based on their access to copious amounts of statistical data.

Copious analysis of imperfect data is unlikely, alone, to help our regulators hone in on an inevitable crisis – much less prevent it. Let's not strive to build complex economic models whose success hinges on sensitive data. Let us rather encourage a keener appreciation of the limitations of data, the intentional proliferation of informational asymmetries, and the incentives that can cause a meltdown.

Ratings Reversals

2011-04-22T12:43:00.006-04:00

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

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For more on this topic, click here.

Split Ratings

2011-04-13T09:41:00.017-04:00

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.

Contested Pricings List

2011-04-07T15:27:00.028-04:00

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.

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

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

Oct. 2011: Oversight board faults Deloitte audits

July 2011: Polygon Faces Accusations It Used Tetragon For Cash

April 2011: Report says Goldman duped clients on CDO prices

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

March 2011: Buffett’s Berkshire Questioned on Accounting

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

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

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

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

May 2010: HK watchdog slaps fine on Merrill units

April 2010: Legal Woes for Regions Financial

Nov. 2009: Ambac Misstates Financials to Meet Minimums

July 2009: Under Fire, NIR Group Switches Valuation Firms

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

April 2009: FHLB Executive Who Left Cites Securities Valuations

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

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

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

Feb. 2008: AIG's bad accounting day

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")

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

Oct. 2007: Pricing Tactics Of Hedge Funds Under Spotlight

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

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

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

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

Central Pricing Solution

2011-03-31T13:43:00.007-04:00

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.

Looking for a Mis-Rated Subprime Bond?

2011-03-17T09:50:00.000-04:00

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

Click to enlarge

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

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

Christine Richard, on Confidence

2011-03-10T16:56:00.000-05:00

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.

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To read more about the Confidence Game, click here.

The Curious Case of Carrington

2011-03-04T10:13:00.002-05:00

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.

The Proof is in the Shadow

2011-02-17T11:53:00.000-05:00

We did some work last year detailing the dynamics of the multi-billion dollar negative basis trade, the off-balance sheet trade that helped bring several insurers to their knees, as well as a number of banks including UBS (as soon as the trade was forced back onto their balance sheets).

The lack of financial reporting transparency was only one of the problems. Some parties, of course, had insight into the multi-trillion dollar shadow banking system. But two other major pitfalls spring to mind: the lack of asset transparency (that is the ability to understand what is being referenced) and the lack of pricing transparency (that is the ability to know the value of an opaque asset).

The lack of transparency is entirely convenient to those in the know: it creates numerous opportunities to take advantage of those with less information. We call this imbalance an "informational asymmetry."(Click here to visit the appropriately titled Fed's report "Could Asymmetric Information Alone Have Caused the Collapse of Private-Label Securitization?"

While 2010's Dodd-Frank Act attempts to add asset transparency in various forms, it was interesting to note Frank's disheartened tone, yesterday at the House Committee Hearings on Financial Services, when speaking of the other "transparencies." Here's an excerpt of his commentary (emphasis added):

"Hedge funds will remain uncovered.

We gave the CFTC the mandate to begin to regulate derivatives, including mostly -- including for end-users, making public the price. Not for end-users in any other way regulating them. What we did then was both derivatives and with regard to hedge funds and private equity was to get some more information. People have been talking about the shadow banking system. Well, one of the things we did in the bill was to try to bring that out of the shadows. But as a result of the Republican budget, neither the SEC nor the CFTC will have the money to do that.

And so we will back, I from time to time talk about old radio programs. I think we have another one.

Who will know what risk lurks in the heart of the financial system?

And the answer is, the shadow will know. But nobody else.

Because our efforts to put some light on the shadow banking system, by having hedge funds register with the SEC and have them be able to calculate what's up, and having derivatives regulated by the CFTC, those won't happen."

Risk - Discombobulated

2011-02-10T15:21:00.000-05:00

Investing brings with it many risks. When things go wrong, they often tend to go wrong in concert: credit risk and market risk and illiquidity risk and complexity and legal and operational risks can all be confused and are often indistinguishable, especially when they need to be realized.

Certain rating agencies have specific ratings for these "non-credit risk" measures. One can get a liquidity rating, a market risk rating, even a trustee quality rating or a hedge fund operational quality rating.

But credit risk doesn’t exist and typically isn’t measured in a vacuum – at least not according to recent ratings criteria. When a product is exposed to operational risk, for example, failures in operational quality can bring down the credit rating itself, making it very difficult for an investor to separate the different risks being measured.

For example, Moody’s today announced that its soon-to-be-released operational risk guidelines could result in rating actions (primarily downgrades from the sounds of it) on the senior ratings of up to 200 structured finance ratings.

"The performance of a securitisation transaction depends not only on the creditworthiness of the underlying pool of obligors, i.e. the quality of the collateral, but is also closely linked to the operational performance of various transaction parties such as the servicer, trustee and cash manager"

With investors looking increasingly to non-traditional investments for heightened returns, and with banks pushing risky activities into the opaque shadow banking system (to minimize regulation and oversight), it’s high time we all started to manage our risks out of one centralized division. That way credit risk doesn’t escape the market risk team, and funding risks don’t escape the credit guys.

Corporate Governance for the Shareholders (Part 1)

2011-01-28T10:44:00.004-05:00

2010 and the Dodd-Frank Act ("DFA") brought to the fore Say-on-Pay and certain other delights for those investing in shares of financial institutions.

DFA enhances the SEC's enforcement abilities, while creating an additional watchdog (the Consumer Financial Protection Bureau) which has both examination and enforcement capabilities. It also demands that both companies and regulators reduce their dependence on credit ratings: over-reliance on credit ratings served to exacerbate the depth of the financial crisis, as rating downgrades precipitated further pricing pressures.

Indeed, in our experience several regulatory bodies have approached the new regulatory landscape with a zest and energy that was perhaps absent in the years leading up to the crisis.

Having said that, many critics feel that financial reform measures fell short; some are critical of the regulators' enforcement intent (see here and here), especially as they experience budget constraints; others are skeptical of the newly-created FSOC's ability to even define systemic risk, never mind recognize or measure it.

What other improvements, then, can be introduced to protect against large-scale business risks at financial institutions?

Risk Must Have a Voice

We would like to see Risk have a voice. Certainly, many risk managers were very good at measuring risk. But their institutions failed anyway. Why? Often, the objectives of risk management (preservation of capital reserves) run counter to the growth objectives of the CEO, who is incentivized to put capital to work. One could argue that the too-big-to-fail banks are or were long risk, knowing that they had large potential short-term upside and low downside given the (implicit) government guarantee. The government or the taxpayer, in this scenario, is short risk. One option is to ensure that the chief risk officer reports directly to the board, rather than to the CEO. Again, if the CEO is the chairman of the board, risk's voice may be dampened and this may provide a warning sign.

Risk and Compliance Must be Independent

Similarly, it is crucial that risk managers and compliance officers are incentivized, and safe, to voice their concerns. As a cost center with relatively limited bonus potential, shareholders ought to recognize that "at-will" risk and compliance managers -- especially if they are (intentionally) over-paid -- often have little advantage for being right but significant downside for being wrong. (Click here for an example of objections ending poorly for "at will" employees.)

-End Part 1

We will be exploring further avenues for improvement in subsequent pieces of this series, including a discussion of management's communication of its risk appetite. If you have any corporate governance suggestions you would like us to consider or include, feel free to email them to us or leave them in the comments section below this post.

Deferred 4 Ever

2011-01-05T15:12:00.006-05:00

One of the problems we come across when we examine the models our clients rely on is the incorrect modeling of the payment of deferred, or capitalized interest.

What do I mean?

If you model enough CDO deals, you'll notice that it's not always clear when a deal should be paying the deferred interest on a PIK-able bond. Obviously, in good times, this isn't a big worry but, in bad times this could make the difference between having a noteholder receiving some return vs. no return on his investment.

This is especially meaningful in TruPS CDO world where a good portion of mezzanine bonds are currently in deferral.

I pulled the following steps from a TruPS CDO's Priority of Payments (that section is found in the deal’s Offering Memorandum and defines how the liabilities are paid on each distribution date):

The B1s are entitled to receive interest here:

“SIXTH: to pay Periodic Interest on the Class B-1 Notes at the Applicable Periodic Rate and the Class B-2 Notes at the Applicable Periodic Rate, pro rata based on the amounts of Periodic Interest due;”

And principal here:

“EIGHTH: to pay an aggregate amount equal to the Optimal Principal Distribution Amount, in the following order, (a) principal of the Class A-1 Notes until the Aggregate Principal Amount of such Notes has been reduced to zero, and then (b) principal of the Class A-2 Notes until the Aggregate Principal Amount of such Notes has been reduced to zero, and then (c) principal of the Class B-1 Notes and Class B-2 Notes, pro rata, until the Aggregate Principal Amount of such [B-1 and B-2] Notes has been reduced to zero;”

Where does deferred interest fit in, in the above steps?

Well not under the definition of Periodic Interest:

“With respect to the Class A-1 Notes, the Class A-2 Notes, the Class B-1 Notes and the Class B-2 Notes, in each case interest payable on each Payment Date on such Notes and accruing during each Periodic Interest Accrual Period at the Applicable Periodic Rate.”

Nor the definition of Aggregate Principal Amount:

“With respect to any date of determination, (a) when used with respect to any Pledged Securities, the aggregate Principal Balance of such Pledged Securities on such date of determination; (b) when used with respect to any class of Notes, as of such date of determination, the original principal amount of such class reduced by all prior payments, if any, made with respect to principal of such class; and (c) when used with respect to the Notes, the sum of the Aggregate Principal Amount of the Senior Notes, the Aggregate Principal Amount of the Senior Subordinate Notes and the Aggregate Principal Amount of the Income Notes.”

Why does any of this matter? Can’t deferred interest be paid in either step?

Sure but the problem here is that choosing to pay deferred interest in one step over the other could have a huge impact on the cash flow to various notes.

Imagine the B-1s have $30 million in deferred interest. If that amount is paid under step SIX then the B-1s’ deferred interest is prioritized over the senior notes’ principal. If you go with step EIGHT, the opposite occurs. It’s a zero sum game, but either way, someone loses a good chunk of change based on the adopted interpretation of this vague language.

P.S. this is a common issue that you’ll find in CDOs backed by all types of assets (not just TruPS) so make sure your forecasting models are tuned to this properly.

The Psychological Biases of Holding Downgraded Bonds

2010-12-21T10:20:00.004-05:00

The early days of this economic slowdown brought to our attention a plethora of examples of investors choosing to hold on to downgraded bonds in the belief that “they will come back again,” and that “it is only a temporary market dislocation.”

(Incidentally, it is not traders alone who fall prey to the “return-to-normalcy” ideology. Many of us carry the internal belief, for example, that all will be well immediately a blundering institution recognizes its folly. Being exposed to one’s folly, and fixing it, however are two different things. Thus, history tends to be allowed to repeat itself.)

From a strict utility function perspective, opting to hold on ought probably to prove the inferior choice: downgraded bonds tend to be more likely to be downgraded (again) versus comparably-rated bonds that have yet to be downgraded; moreover, the risk of an associated exponential increase to reg. capital radically changes the risk-return profile of the investment.

But there are a number of psychological forces in play that make investors particularly vulnerable to the need to hold downgraded securities whose market value is quickly diminishing.

Psychological Biases

First is the obvious — that investors exhibit risk-seeking behavior in the face of losses while being risk-averse in the face of gains.

Next, investors originally held some derivative of an innate belief that the rating agencies possessed magical capabilities and material non-public information which resulted in their original ratings being correct and any subsequent rating changes posing mere caveats before the return to normalcy. This “everything will come back again” mentality demonstrates at least two behavioral biases: (i) representativeness, the willingness of investors to base their decisions of superficial (or artificial) characteristics as opposed to underlying probabilities, and (ii) conservatism, the willingness to cling to a prior belief despite the receipt of new information.

Were They Right?

The answer is... sometimes.

Here are certain factors that should be taken into account, followed by a solution to the quandary:

First, rating agencies’ actions are often retroactive: the rating action only occurs well after the fact. In some cases, that means that as an investor you can look directly at the current situation to gauge whether subsequent upgrades are imminent.

Example: according to information we have been provided, one rating agency began downgrading collateralized loan obligation (CLO) securities between September 2009 and May 2010, well after the market shock had ended, with loan prices generally having begun returning to “normal” levels in December 2008. Depending on what indices you examine, loan prices generally went up roughly 40% during calendar year 2009, and this trend has continued in 2010. CLO prices improved too, as have their underlying portfolios. So while the rating agency was aggressively downgrading almost 3,000 bonds during this time period, the underlying loan market and the CLOs themselves were markedly improving.

According to JPMorgan data, the spread levels on 5yr LCDX tightened from 556 basis points to 377 basis points over the relevant Sep. ’09 to May ’10 period, demonstrating the market’s interpretation of decreased credit risk on similar loans to the ones in CLOs. Next, Wells Fargo data show that whereas almost half (49.3%) of CLOs were failing their junior par coverage test as of mid Sept. 09, less than one fifth (18.86%) were still failing as of early May 2010. This key ratio perhaps best describes the improved performance of CLO securities.

Thus, in a market when the rating agency should have been upgrading bonds on a net basis, it (perhaps retroactively) downgraded more than 75% of all CLO bonds rated by them, including 76.27% of all triple A securities they rated, the market was already well into its turnaround and continued to improve. Those downgraded bonds are now being swiftly upgraded.

In other cases the “hold-to-normalcy” trade hasn’t worked as well: trust preferred (TruPS) CDOs seem continuously to be downgraded, as bank failures and bank deferrals continue to plague this market. While in certain markets default rates were significantly lower in 2010 than 2009, there has been an approximately 20% increase in bank defaults this year (annualized) versus in 2009. The credit performance of certain tranches, unfortunately, may never return to their pre-crisis levels.

In it in this light that S&P’s announcement last week was so interesting to us. S&P placed 1196 bonds on CreditWatch negative as they “incorrectly analyzed the timely interest payments, and did not incorporate an analysis of the effect of interest paid pro rata on the senior securities (that, all else being equal, inherently contain lower credit protection than those in which the interest is paid sequentially) for those transactions that have this structural feature. Approximately two-thirds of the classes affected by this CreditWatch action are from transactions issued in 2010 and approximately one-quarter were issued in 2009.”

(To be clear, their misrating of RMBS re-REMICs was not the interesting element. A week prior to this announcement we submitted to the Financial Times a comment letter that described the continued misrating of these securities, click here www.ft.com/cms/s/0/c51bb428-072c-11e0-94f1-00144feabdc0.html. We cite a Re-REMIC rated AAA in 2008 that currently languishes in the CC region.)

The magnitude is certainly severe, but the confession is the focal point, as it allows investors to immediately recognize that, wait, these bonds were incorrectly rated and contain risk in excess of that originally estimated by S&P. In publicly admitting to their error, a true “investor service” was provided to the investors by S&P. Naturally, one might be less enthusiastic about this announcement if one were to own a to-be-downgraded bond.

The next question, of course, is who else rated these bonds? And which rating agencies chose not to rate the bonds as a result of their model not being able to achieve the high ratings S&P's model produced?

The Solution

If you’re an investor, we suggest due diligence. Look into the assets being downgraded. If reg. capital is a question for you as a bank or insurance companies — or margin for leveraged funds — build a model to capture probabilities of being right versus wrong, pre-decision. Work out the probability that a large downgrade is to be followed by an upgrade, versus subsequent downgrades, asset-class by asset-class.

Welcome to the brave new world of investor due diligence.

Meredith Whitney and the Future of Credit Rating Agencies

2010-11-19T10:25:00.002-05:00

The popular media are harping on the wrong issue in respect of the future of the credit rating agencies. They say that despite financial overhaul aimed at reducing their influence, “credit raters keep their power” (WSJ Nov. 16) and that “[for] potential newcomers, … , it is difficult to compete against established agencies [like Moody’s and S&P].” (FT Nov. 19)

Rather, the regulatory proposals in both the U.S. and Europe have been quite severe on the rating agencies, demanding both improved transparency and enhancing transparency, which increasing the potential for legal liability; and the very reason that players like Kroll and Meredith Whitney are entering the rating environment is that the established agencies are particularly vulnerable to competition.

To be fair, it is always a challenge to compete against a well-established company. But Kroll and Whitney are seizing the opportunity while the raters are weakened by poor ratings performance, and distracted by the significant increase in both the “volume and cost of defending such [related] litigation.” - from Moody’s (MCO) 10Q

Ratings, as we all know, are interwoven throughout our financial framework. It takes time to remove references to them and there remains a modicum of inertia among market participants in moving away from the Big Three or away from credit raters in general. But there has been a tangible change in momentum, with raters like Canada’s DBRS having already secured a large (majority) share of the U.S. residential mortgage-backed securities (RMBS) market — hardly a sign of “difficulty competing.” (WSJ May 2010)

Rather than being anxious about seeing immediate changes despite the lengthy history, and deeply embedded nature, of credit ratings, we urge the media to rather applaud the substantial regulatory improvements that have been made in respect of reducing reliance on ratings and heightening the integrity of the ratings process. We caution, however, that a material increase in the number of rating agencies leads to greater competition and not to higher quality ratings. More accurately, the readier the supply of ratings, the higher the inflation of ratings provided.

Notes:
(1) Aside from the 11 SEC approved NRSROs, there are already according to our calculations 108 other debt rating companies worldwide, 18 of which are affiliated in some way or other with one of the NRSROs.
(2) To visit submissions to the SEC, including our submission, on the credit rating reform proposals put forth in the Dodd-Frank Act, click here.

The Importance of Being Investment Grade

2010-10-20T16:04:00.006-04:00

While references to credit ratings are being removed from statutes and federal regulations (effective July 2012) their position in our existing investment framework remains secure.

We have discussed previously how credit rating downgrades might negatively influence a security's price by decreasing investor demand (some funds and companies, for example, can only buy debt of a certain credit quality) and increasing funding costs (collateral/margin requirements), which may lead to the inevitable vicious cycle.

The deeply embedded nature of ratings in financial contracts is even more apparent when we look at the ramifications of a downgrade on H&R Block's corporate debt (CUSIP 093662AD6), which has been the recent focus of negative attention from the rating agencies. If the debt is downgraded by Moody's to Ba1 or below and/or by S&P to BB+ or below, the coupon on these notes will increase, and the debt will thereby become more expensive to HRB. In other words, if a downgrade is an indication that a company is struggling to meet its obligations, the downgrade in its enactment (by construction) might make said obligations more expensive, which precipitates further difficulty in meeting them. As such, the rating provided is integral to, and certainly not de-linked from, the performance of the security being rated.

These bonds are currently Baa or BBB, investment-grade bonds. However, as the table illustrates, if either rating agency alone downgrades the debt to the Ba1 or BB+ level, the coupon on the bond will increase by 25bps from 7.875% to 8.125%. If both rating agencies downgrade the debt to this level, the result will be a 50bps increase to 8.375%. The interest rate increase is capped at 2%, which will be effectuated if Moody's downgrades the bond to B1 or below and S&P downgrades it to B+ or below.

The (unfortunate) consequence: a downgrade immediately increases the coupon on the bond, which decreases the price. That's in addition to the decreased demand for the bond, the heightened illiquidity, and the increased funding costs for holding the bond. If downgraded, a devaluation of the bond is inevitable, irrespective of the market's opinion of the accuracy of the rating agencies' opinions.

Phantom Pricing

2010-10-05T11:12:00.005-04:00

Mario Draghi, head of the Financial Stability Board, is making a splash about the loosely regulated “shadow banking system.” While estimates of the size of the system are tough to come by (the FRBNY report suggests $16 trillion) what makes this system a “shadow” system is not its size, but the location of the assets. Who owns what, where?

The provisions of off-balance-sheet accounting made it very difficult to know the exposures of your counterparties, one of the reasons Mr. Draghi felt the shadow banking system to be a key contributor to the crisis: if you don’t know what else your counterparty’s holding, you won’t lend to it in a time of crisis. The lending freeze, then, only serves to exacerbate the crisis for those parties in need of short-term liquidity. A minor disconnect in a small part of the market can therefore lead to panic, bank runs, and mass deleveraging. The scenario painted exaggerates what happened in our financial downturn, but the elements remain true.

The challenge becomes how best to cure this lack of transparency. Unfortunately there are at least three parts at play in this multidimensional version of Heisenberg’s uncertainty principle: we cannot measure the exposure because we cannot see it (questionable balance sheet transparency), we know not what it is (questionable asset transparency) and we cannot rely on the value being associated with it (questionable pricing transparency).

If we could cure the “balance sheet transparency” element, the difficulty would by definition be removed from the shadow banking system. Enhancing asset transparency practices is a regulatory initiative that has begun. The process toward improving pricing transparency, however, remains in its infancy.

Why the lack of transparency? The answer: a lack of transparency in the market creates a money-making opportunity for those parties in the know. The informational asymmetries in the market allow the better-informed market participants to take advantage of those who are guessing at certain characteristics. From The Big Short:

[Yale professor] Gary Gorton guessed that the piles were no more than 10 percent subprime. [Gene Park] asked a risk analyst in London, who guessed 20 percent. “None of them knew it was 95 percent,” says one trader. “And I’m sure that [AIG’s Joe Cassano] didn’t either.” In retrospect their ignorance seems incredible—but, then, an entire financial system was premised on their not knowing, and paying them for this talent.

Absent the ability to perform due diligence internally, market participants grew increasingly dependent on the soundness of advice being offered to them by their broker-dealers, a situation which has created forum for BD litigation. From Confidence Game:

Meanwhile, [MBIA’s lawsuit against Merrill Lynch alleged that] because MBIA “did not and could not perform a cost-effective loan-level valuation analysis of the ML-series CDOs, it relied on and trusted Merrill Lynch’s statements about the quality of the underlying loans.”

Pricing transparency is similarly powerful and problematic. In the deeply veiled world of broker-dealer intermediation, the buyer and seller seldom know each other. The bidder (for example a regional bank or a hedge fund trader) doesn’t know the offerer, nor the offer itself, nor the number of offerers out there, and vice versa.

In other words, neither party knows the bid-offer spread being made by the broker-dealer and they don’t know whether there are many bids or just a few. Buyers and sellers are guessing at the price and the liquidity.

The larger problem, of course, is that for leveraged funds your margin is being dictated by the seller’s price, and that price is not necessarily an independent, unbiased opinion. Back to The Big Short:

“Whatever the banks’ net position was would determine the mark,” [Scion Capital’s Michael Burry] said. “I don’t think they were looking to the market for their marks. I think they were looking to their needs.”

One solution, thus, is to centralize the pricing operations among one or more independent bodies — perhaps among existing regulatory bodies to the extent we can avoid conflicts of interests between their supervisory agenda and their pricing power. Else, why not create a new agency that creates various economies of scale in promoting pricing transparency and consistency in the name of, wait for it, consumer protection.

Credit Ratings Reversals

2010-09-27T11:44:00.007-04:00

The debate continues over the usefulness of credit default swaps (CDS) spreads as alternatives to ratings.

Today, Moody’s Corporation announced that its Analytics division – separate from its ratings group – has improved the ability of its EDF (expected default frequency) model to estimate default probability as a result of the incorporation of CDS spreads to the platform.

Moody’s Analytics clearly agrees that CDS spreads provide useful predictive content. So did a fellow panelist of ours at a distressed debt conference on Friday.

Jerome Fons, EVP of Kroll Bond Rating Agency, included the following slide in his presentation (click here to download the presentation in its entirety).

Among other things, it shows CDS spreads to be better predictors of default probability (see the higher Accuracy Ratio).

The slide also displays the lower frequency with which credit ratings are reversed by rating analysts, versus the regularity with which CDS spreads can move from one bucket to another as per the market’s whims.

This feature, as displayed by Ratings Reversals and Rating Changes, reminds us of the human nature of rating agency analysts and in particular their psychological predisposition against reversing a prior rating action. The obvious upside is ratings stability – at the expense of volatility -- to the extent we care for it. Would we want our regulatory capital ratios to move on a daily or secondly basis, as a stock price may trade on the news, or on gossip?

For example, consider the case of Arlington CDO tranche A3. Moody’s and S&P both started off at Aa2/AA ratings, respectively, in the year 2000. In 2002, Moody’s downgraded it more aggressively than S&P, a situation which lasted until 2006, at which stage Moody’s upgraded the bond to A3, which was the then-current equivalent of S&P’s rating of A-. 2009 arrives and Moody’s drops to Caa3, before upgrading to B3 in early 2010 and then Ba3 last week. Moody’s is now just short of S&P’s current equivalent rating of BB+.

While certain market participants might benefit from more regular rating actions, others no doubt value ratings stability above all else. But either way, it seems entirely unlikely that rating stability and ratings accuracy go hand-in-hand.

-------------
We remain very interested in the topics of ratings alternatives and the comparison of ratings performance. Let us know if you have a similar interest in these topics.

For more on CDS spreads as alternatives to ratings, click here; to visit our submission to the Fed, OCC, OTS and FDIC on this topic, click here.

Basel Dazzle

2010-09-22T09:25:00.004-04:00

“Jean: Don't you know that it is dangerous to play with
fire?
Julie: Not for me. I am insured.”

— from August Strindberg's Miss Julie

Basel III’s newly announced bank capital requirements have received their fair share of criticism from the public media. Many of the opinions shared center on the (expected) limited effectiveness of the increased capital standards.

Indeed it is basic approach to simply bolster the reserve requirement. It has its downsides — stemming growth and lending activities — while also failing to strictly eliminate an eventual default: higher reserves might in certain cases simply allow a troubled bank to linger as a going concern before defaulting, without necessarily staving off the default.

How else to protect against another system-wide financial institution failure?

The first question to answer is whether capital reserves that were in place were being correctly applied and adhered to. If not, it leads one to question whether it is the capital reserves that need increasing or whether it is their application that begs tightening.

Prior capital reserve and accounting requirements encouraged banks to game the system by, among other things:

(1) obscuring their balance sheets and taking as many assets as possible off their balance sheet (see for example the infamous Repo 105; the negative basis trade; Madoff’s supposed year-end movements into Treasuries to thwart auditor supervision; and the various mechanisms uncovered for hiding assets and insurance policies, such as is being alleged in the case of the SEC vs. Sentinel); and

(2) creating, through securitization, phantom diversification benefits that were rewarded by the risk-based capital regimes then in effect.

Thus the converse would be to endorse a system that encourages true diversification on the vanilla asset level — not on complex structured finance and portfolio investment vehicles where diversification is gamed and over-rated (no pun intended). We ought to reward transparency, as well as the usage of up-to-date, reliable, complete and comprehensive data and models, or punish the converse.

To protect against systemic risk concerns, we can further require that the rating agencies, too, remain current on their ratings. This will create a useful buffer against large downgrades, the coup de grâce for many leveraged financial institutions.

From a high-level point of view, one may argue that to avoid a crisis similar to the current one, one has to ensure the incentives that led to our current crisis are adjusted towards promoting active risk management and prudent risk taking. Let’s channel our energies towards fostering an investment environment, a culture of proactive risk, reward and responsibility.

Warning: Insurance TruPS

2010-09-03T13:43:00.005-04:00

In an atypical, ominous maneuver, rating agency A.M. Best has today placed on negative watch the ratings of (we believe) all tranches of all trust preferred CDOs rated by them. From the most junior notes to the most senior notes, all in one fell swoop.

The insurance trust preferred CDO securities -- the area in which A.M. Best focused -- have thus far outperformed their bank or REIT TruPS counterparts, which is one of the reasons behind the comparatively stronger performance of A.M. Best's ratings versus others in the TruPS CDO space, thus far (click here for details).

The reason for the negative attention according to A.M. Best?

The rating actions reflect concerns in a number of areas including (1) the growing number of “defaulted securities” and capital securities whose periodic interest payments are in a deferral mode in the various pools; (2) capital securities redemption activity occurring in the pools; (3) increased stress upon the various credit support/enhancement mechanisms; and (4) deterioration in the issuer credit ratings of individual insurance companies and deposit taking institutions within the transaction pools.

Credit Rating Alternatives

2010-08-30T10:07:00.005-04:00

At a time of increased tension in and among the larger credit rating agencies, Frank Partnoy, Mark Flannery and Joel Houston have submitted a suitably-titled research piece that addresses "Credit Default Swap Spreads as Viable Substitutes for Credit Ratings."

Inconveniently they have chosen 15 highly liquid financial names for comparison purposes, which unfortunately means their conclusions do not address our concerns that credit default swaps (CDS) spreads remain questionable estimates when the CDS and the rated underlying itself have vastly different trading volumes, or for illiquid or unrated securities (visit our April piece "Credit Ratings vs. Credit Default Swaps").

As the banking regulators consider following the NAIC's lead in finding alternative solutions to relying on credit rating agencies for regulatory capital reserve considerations, another key features to consider is their respective predictive content: do ratings or CDS spreads have any long term opinion associated with them, or are they purely back-looking or point-in-time estimates. The authors attend directly to the search for regulatory scrutiny alternative and the possibility of relying on CDS for this purpose (emphasis added by us):

"More generally, it is apparent that CDS spreads reflect available information, which makes them useful for regulatory and risk management purposes, even if they are not necessarily suitable for forecasting."

...

"At a minimum, our analysis supports the conclusion that CDS spreads reflect information more quickly and accurately than credit ratings. Specifically, we find that as information about the subprime mortgage exposure of financial institutions was disclosed during 2007 and 2008, CDS spreads reflected that information, whereas credit ratings remained relatively unchanged.

If regulators and investors had looked to CDS spreads to assess the riskiness of financial institutions during this period, they would have found as early as April 2007 that such risks were significant and increasing. By early 2008, CDS spreads reflected a significant likelihood of default by one or more investment banks. In contrast, credit ratings reflected little or none of this information."

FDIC Esoterica – It's Capital

2010-08-09T09:39:00.008-04:00

The FDIC is following the NAIC's lead in considering alternatives to credit rating agencies in determining capital reserve standards for their underlying banks. According to the WSJ's "Regulators Plan First Steps on Credit Rating:"

[among] the options being discussed is a greater use of credit spreads, having supervisors develop their own risk metrics and a reliance on existing internal models...

The other option likely to be mulled is the use of service providers and rating agencies outside of the Big Four (Moody's, S&P, Fitch and DBRS). We have contemplated some of the elements of rating operational agency due diligence, here, but ultimately this process would require an understanding of the varying levels of expertise within each rating agency, it's level of accuracy and stability, and the various limitations of its model. (For example, this morning's WSJ reports on Morningstar research that concludes oddly that "using low fees as a guide [to a mutual fund's future success] would give investors better results than even Morningstar's own star-rating system...[because while] the stars system has typically guided investors to better results, it isn't as effective in predicting future returns at times of big market swings.")

The movement towards relying fully on credit default swaps, as contemplated above, seems to us a distant longing: first, CDS liquidity (not to mention maturity) isn't always comparable to that of the securities being referenced resulting in an imperfect spread-to-risk mapping; next, we are yet to witness substantial research evidencing the predictive content of CDS spreads on unrated securities; last, it remains questionable to what extent CDS spreads directly mimick the underlying's fundamental credit risk. (See Credit Ratings vs. Credit Default Swaps for more on this.)

There are at least three reasons why we would welcome the FDIC's direct participation by analyzing the securities interally:

1 - If the FDIC decides to create its own models, they'll be better equipped to appreciate the risks inherent in the securities being purchased by the banks they're to an extent insuring. Not only will they be less reliant on credit rating agencies, but also on broker-dealers' and third-party providers' differing opinions.

2 - With investor sophistication levels having (unfortunately) softened from a legal perspective, it augurs well to have a regulator play an active role in overseeing the investments being allowed by its underlying members. They would be better positioned to push back on riskier investment activities, or to encourage improved hedging or risk mitigation techniques on the bank or system level.

3 - Aside from the obvious advantages of treating all banks equally, the other benefit of having regulators play a more active role in examining capital adequacy reserves is the informational advantage they bring to the table:

For a real-life example, consider the $60bn world of trust preferred securities CDOs (or TruPS CDOs), whose performance depends on the performance of its underlying banks. Who would be better positioned than the FDIC to have an accurate handle on future bank defaults? With a model to support them, the FDIC can estimate the effect of default of all banks they consider to be poorly-positioned or undercapitalized. As it happens, in somewhat circular a fashion, banks (like Zions Bancorp) often also hold TruPS CDOs, which are themselves supported by other banks. Thus, the FDIC will be able to model the exact public utility of allowing a bank to prepay on its preferred securities at a discount, as they'll be able to measure the overall affect of that bank's prepayment on all TruPS CDOs holding that bank's preferreds; and they'll know how much each other bank holds of those TruPS CDOs which hold the original bank's preferreds. Ah, the beauty of information!

As an alternative, banks holding TruPS CDOs have been subjected to abysmal ratings performance which has come in tremendous waves of downgrades by rating agencies that in some cases are not rating the underlying banks and in other cases are guessing at how the models will perform.

From a recent American Banker article entitled "TruPS Leave Buyers in CDO Limbo:"

According to Fitch's Derek Miller, the agency is "in the process of reviewing all our assumptions" on trust-preferred CDO defaults and deferrals. For recent rating actions, he said, Fitch did not do precise cash-flow modeling, because it felt that the nuances of the capital structure have been drowned out by the sheer volume of defaults and deferrals that determine payouts.

Knowing just how sensitive some banks are to ratings changes en masse, we're excited at the prospect of the FDIC becoming more hands-on, and potentially smoothing the shocks. In this way, not every ratings failure need precipitate a liquidity crunch, a lending freeze, or a public-sector intervention.

Trust Preferred CDO Update

2010-07-01T11:15:00.005-04:00

We ended last year with a special report on what we saw as the changing nature of banks’ “choice” to defer. Our piece, entitled “The Tripping Point” concluded as follows:

“…while data remain scarce for the illiquid, opaque world of bank trust preferred securities in TruPS CDOs, our preliminary analyses tend to support the theory that not all deferring banks are poorly positioned, under-capitalized institutions. As we monitor the situation and continue to gather further evidence to either support or reject this argument, we eagerly anticipate a conclusion that not all deferring banks are doomed to fail.”

Since January 1, 2010, we have an increasing DEFAULT rate on banks in general. Using the FDIC’s cohort of 8,012 FDIC-insured financial institutions as of 12/31/09, we calculate a roughly 2.24% annualized default rate as of June 18, 2010. This default rate constitutes a 46% increase since the September 30, 2009 annualized default rate of approximately 1.53%, which was based off a 12/31/08 cohort of 8,305 FDIC-insured financial institutions.

(PF2’s base projections anticipated a roughly 50% weighted average increase of this 1.53% default probability over the forthcoming two years. Having realized this 46% increase, and from our various conversations with market participants and regulators, our best guess estimate is to anticipate another weighted average increase of 35%, over the forthcoming two year period. Thus, over the coming period, we attach an expected default probability of 3.02% to the average performing bank in our analysis of TruPS CDOs.)

We also encourage you to visit some of the excellent investigative journalism that’s been covering the TruPS market this year. Here follow some key pieces that provide insights into the differing pressures on and by banks, CDO investors, and external market participants. Amongst other things, the two June articles throw further light on the possibility that certain banks are opting to defer simply as a ploy to encourage investors to allow them to pre-pay their preferred securities at a discounted. (Of course this is not always the case, and banks certainly have the right to defer on their preferreds.)

June 11, 2010; American Banker: Blocking Rescues, or Challenging Bum Deals?

June 8, 2010; Bloomberg: Banks in `Downward Spiral' Buying Capital in CDOs

March 19, 2010; Bloomberg BusinessWeek: CDO ‘Samaritan’ Hildene Duels Funds Over Collateral

April 27, 2010; American Banker: TruPS Leave Buyers in CDO Limbo;

In Due Diligence We Trust

2010-06-24T09:01:00.003-04:00

“Guildenstern: We only know what we’re told, and that’s little
enough. And for all we know it isn’t even true.

Player: For all anyone knows, nothing is. Everything has to be taken on trust; truth is only that which is taken to be true. It’s the currency of living. There may be nothing behind it, but it doesn’t make any difference so long as it is honoured. One acts on assumptions. What do you assume?”

- Tom Stoppard’s Rozencrantz and Guildenstern are Dead

As we battle a crisis among crises, the informational asymmetry between sophisticated and unsophisticated investors becomes all the more striking.

The so-called sophistication level requirements have conveniently lingered despite the increasing complexities brought on by financial innovation: the dollar amount of income or net worth for natural persons to be considered “Accredited Investors,” for example, has not been adjusted for inflation in the almost 30 years since it was originally adopted; similarly investments in auction rate securities (ARS) were initially limited to institutional investors with minimums of $250,000. In recent years the minimum level has been brought down to $25,000 in an effort to lure as many market participants as possible, and more worryingly to make ARS available to the general public.

(“Accredited Investor” is defined to include natural persons having an annual income of $200,000 -- or $300k with spouse -- over specified periods or a net worth of $1mm or more. ARS typically refers to either municipal or corporate debt securities or preferred stocks which pay interest at rates set at periodic auctions. The market for ARS, prior to the collapse of the auction market, purportedly stood at around $350 billion.)

As such, Accredit Investors have over time become far less “accredited.” More importantly, the less “accredited” investors were being allowed to purchase increasingly complex securities. Investors, not wanting to look bad, chose to trust others rather than give voice to their lack of understanding. They place their trust in their lawyers, accountants, financial advisers and brokers. And the rating agencies.

They trust these parties differently: they trust their lawyers, financial advisers and brokers to act in their best interests and to be mindful of their risks. They trust them based on their credentials, the lengthy relationship they’ve had with them in the past and the fact that they have supervisory boards (e.g., FINRA, FASB and the SEC) tasked with ensuring they behave properly. They trust the rating agencies to provide an independent, objective opinion that has no party’s ulterior motives at heart and accuracy as its only goal.

Unable to perform their internal analysis, investors increasingly had to blindly trust the rating agencies’ ratings, from both a modeling perspective, and from an unbiased credit risk opinion perspective. Less sophisticated investors tended to rely more heavily on analyses performed by the rating agencies. More sophisticated investors, like Paulson, worked day and night to take advantage of their analytical advantage, by finding and betting against those bonds whose ratings least reflected their true credit quality.

The opaque, private securitization market provided a handy tool for poorly incentivized parties to take advantage of less sophisticated parties: the immature securitization market is noted for its lack of transparency and disclosure. More recently it has been marked by its misrepresentations. Battles continue to be fought over who owns the rights to the mortgages underlying the mortgage-backed securities vehicles; the bankruptcy process for off-shore vehicles remains underdeveloped relative to the United States; off-shore legal counsel seems nowhere to be found; and the complexity of some of the special purpose entities (and the number of different interests being represented) creates havoc for our litigious society.

In sum, the securitization market was particularly susceptible to being abused. And it was abused. The SEC vs. ICP case, seems only the tip of the iceberg as we begin to examine the repercussions that come from the several incentive misalignments that are apparent throughout the securitization vehicle. We are abounding with conflicts of interest while informational asymmetries, resulting in various forms of moral hazard, proliferate.

Economy-wide, we have realized that we need to encourage, if not force, the investor to perform necessary levels of due diligence both pre and post investing in complex securities. We need to impose adequate safe-guards on these vehicles to ensure that they are not mismanaged, and that managers are incentivized to manage across the capital structures, in the spirit of the deals. We also ought to encourage regulator responsibility, and permit them the authority necessary to step in sooner – to act before the problems become insurmountable. The recent, indefatigable, examiner activity seems too little too late. But it is crucial that the standard be set.

TruPS CDO Ratings Performance

2010-06-11T08:43:00.005-04:00

Click on the diagram to enlarge it

Notes

(1) Performance includes bank, insurance and REIT TruPS CDOs.

(2) The data show no upgrades on any tranches by any of the rating agencies.

(3) The migration tables indicate an average downgrade in the region of 12 rating subcategories; downgrades are continuing to this day.

(4) Often the same tranche is rated by more than one rating agency.

(5) The tranche ratings exhibited, in some instances, continue to benefit from the rating of the insurer, to the extent the insurer's rating remains stronger than that of the underlying tranche.

(6) The vast majority (91.76%) of the deals closed in the region between 2003 and late 2007.

(7) Please visit cdodatabase.com for more information on TruPS CDOs.

(8) Data on TruPS CDO issuance can be found here.

The Carry Trade from Off-Balance-Sheet Heaven

2010-05-10T13:59:00.010-04:00

The Citigroup-structured CDO, Adams Square Funding II, Ltd., closed in March 2007 with the $600mm Class A1 Floating Rate Notes (Due 2047) not being offered by Citi; rather the A1 notes were being insured by a swap counterparty by way of the then-convenient-and-now-infamous negative basis trade.

By insuring this A1 tranche trade (Ambac Assurance was reportedly the ultimate swap counterparty), Citi was able to lock in substantial up-front “profits” on the trade in addition to their significant underwriting fee. FASB’s accounting regime (1) enabled the so-called profits on the trade to be recognized immediately, by way of “sale accounting,” and (2) allowed the trade to disappear into off-balance-sheet oblivion, away from Citigroup shareholder verification.

The negative basis trade was perpetuated by several banks for many reasons, as described more comprehensively here. The forthcoming chart provides what we believe to be a thorough breakdown of the minimum estimated up-front profit -- of approximately $9.8mm -- Citigroup would have been able to achieve in having the A1 wrapped by a monoline guarantor.

Indeed UBS’s shareholder report explains that

[UBS’s] CDO desk viewed retaining the Super Senior tranche of CDOs as an attractive source of profit, with the funded positions yielding a positive carry (i.e. return) above the internal UBS funding rate …

and…

Day1 P&L treatment of many of the transactions meant that employee remuneration (including bonuses) was not directly impacted by the longer term development of positions created…

UBS may have made larger sums on the deals they had wrapped: UBS’s cost of credit default swap (CDS) protection was on average as low as 11 bps, or 0.11%.

The ability to lock in such enormous, fictitious, gains (and potentially distribute some of these gains immediately in the form of bonuses to investment bankers) proved to be a major contributor to the financial crisis. With the under-capitalized monolines – such as ACA, AIG, Ambac, CIFG, FGIC, FSA, MBIA, Radian and XL -- struggling or failing to support the credit protection contracts they had over-sold, several of the TBTF banks were forced to rely on the government’s (and taxpayers’) aid to fund the ultimate return to their balance sheets of what we estimate to be $300 billion of off-balance-sheet negative basis trade securities.

Other resources: a diagram describing the trade more generally, in its context relative to the CDO, can be found here.

Credit Ratings vs. Credit Default Swaps

2010-04-28T17:48:00.005-04:00

As an alternative to relying overly on ratings produced by credit rating agencies, several ratings reform proposals offer the usage of bond or credit default swap (CDS) prices or spreads as a more plausible option. Some of these proposals are positively suggestive of the fact that market prices are both more accurate and more predictive than credit ratings.

I’m not convinced.

Firstly, with ratings being so deeply embedded throughout our financial structure, the ratings of the assets themselves become an integral component of the market-implied risk assessment. For example, even when analyzing securitized products Vink and Fabozzi (2009) show credit ratings to be a major factor accounting for the movement of primary market spreads. Thus, for any proposal to be convincing it would have to test the accuracy and reliability of CDS spreads on unrated bonds or companies. Alternatively, a study would need to compare the performance of traded securities whose ratings are not publicly known (also known as shadow ratings) to the performance of those shadow ratings.

Secondly, bond yields (or spreads-to-swaps) and credit default swap premiums are largely incomparable to credit ratings for many reasons. These differences will have to be tackled in a separate piece, but at the very least there’s that non-insignificant concept of liquidity. Both CDS premiums and bond yields include the various risks – not just credit risks – that come with investing in, or buying protection on, a security. Credit ratings speak solely to long-term credit risks.

One may argue that the ratings were far less accurate than CDS spreads during the crisis, and that this (i.e., during a market dislocation) is the only time we depend on accurate default projections and we should therefore abolish rating agencies in general. While I don’t wish to complain of these proposals, I fear that they complain unfairly of the rating agencies.

Yes the CDS spreads may better reflect default probability during a crisis. By definition they’re more adaptive to changing market conditions, versus the ratings which are long-term predictors. But would you want ratings to change in as volatile a fashion as CDS spreads? Would you want ratings to depend on headline news, or on audited (or lightly audited) financial data? Also, one shouldn’t forget that CDS spreads on CDOs and RMBS tranches were just as poor reflections of market-perceived asset quality before the crisis. The crisis could only occur, in part, because the banks were able to buy protection so cheaply from the monolines, by way of being long the CDS -- the infamous negative basis trades.

But even if these proposals made sense and even if their hypotheses were correct, they would be missing at least one crucial point: we need ratings. Meaningful ratings are essential – certainly now. Let me explain why, albeit by way of a long-winded explanation.

For financial reform to be successful it needs ultimately to deal with the flaws in our banks’ risk management procedures – and to deal with them in an environment in which the very serious practice of risk mitigation is left by senior management to risk managers, just as the serious business of growing revenues while attending to shareholder pressure is left by risk managers to upper management.

That these two functions are more adversarial than independent in nature is a concept not to be lost on us. Overly cautious risk management might hinder the implementation of growth opportunities, or the extent thereof. At times, indeed, they may be thought by the skeptic to be mutually exclusive.

Indeed the overpowering pressures that come with business initiatives can influence even the most judicious risk manager’s ability to perform her function in an objective manner, even though her function ought to be both separate from and independent of the business strategies. (See for example “Lehman’s Worst Offense: Risk Management.”)

With both traders and management being compensated for revenue generation, and with prudent risk managers acting only as a hindrance to the initiation and exploitation of growth opportunities, there remains little incentive for senior managers to maintain a healthy risk management environment. Instead of cultivating an environment in which risk managers are educated in monitoring the real risks (which requires expensive resources including personnel, data and systems) they are seen rather as a burden and a cost center, and are therefore starved of the resources necessary to question traders, trades, and trading strategies.

In sum, we remain in the infancy of creating a functioning risk control practice in place at our major banks. We are yet to promote adequate business-peer challenge processes and our price verification processes remain immature. Credit ratings, if created and applied properly, can provide a healthy starting point for internal skepticism; they can provide the independent credit risk assessment that supplements an analysis performed by the front-office or by the back-office.

Conclusion

CDS spreads are untested as a predictor of long-term default probability on unrated securities. Perhaps the reliability of CDS spreads depends on the underlying referenced entity being rated. There’s no doubt that CDS spreads are useful indicators – but I seriously doubt that they’re anywhere near as useful as ratings in predicting long-term default probabilities or losses.

I remain convinced there's an important place in our market for one or more independent agencies to provide their objective opinions in the form of a rating. For ratings reform to be successful, however, requires that the necessary measures be put in place to ensure that rating analysts are unfettered by market share concerns, and are incentivized only by ratings quality and accuracy. If we can achieve these objectives, ratings will return to providing a meaningful utility.

The SEC v. Goldman Sachs

2010-04-19T13:10:00.003-04:00

The civil suit filed by the Securities and Exchange Commission against Goldman Sachs revolves around a combination of three patterns we have seen recently:

(1) the ability of external parties to adversely influence the portfolios that support securitized vehicles (see for example the Magnetar trade or the TPG trade);

(2) the harmful effects of the negative basis trade (according to the New York Times article, seven of Goldman’s Abacus deals were wrapped by AIG); and consequently

(3) the capacity for ratings to be “gamed.”

Ultimately, the complexity and opacity of the structured finance product make it susceptible to abuse by poorly incentivized parties. Securitization is abounding with conflicts of interest while informational asymmetries, resulting in various forms of moral hazard, proliferate.

But none of these problems would exist if ratings were always perfect: the negative basis trade would never have existed and the Abacus deal’s reportedly poorly-selected portfolio would never have received the ratings it was able to achieve.

And so we must deal with the very serious business of underwriters “gaming” the ratings system, which jeopardizes both the accuracy and the integrity of ratings and the ratings process.

But first we need to understand the observer effect.

The Observer Effect

In the social sciences any framework or methodology is subject to what is called the observer effect. The observer effect deals broadly with the process by which subjects alter their behavioral patterns on becoming aware of a test’s objectives.

Consequently, behavior induced by the methodology can be different from that on which the historical data was based. The subjects’ response varies based on the incentives of the subjects and the potential complexity of the underlying product.

The problems for ratings become most apparent when the incentives of the subjects (e.g. mortgage bankers) vary significantly from those of the creators of the methodology (i.e. rating agencies). The assumption, or hope, that models and careful study of the historical data can overcome the misalignment of incentives has been shown to be a fallacy: poorly incentivized market participants were able to create products and scenarios never contemplated by historical analysis.

How? Suppose we have a duopoly of rating agencies X and Y. Rating agency X decides that according to its internal calculations, it will more heavily scrutinize a particular quantitative factor – the borrower’s FICO score – when considering the quality of a mortgage for the purposes of its ratings methodology. Rating agency Y, however, discloses that its methodology predominantly hinges on the loan-to-value (LTV) ratio of each mortgage.

As an originator of mortgage loans (or structurer of RMBS securities) if you have a package of loans possessing high FICO scores, capitalistic tendencies will encourage you to approach rating agency X for your rating.

This is known as ratings arbitrage, or “gaming the system.” A more realistic scenario may be that once rating agency X publicly discloses that it considers FICO to be the key driver of mortgage performance, mortgage originators or structurers, will seek to put together a bunch of comparatively cheap mortgages representing high FICO score borrowers but with very poor other qualities and bundle those together in an RMBS to be rated by rating agency X. Originators might specifically target high-FICO individuals, knowing they’ll be able to off-load these mortgages by way of an RMBS to be rated by rating agency X, almost irrespective of the other qualities pertaining to the borrower (e.g. salary) or the mortgage itself (e.g. documentation level). While FICO score may have originally been a key driver of mortgage performance, all else equal, these high-FICO pools now significantly underperform.

Thus, due to what we call customization — or active adverse selection – rating agency X’s RMBS analysis turns out to have been inaccurate or compromised. (The “problem” of customization is not limited to the selection of the portfolio, but may include adverse selection of the securitized vehicle itself, or counterparties to the structure. Like the product itself, the problem is multidimensional.)

If the rating agencies continue to publicly disclose their procedures they will need to be increasingly adaptive and accurate in our computationally-intensive market, lest their rating models be otherwise gamed. They will have to be nimble and swift, like investment banks: they will need to be everything they currently are not.

The regulatory drive towards creating multiple rating agencies presumes that increased competition encourages higher standards. Niels Bohr noted that “the opposite of a great truth is also true.” In this situation, perhaps the flip-side is a greater truth: that as far as creating rating agencies goes, less is more.

Ratings competition was a key driver in the decline in standards, with rating agencies competing on ratings for market share: higher ratings translate into increased market share, which is crucial for publicly-traded companies.

The more models and options available, the easier it is to arbitrage the system, finding the least conservative rating agency to rate each particular pool of assets.

Choose Your Own Adventure

2010-02-08T10:59:00.006-05:00

In good times anything is possible. Second class managers can raise capital for new funds; corporate debt managers suddenly become experts in structured finance; and trust proliferates.

In good times risk-averse pension funds invest in ABS CDO equity and traditional managers go for the exotics, be they weather derivatives, airline securitizations or bonds secured by the future royalties from David Bowie’s music. In good times small managers win bids to manage multi-layered complex CDO-squared portfolios supported by actively-managed leveraged loan funds, ABS CDOs, CDOs supported by commercial real estate, bond funds, trust preferred CDOs and other CDO-squareds, collectively; and structurers can sell anything, everything. Oh, in good times

… anything is possible. And if it shouldn’t be possible, it can be hidden away behind all the growth that we are seeing -- and we can be easily distracted by, and forgiving due to, all the peripheral positives.

STYLE DRIFT

In bad times everything is illiquid. Those same managers no longer have the experts around who made them believe their forays into alternative exotics would pay off. Those exotics lie in side pockets, either unanalyzed or constantly scrutinized -- but no longer ignored.

Oh in bad times the too-big-to-fail become too-big-to-succeed and have to be trimmed to take advantage of overlaps and economies of scales.

... in good times we overcome our animalistic instincts to preserve. Utility theory trumps our innate loss aversion and for a short while the concept of risk leaves the dictionary.

Then we blink, take a good look around and troubled times have come
to My Hometown.

Counterparty Risk

2010-01-29T08:56:00.007-05:00

In 2009 we discussed in great depth many of the risks relating to both CDO structures and to their underlying securities. We'll continue to explore these nuances in 2010, but first we'll kick off with one of the risks we only covered lightly in '09 - counterparty risk.

Stepping back for a second here: the key concept is that in the complex, opaque and illiquid world of CDOs, at each credit rating level you were being paid more -- higher coupon or spread -- to assume additional risks, other than credit risks. These include but are not limited to illiquidity risks, model risk, operational, legal and counterparty risk.

We commented in a NYSSA article that: "We desperately need to move away from a culture in which investors, sophisticated or not, would buy the highest-yielding asset at each rating level, irrespective of its other-than-credit risks and without having performed an adequate analysis (or even possessing the tools or skills to perform such an analysis)."

The recent U.S. Bankruptcy Court ruling in the Dante CDO lawsuit captures several of these key risks: complexity, model risk, counterparty risk and legal risk. For an immature product (synthetic CDOs) supported by an imperfectly defined-or-tested bankruptcy process, the several layers of risks and dependencies inevitably give way when the unexpected occurs: in this case, the default of Lehman Brothers. (Lehman was single-A rated, not AAA, and so it raises an additional eyebrow that its default should impinge upon the performance of a tranche whose AAA ratings were designed to have been removed from any such dependencies.)

Debtors: LEHMAN BROTHERS HOLDINGS INC., et al.
Plaintiff: LEHMAN BROTHERS SPECIAL FINANCING INC.
Defendant: BNY CORPORATE TRUSTEE SERVICES LIMITED

Here follow some choice extracts from the ruling:

"This is a matter arising out of a complex financial structure that includes an added layer of complexity due to the pendency of parallel and potentially conflicting legal proceedings in this Court and the United Kingdom. The litigation in England (the “English Litigation”) was first commenced in the High Court of Justice, Chancery Division (the “High Court”) followed by an appeal to the Court of Appeal, Civil Division (the “Court of Appeal” and, together with the High Court, the “English Courts”). At issue both here and in the English Courts is the priority of payment to beneficiaries (one a noteholder and the other a swap counterparty) that hold competing interests in collateral securing certain credit-linked synthetic portfolio notes. The swap counterparty is Lehman Brothers Special Financing Inc. (“LBSF”), one of the Lehman entities whose chapter 11 case is before this Court.

... After a trial, the High Court issued a judgment in which it held, inter alia, that LBSF’s interest in the collateral securing the Swap Agreements (the “Collateral”) was “always limited and conditional,” and, therefore, payment pursuant to Noteholder Priority did not violate the so-called “anti-deprivation principle” under English law.

... the Court has learned that the Debtors are perhaps the most complex and multi-faceted business ventures ever to seek the protection of chapter 11. Their various corporate entities comprise an “integrated enterprise” and, as a general matter, “the financial condition of one affiliate affects the others.”

... The issues presented in this litigation are, as far as the Court can tell, unique to the Lehman bankruptcy cases and unprecedented. The Court is not aware of any other case that has construed the ipso facto provisions of the Bankruptcy Code under circumstances comparable to those presented here. No case has ever declared that the operative bankruptcy filing is not limited to the commencement of a bankruptcy case by the debtor-counterparty itself but may be a case filed by a related entity -- in this instance the counterparty's parent corporation as credit support provider. Because this is the first such interpretation of the ipso facto language, the Court anticipates that the current ruling may be a controversial one, especially due to the resulting conflict with the decisions of the English Courts.

One of the distinguishing characteristics of the Lehman bankruptcy cases is the complexity of the underlying financial structures many of which are being analyzed for the first time from a real world bankruptcy perspective. It is to be expected, as a result, that the cases of LBHI and LBSF on occasion would break new ground as to unsettled subject matter. This is one such occasion.

This decision places BNY in a difficult position in light of the contrary determination of the English Courts confirming that Noteholder Priority applies to claims made against it in England by Perpetual. This is a situation that calls for the parties, this Court and the English Courts to work in a coordinated and cooperative way to identify means to reconcile the conflicting
judgments.

For more on counterparty risk in CDOs, see: Hedged Trades: Lessons from the Crisis (slide 9)

If you haven't already joined us at our Ratings Reform website, please visit http://ratingsreform.wordpress.com/. We look forward to your comments and suggestions throughout 2010, and beyond!

The Winter of Our Disconnect

2009-12-11T13:25:00.003-05:00

Asset-Backed Alert has been kind enough to allow us to republish their one article from this morning's edition. It brings to the fore various of the topical issues that face and undermine the future securitization as a whole: lack of transparency, lack of supervision, and an unwillingness for market participants to take responsibility for anything that isn't explicitly defined to fit within their specified, direct jurisdiction. Without further ado, I hand you over to Asset-Backed Alert (all emphasis added by them):

------------

BONY Keeps Distance From CDO Tussle

Hildene Capital has hit a snag as it tries to have Cohen & Co. removed as manager of four collateralized debt obligations.

Hildene, which has been butting heads with Cohen for about two months, fired its latest salvo last month by trying to organize a vote among noteholders. But trustee Bank of New York balked when Hildene asked it to help arrange the ballot, saying it’s not the bank’s job to circulate such proposals.

The matter underscores an ongoing debate among market players about the roles trustees should play, especially when it comes to serving as a conduit of information and policing potential indenture violations. Some believe those shops are best suited to handle requests like the one from New York-based Hildene, as investors are often unaware of the identities of other bondholders.

Hildene holds junior paper from the Cohen deals — Alesco Preferred Funding 1, 2, 3 and 4 — and has nominated itself to step in as manager. The deals, issued in 2003 and 2004, were each backed by trust-preferred shares. Their combined face value was initially almost $1.5 billion.

At issue is a practice in which Cohen has moved collateral in and out of the transactions even though the underlying asset pools are supposed to be static. Cohen has said that it acted properly. But Hildene, which bought its interests on the secondary market, insists that Cohen’s moves are grounds for the Philadelphia firm’s dismissal.

Hildene’s complaint revolves around the idea that it was misled into basing its purchases on evaluations of the Alesco issues’ original obligors, as Cohen wasn’t supposed to trade the underlying collateral. Hildene cites an example in which Cohen removed $24 million of shares issued by FBR Capital from one of the deals this year and replaced them with $25 million of shares from Colonial Bank, which was subsequently seized by the FDIC.

Hildene said in an Oct. 5 letter to Bank of New York that such swaps violate the transactions’ indentures, and thus are illegal. The firm followed up on Nov. 25 by sending a letter to investors that it knows to hold stakes in the Alesco issues, requesting that they cast ballots to fire Cohen from its management role. It asked for Bank of New York’s help in the voting process around the same time.

Cohen, meanwhile, responded by asking Bank of New York to distribute a Dec. 7 letter in which it proposes to stop trading the deals’ underlying shares unless it receives investor approval. The firm also promises to direct any proceeds from such sales to investors, including all fees.

Cohen’s letter reiterates the firm’s denials of wrongdoing and reaffirms that it had the right to carry out the trades Hildene is disputing. “Moreover, we believe that asset exchanges helped to stabilize the portfolio and resulted in an enhancement of the financial interests of our investors,”
Cohen wrote.

The Alesco deals were among 17 that Cohen issued under that banner.

Too Big Too Frail, or a King’s Gambit

2009-12-04T09:49:00.008-05:00

Looking back at the years from the late 1990s to, really, 2006, the escalation of securitization acted as a vehicle for tremendous growth in the United States. It provided an additional source of demand for receivables from student loans and credit cards to residential mortgages; and it allowed investors the ability to gain exposure to certain of these asset classes in accordance with their desired risk level.

If rapid economic growth was the advantageous result of securitization, what was the cause? The usual suspects: to avoid certain taxes and regulatory capital charges, taking assets off banks’ balance sheets in such a way as to allow or promote almost unlimited lending.

Having grown together and having fallen apart together, it’s difficult not to see securitization and our economy in a similar light, or at least to see the art form of securitization as a microcosm for the U.S. financial economy as a whole.

The parallels are uncanny

While European and Asian investors, post the Asian crisis, had an insatiable desire from the supposedly safe and reliable U.S. market, structured finance investors’ appetites were similarly indefatigable. Foreign investors moved steadily from U.S. Treasuries to agency mortgages to corporate bonds, non-agency mortgages and on as their confidence increased; structured finance investors transitioned from CMOs to CBOs, CLOs, trust preferred CDOs and then on to CDOs of CMOs, CDOs of CDOs of CMOs, and even collateralized fund obligations (CFOs).

Both foreign investors and structured finance investors were burnt. Both the U.S. economy and the securitization market are trying to struggling new ways to grow, to reinvent themselves. Both are recovering from severe criticism pertaining to their regulation (e.g., the SEC has been faulted for its failures to investigate certain Ponzi schemes like that of Madoff, and to monitor the credit rating agencies (CRAs); while the CRAs are heavily criticized for their ratings on residential mortgage-backed securities, among other products).

And both are realizing that the interconnectedness of their risks pose “systemic” risk issues: while “too-big-to-fail” banks are purportedly being supported by the U.S. government to mitigate against further widespread turmoil, the effects of single mortgage and corporate credit failures are rolling through the structured finance products network, from direct securitizations to resecuritized products like RMBS CDOs, CDO-squareds and even CFOs, backed by hedge funds that have often invested in structured finance securities.

The “holes” that exist in certain CDOs and have been exploited recently by, among others, TPG, Marathon, Goldman Sachs, Cohen and KKR, remind us of the vulnerabilities in our financial system, where Marxist (or Michael Moore-like) capitalistic short-term measures continue to be the order of the day, be it in the form of bonuses or aggressive trading strategies. It’s not your money, and hey if it doesn’t work out, there’s always another firm looking for an aggressive trader. Reputation and responsibility to the client or customer seem to be a thing of the past. (Think of Billy Joel's Allentown or Bruce Springsteen's -- ironically called the "Boss" -- My Hometown.) The U.S. work culture is moving further and further away from the “permanent employment” environment, such as that of Japan.

Financial product regulation needs to be mindful of, and consistent with, the changing working environment and investment tendencies.

The King’s Gambit opening in chess is just that – a gambit. White offers a free pawn and weakens his king’s safety in exchange for a gamble on speedy development. The quick expansion leaves “holes” that can only be ignored for so long. If the speedy development doesn’t prove successful (i.e. meaningful and lasting) white is in danger of having a weakened, exposed king, and must quickly consolidate if he wishes to survive.

Relative to the economy, the problem is not how big the banks are, but how exposed they are to poor investments, how well their risks are managed and how liquid their capital. Do we have the transparency to regulate them, and can they adequately manage themselves? (State Street and US Bancorp are examples of “big” institutions that have not failed, being service rather than investment-heavy: the key differences being strategy, focus and management.) It’s not, therefore, a question of “too-big-to-fail” as Mortimer Zuckerman suggests. Nor is it a problem of too-big-to-succeed. (BlackRock has shown us that.) It is a problem of too-complex-to-regulate.

Consolidation, thus, ought to comprise a slew of objectives, including: ensuring all players in the game are more responsible and perform the necessary due diligence; ensuring that regulators understand and are able to accurately gauge the marginal and cumulative risks involved before approving the usage or purchase certain financial products; and requiring that regulators be granted the necessary authority and be incentivized to apply it, responsibly, to enable their efforts to have a lasting effect.

And so we end off with our financial reform motto: the key challenges at hand are to better align regulatory interests and to create an environment that encourages market transparency, consistency, and responsibility. Liquidity will inevitably follow.

Introducing RatingsReform Blog

2009-11-30T09:37:00.005-05:00

Expect[ed] Loss Readers,

We'll be moving our future blogs on rating agency reform and regulation to a new site: http://ratingsreform.wordpress.com.

Please visit us there to follow our commentary on credit ratings reform and to share your opinions with us. Oh, and don't be shy to sign up!

- ExL

Marathon, or Just a Quickie?

2009-11-10T11:31:00.007-05:00

Friday’s Asset-Backed Alert describes the (mildly fascinating) behind-the-scenes activities of Marathon CLO I, a 2005-vintage CLO managed by Marathon Asset Management.

According to the article, Marathon itself recently purchased most or all of its deal’s senior-most tranche from Bank of America, at prices purported to be in the 85 cents on the dollar range. To turn a quick profit on their senior note investment, Marathon swiftly sold off roughly two-thirds of the collateral underlying the CDOs, with the proceeds being diverted towards substantially paying down their senior tranche, at par. By our back of the envelope calculations, if Marathon purchased the entire tranche, they would have made a profit on this trade of roughly $26.75mm already, with potentially more to follow.

As far as we’re aware all of the deal’s par coverage tests (“OC tests”) declined between mid-September and mid-October, despite continued improvement in the market for leveraged loans, which support these CLOs.

Why is this Interesting?

(1) While Marathon may have benefited greatly from its extensive trading activity, all other noteholders are, at least in our opinion, worse-positioned for it: in a month in which most CLOs’ OC test ratios improved, all OC ratios of Marathon CLO I suffered, arguably purely as a result of their aggressive trading during this period.

(2) The substantial paydown of the Class A1 notes (CUSIP 565763AA7) might encourage Moody’s to upgrade the tranche from its current rating of A1, with a possible Aaa rating in sight.

(3) Managers are typically disincentivized from any earlier-than-necessary unwinding of their deals: the longer their deals run, the longer they continue to collect management fees for managing the collateral; however, in this situation, the upfront profit of say $26mm would vastly outweigh the potential additional revenue stream of less than $2mm per year that a manager may hope to earn in fee from managing a deal such as this. (Managers earn fees based on the size of the portfolio, so a paydown decreases future fee generation.)

(4) The spirit of the deal is that managers are supposed to manage “across the capital structure.” In other words, though very difficult, they’re supposed to make managerial decisions that are in the best interests of all investors of the deal, certainly not only the senior-most tranche holders. At the same time, the dynamic is that rating agencies are trying to protect their rated noteholders, but not only the senior-most holders. Though it’s an imperfect system, the collateral manager is often required to purchase some of the equity of its own deal, to ensure that it manages across the structure, thereby sending proceeds down the waterfall as far as the equity notes (see here for examples of how this structural nuance can be manipulated).

(5) In this scenario, largely as a result of the early liquidation of assets, most if not all of the other rated noteholders will suffer, which could bring the rating agencies’ ratings on these notes into question, and the equity holders likely lose any potential upside they might otherwise have hoped to gain on their investment.

(6) Aside from allowing “Credit Risk” sales, rating agencies try to protect against aggressive management by limiting the amount of trading activity permissible by a manager (see example language below). With Marathon posturing such a large proportion of these sales as “Credit Risk Sales” it really calls into question the definition of a “Credit Risk Sale” and the question of a manager’s ability to arbitrarily designate a sale as a Credit Risk Sale simply to allow for its effectuation. Given that they were able to sell these assets at, on average, over 90 cents on the dollar, can they really have been Credit Risky? Does Marathon know something about all of these loans that the rest of the market does not? Did they all just suddenly become Credit Risks, encouraging Marathon to liquidate them in the best interests of all holders, or is Marathon acting in its own capitalistic interests?

Example Indenture Language

ARTICLE XII

SALE OF UNDERLYING ASSETS; SUBSTITUTION

Section 12.1. Sale of Underlying Assets and Eligible Investments.

(a) Except as otherwise expressly permitted or required by this Indenture, the Issuer shall not sell or otherwise dispose of any Underlying Asset. Subject to satisfaction of all applicable conditions in Section 10.8, and so long as (A) no Event of Default has occurred and is continuing and (B) each of the conditions applicable to such sale set forth in this Article XII has been satisfied, the Asset Manager (acting pursuant to the Asset Management Agreement) may direct the Trustee in writing to sell, and the Trustee shall sell in the manner directed by the Asset Manager (acting as agent on behalf of the Issuer) in writing:

(i) any Defaulted Obligation, Credit Improved Obligation or Credit Risk Obligation at any time; provided that during the Reinvestment Period and, with respect to Defaulted Obligations and Credit Risk Obligations, at any time, the Asset Manager (acting as agent on behalf of the Issuer) shall use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets having an Aggregate Principal Amount (A) with respect to Defaulted Obligations and Credit Risk Obligations, at least equal to the Disposition Proceeds received from the sale of such Underlying Asset (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon), and (B) with respect to Credit Improved Obligations, at least equal to the Aggregate Principal Amount of the Underlying Asset that was sold; and provided further, that the Downgrade Condition is satisfied;

(ii) an Equity Security at any time (unless earlier required herein); provided that during the Reinvestment Period, the Asset Manager (acting as agent on behalf of the Issuer) will use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets with a purchase price at least equal to the Disposition Proceeds of such Underlying Asset (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon) received from such sale;

(iii) any Underlying Asset which becomes subject to withholding or any other tax at any time; and

(iv) in addition, during the Reinvestment Period, any Underlying Asset not described in clauses (i), (ii) or (iii) above, if (x) no Downgrade Event has occurred and (y) with respect to any sale after the Payment Date occurring in September 2012, the Aggregate Principal Amount of all such sales for any calendar year does not exceed 25% of the Portfolio Investment Amount; provided that the Asset Manager (acting as agent on behalf of the Issuer) will use its commercially reasonable efforts to purchase, before the end of the next Due Period, one or more additional Underlying Assets having an Aggregate Principal Amount at least equal to the Aggregate Principal Amount of the Underlying Asset sold (excluding Disposition Proceeds allocable to accrued and unpaid interest thereon).

UPDATE, November 20, 2009: This morning's Asset-Backed Alert edition suggests, quite disturbingly, that Fortress and TCW may be considering similar moves to that of Marathon, in their Fortress Credit Funding CLO and Pro Rata Funding Ltd. deals, respectively.

Piercing the Securitization

2009-11-05T14:32:00.013-05:00

Wells Fargo is cursing the day it agreed to act as trustee on the Tropic and the Soloso TruPS CDO series...

For those not following, TPG found a loophole in the deal docs which allows it to cherry pick assets directly out of the CDO's portfolio, at ridiculously discounted prices, if 66.66+% of the CDO’s equity agrees to it.

TPG aims to secure the equity’s vote by paying them a consent fee* – obviously, this is bad for all the rated notes (who were hoping for par or at the very least a real market price).

* bribe

Read more here.

Tropic IV CDO Ltd.'s equity has voted. No surprise there, the equity went with yes.

Whether or not to execute, on the equity’s yes, is now Wells Fargo’s call - this leaves them in a bit of an awkward position: (1) accept and get sued by the rated notes, (2) reject and get sued by the equity.

This past Monday, Wells Fargo turned to a higher power, the United States District Court Southern District of New York, to protect itself against/resolve the Tropic IV CDO Ltd. dispute and all related future disputes.

Only have a hard copy of the Wells Fargo's interpleader complaint. Will update with a link soon.

The complaint discloses some of the participants involved in the Tropic IV CDO Ltd. dispute – see below.

The Imperfect Hedge

2009-11-02T08:42:00.004-05:00

The outlook continues to be bleak for trust preferred securities CDOs (TruPS CDOs).

Not only does the FDIC continue to seize bank after bank, but the rate of bank failure continues to increase. By our calculations, using FDIC data, we moved from an annualized FDIC-insured institution default rate of 1.1% as of mid-year 2009 to 1.53% as of quarter-end September 31.

These default rates appear to be relatively mild versus say corporate bond default rates (which are well north of 10%); but we must remember that TruPS CDOs were structured based on the implied and historically-observed lower default rates of banks, due to their operating in a more heavily regulated environment. Thus, TruPS CDOs were able to be arranged with comparatively low levels of subordination, despite the low recovery rate on TruPS CDOs' deeply subordinated underlying asset class: trust preferred securities. In other words, built to protect against annualized default rates around 0.35%, TruPS CDOs find themselves ill-positioned to stomach the exponentially higher default rates.

Nor does it help that the FDIC might be incentivized to close all banks -- that is, including the well-capitalized banks -- if they operate under the same bank holding company umbrella. With the FDIC's deposit insurance fund running low, the FDIC's ability to exercise their cross-guarantee authority results in this unfortunate consequence for the better performing banks, as was the case with Citizens National Bank (Teague, TX) and Park National Bank (Chicago, IL) who were brought down along with FBOP. Both Citizens and Park National are considered "Average" performing banks by PF2's internal analysis, based on 6/30 call report data.

With bank default and deferral rates moving up, resulting in deal-wide decreases in "excess spread" levels, many TruPS CDOs have become increasingly sensitive to their interest rate hedges.

In our July 22 report we noted that:

"With TruPS CDOs already being pressured by the lack of interest generation by the defaulted and deferring securities they’re holding, the additional burden caused by the deals’ interest rate hedges is becoming increasingly torturous. TruPS CDOs usually have asset‐level swaps (although sometimes the swap has been implemented on the deal level) that exchange a pre‐negotiated fixed rate for LIBOR. With LIBOR being low, the cost of the swaps to the deal becomes tangible, on average accounting for 1.23% of the total deal portfolio size on an annual basis, or 1.45% of the performing deal size. (The median cost is 1.31% of total or 1.58% of the performing
balance.)"

These detrimental interest rate hedges -- almost always at the top of the waterfall BEFORE any payments are made even to the most senior rated notes -- are now coming under scrutiny by the rating agencies. For the first time (as far as we're aware)Moody's explained in a press release on Friday that the interest rate swap in Soloso2007-1 may negatively affect the performance of the original senior Aaa tranche, Class A-1L, prompting its downgrade to sub-investment grade (Ba1 rating). Emphasis added by us.

"Furthermore, due to the significant increase in the actual defaulted amount (an additional $17mm occurred this past month), the transaction is now negatively impacted by an unbalanced pay-fixed, receive-floating interest rate swap that results in payments to the hedge counterparty that absorb a large portion of the excess spreads in the deal. Today's actions therefore reflect that the burden of making hedge payment over the remaining life of this transaction will significantly reduce the amount of cash available to pay Class A-1L Notes and put interest payments of Class A-1L at significant risk."

Moral of the blog: beware of the hedge.

UPDATE November 3, 2009: We have received a press release from Moody's stating that a supermajority of equity noteholders in at least one TruPS CDO, Tropic CDO IV, have voted to allow the execution of a certain problematic loophole. You can read more about the loophole here, but here's a summary: the loophole allows a third party, subject to obtaining supermajority equity vote, to purchase assets directly out of the CDO's pool at the proposed and voted-upon price. The caveat is that the equity holders are pretty much out of the money at this point in TruPS CDO world, and so for a reasonable consent fee may reasonably be induced to vote in the affirmative, having (as far as we're aware) no fiduciary responsibility to protect noteholders senior to themselves. In the case of Tropic IV, the bidder was Trust Preferred Solutions LLC, which we understand to be a Minnesota vehicle of private equity firm Texas Pacific Group (TPG). Their bid was 5 cents on the dollar for what we believe were among the better preference shares in the portfolio.

Here follows an excerpt from Moody's press release that speaks to this situation:

"In a notice dated October 30, 2009, Wells Fargo Bank, N.A., trustee for Tropic CDO IV, stated that the holders in excess of 66 2/3% of the Preferred Shares directed the trustee to accept an offer to sell certain [securities] to a third party. This offer to purchase part of the transaction collateral at a substantial discount, if executed, will have a negative impact on the rated notes. The trustee has also stated that it intends to file an interpleader action requesting a judicial determination regarding how to proceed in respect of the offer. Today's rating action reflects the uncertainty surrounding the outcome of this proceeding and the potential negative impact from the Offer. Moody's is following the development of this situation closely."

"and yes I said yes I will Yes."

2009-10-29T10:42:00.003-04:00

The Wall Street Journal reports this morning that Dallas-based Highland Capital is putting together three CDO deals backed by corporate loans, one of which “will have no credit ratings at all.”

OUR OPINION

Highland is using the wide-spread investor dissatisfaction with rating agencies as a “screen” for not wanting to rely on them for CLO ratings.

Highland might wish to make the argument that the credit rating agencies (CRAs) are an unnecessary expense to the deal and that they are inaccurate anyway, right?

If, as a potential investor, you’re open to be swayed by this argument alone, we would ask you to consider at least three areas where we believe you will be losing out absent a rating:-

Structural Protections

While we have been critical of certain CRA ratings decisions, including in the CLO space, it is clear to us that underwriting quality has improved over time on the CLO documentation side. The rating agencies have learnt various lessons and imposed new restrictions over time to protect against what they believed were aggressive loan management plays, or against loan managers’ aggressive interpretation of the terms of the indenture. These “lessons” resulted in, for example, the implementation of the triple C bucket haircut (see here), which aims to disincentivize managers from building “fantasy” par or interest coverage by buying lowly-rated securities.

The CRAs, in other words, have warmed over time to the tricks of the aggressive management trade and have built in certain structural protection to protect the rated noteholders.

(Highland, like many other CLO managers, often hold an equity or residual stake in their own deals, and so may be otherwise incentivized to “flush” proceeds as interest proceeds down the CLO waterfall to the equity tranche. The “game” is thus for the rating agencies to protect their rated noteholders, ensuring only the justifiable proceeds are being alloacted for distribution to the equity holders and out of the deal, according to the design or "spirit" of the deal. More can be read on managers' interests in the CLO, and potential conflicts of interest in managing across the capital structure, here.)

Absent structural protections and rating agencies, who or what will protect the noteholder against a manager's running amok?

An Extra Eye on Deal Terms and Analytics

Even if you believe that the rating have been entirely wrong on the analytics side of their CLO ratings – and this is a hard claim to make for this asset class – they provide the investor with an additional set of eyes on the deal terms. While there are and will always remain certain loopholes and ambiguities (see for example the TPG issue in TruPS CDO world here), one can only imagine how many more difficulties would have arisen if it weren’t for the trained eye of the rating analysts.

Liquidity

Firstly, having rating agencies analyze the documents heightens the consistency across documents, and decreases the likelihood that your bond won’t have this minor helpful nuance that was introduced by the rating agencies for other bonds. Consistency is good – it helps subsequent potential investors compare apples to apples. This improves, among other things, the ability to value your security and, probably, the value of the security itself as complexities drive prices lower.

In tandem with consistency comes liquidity. The more similar your security to others that are traded, the less security-specific work any bidder would have to do on yours, which drives up the price.

But more importantly, certain funds and companies may still require or prefer ratings in the future on all purchased securities. If your security’s not rated, you’ll have a smaller set of bidders. Less demand, lower price.

Moral of the Blog: it’s not advisable to hop off the ratings wagon, especially for complex, already-illiquid securities such as CLOs, where the rating agencies provide a tangible service to the investor. Separately, we need to continue our efforts towards restoring investor confidence in ratings integrity as soon as possible.

Anatomy of a Recovery

2009-10-12T15:19:00.002-04:00

A quick update on the rock star world of corporate loans after a bumper first three quarters of 2009…

Leveraged loans have now rallied for 9 consecutive months on the back of a perceived general economic recovery – or lower probability of total collapse - and the heightened availability of refinancing and loan modification options for the borrowers.

Having been battered throughout 2008, the first quarter of '09 kicked off with the recovery of the higher quality leveraged loans (generally the BBs). Since then, it’s all been about the lower quality loans (the single Bs and the CCCs) whose performance now far exceeds that of the BBs for 2009:
- the BBs, Bs, and CCCs have year-to-date total returns of 34.2%, 55.0% and 76.4% respectively, according to S&P’s LCD Loan Index as of October 9.

A second change in dynamics has been the evolution of loan refinancings, a trend we’ll continue to watch as a ton of loans are set to mature in the coming three years. Whereas in Q1 ’09 we saw borrowers trying to raise capital to buy back maturing loans, they’re now increasingly seeking to extend the maturities of those loans, often in exchange for a minor amendment fee and an increased spread on the loan or facility. (You can read more about the “amend-to-extend” pattern here.)

While loan covenant relief has staved off certain impending defaults, the rating agencies generally see default rates continuing to rise from their current peaks around 10% for these speculative-grade issuers, tailoring off towards year end or at latest mid-2010. (Note that while refinancing opportunities – in particular debt extension – are typically a net positive for both the borrower and the lender, it does little from the rating agency’s perspective, as they focus on the borrower's ability to meet its net outstanding debt payments, irrespective of their form.)

Moving into 2010 and 2011, growth and recovery remain key for this asset class: covenant amendments, while decreasing short-term default probability, often also restrict borrower purchases in exchange for allowing lower coverage ratios. Lower coverage ratios augur poorly for eventual defaults, if and when they do happen; and the purchasing restrictions, coupled with the more expensive debt coupon, may stymie growth potential.

Rating Agency Legal Liability Standards

2009-09-29T14:53:00.003-04:00

Here follows PF2 Director Mark Froeba's written response to one of Senator Bennett's follow-up questions from the August 5th hearing on "Examining Proposals to Enhance the Regulation of Credit Rating Agencies."

SENATOR BENNETT: As we move forward on strengthening the regulation of credit rating agencies, it is important that we do not take any action to weaken pleading and liability standards of the Private Securities Litigation Reform Act of 1995. This Committee worked long and hard, and in a completely bipartisan fashion, to craft litigation that would help prevent abusive "strike" suits by trial lawyers. These suits benefitted no one but the lawyers who orchestrated these suits. This was a real problem then, and could become a real problem again if we dilute the current standard that applies to all market participants. Perpetrators of securities fraud, and those who act recklessly, can be sued under the law we passed in 1995.

Is there any justification for now altering this standard just for credit rating agencies?

MARK FROEBA: Yes, there is ample justification for altering the pleading and liability standards just for the credit rating agencies. Here are three arguments in support of changing these standards.

First, the major rating agencies have enjoyed the privilege of a government-sponsored monopoly for many years. In order to reduce the negative consequences of this monopoly, the government also encouraged competition among the agencies. There is overwhelming circumstantial evidence that the agencies responded by competing with each other not on price or efficiency or productivity or quality but, instead, on rating standards, revising rating methodologies and standards whenever necessary to build or maintain market share and revenue. Changing pleading and liability standards for the agencies would provide a key restraint should rating standards ever again end up in competitive free fall. Fear of liability will curb the appetite for market share, dampen the negative effects of competition, improve rating quality and, thereby, ultimately make lawsuits less necessary. The rating agencies, in exchange for continuing to enjoy the privilege of a government-sponsored monopoly, should be subjected to easier pleading and liability standards at least where litigants claim that bad ratings have injured them.

Second, when the rating agencies generate bad credit opinions, they have nothing at risk except their reputations. Other market participants involved in the transactions that failed in the subprime crisis, eg, investment banks, investors and collateral managers, all had some financial stake in these transactions. When these participants got it wrong, they were punished by financial losses, in some cases even to the point of bankruptcy. Having a significant financial risk is enough to warrant separate pleading and liability standards for these market participants. If reputation risk alone once provided the rating agencies with the same kind of incentives as financial risk, Enron taught them a new lesson. The bankruptcy of Enron within only days of losing its investment-grade ratings did severe damage to the reputation of the agencies but did little to hurt their business. In the aftermath of Enron, the rating agencies enjoyed some of their most profitable years ever. Thus, fear of reputation damage after Enron did nothing to check the ratings that caused the subprime crisis. It would be very difficult now to overstate the damage that the subprime crisis has done to the reputation of the rating agencies. If they all survive the current crisis unscathed – as seems almost certain -- they will be taught a lesson very dangerous to the world financial system: no matter how bad their ratings, no matter how damaged their reputations, they will not fail and the rating business will not go away because there is nowhere else for it to go. Without incentives that are far more potent than reputation risk, we cannot expect the rating agencies to reform themselves and impose greater quality and accuracy on their ratings.

Third, the rating agencies have long enjoyed near complete immunity from liability for bad ratings. This immunity is based upon an old line of cases that found the rating business -- assigning and reporting ratings – to be a form of journalism subject to free speech protections. More than forty years ago, this finding had some merit. The rating agencies assigned ratings to bonds and then reported all of their ratings in periodicals sold to subscriber/investors. Bond issuers paid the rating agencies nothing. However, the rating agencies largely abandoned this model forty years ago. The new model shifts the cost of the rating from subscriber/investors (eager for the most accurate rating) to bond issuers (eager for the highest rating). It is easy to see how the new model changed the rating agencies’ incentives. It is also difficult to imagine how real journalism could make a similar business-model switch. (It would be as if each newspaper story were commissioned by the subject of the story, based solely upon facts submitted by the subject, and published only upon the subject’s approval of the story and payment of a fee for its writing and publication.) Eventually, the courts will discover that the credit rating business is no longer anything like a form of journalism and should not be entitled to free speech protections. This will not happen overnight and may be a long and expensive process. In the meantime, the financial markets need help restoring their confidence in the quality and integrity of credit ratings assigned today. Changing the pleading and liability standards just for the agencies is an important first step in this process.

Rating Agencies: The More the Moroser

2009-09-24T11:43:00.017-04:00

It turns out I couldn't find a better antonym for "merrier" than "moroser."

But it is a grave and serious (both suggested antonyms) issue we're approaching today: the regulators' and market participants' aim to foster competition in the credit rating agency market. Just yesterday, various market participants and reporters expressed great delight at the NAIC's ruling to allow Realpoint LLC to rate portfolios of commercial mortgage-backed securities. (Separately, the NAIC is purportedly considering the viability of creating their own, not-for-profit rating agency.)

While we don't have anything whatsoever against Realpoint -- and while we certainly support the need for reform -- we would want regulators to tread this path carefully to avoid the creation of too many new credit rating agencies (CRAs or "NRSROs"). Remember, it was ratings competition that encouraged the decline in ratings quality in the first place, as the CRAs competed to win and maintain market share and revenue by altering their ratings standards.

We are not alone in this opinion. A former rating agency managing director submitted the following in prepared testimony to the House Oversight and Government Reform Committee:

“Senior management [at Moody's] still favors revenue generation over ratings quality and is willing to dismiss or silence those employees who disagree with these unwritten policies.” - Eric Kolchinsky

Competition as a concept is not necessarily a bad thing: for one it serves to bring down prices. We are not saying the "Big Three" CRA oligopoly should remain status quo. Nor are we saying that there should be a Big Three nor that it need remain Moody's, S&P and Fitch who comprise the Big Three. But we are saying that CRAs are not like hedge funds. Having three or five or ten accurate CRAs is worth a whole lot more than having 30 CRAs, irrespective of whether those 30 are accurate.

Why?

First, the recent years since Enron's failure have shown that regulating the CRAs is no mean feat. (Indeed the reforms proposed then were ineffective in buffering against this financial crisis.) It's going to be much more difficult to regulate an army of CRAs with different methodologies than to regulate only the currently existing ones. The SEC's website indicates that at least ten CRAs have already been granted NRSRO status.

Second, the creation of additional NRSROs places additional burden on the investor, who now has to familiarize herself with the slew of new methodologies.

Third, the CRAs were never competing on ratings cost anyway - they're competing on ratings standards (and historical performance to a limited degree). In other words, the less conservative approach might achieve a higher rating and win business. Now there will be more approaches to choose from. Thus, the availability of several alternatives only increases the problem of "ratings shopping," as issuers and structurers cast a wider net to achieve their ideal mix of (i) ratings quality/timeliness/service, (ii) ratings cost and (iii) minimal subordination level required to reach their target rating, in the case of structured finance securities. In the worst case scenario, thus, the rating chosen by the issuer, which typically seeks the highest rating, will be the most lenient measure available from the numerous CRAs. But this does nothing for the investor, who is usually best served by the most accurate rating. And the rating agencies are, after all, an investors service.

Fourth, the CRAs better fit the mould of regulator than that of market participant (buyer/seller). This financial crisis has brought upon us the realization that often having too many regulators can cause a problem: in the U.K. there is talk of the absorption of the FSA; in the U.S. the independent functionings of the OCC, OTS, and FDIC has resulted in various discussions -- especially with regional and community banks being able to swiftly switch between regulators -- which may result in one or more of them being folded into the SEC or the Fed, bodies proposing to take on further responsibilities going forward. Perhaps, then, we should be keeping tighter reins on the CRAs too and rather working towards creating fewer, manageable NRSROs with more meaningful responsibilities.

- PF2

Step 1: Rating Agency Reform

2009-09-14T14:27:00.004-04:00

Anybody who’s seen the movie Charlie Wilson’s War will appreciate the fact that signs of economic improvement doesn’t mean we can take our foot off the peddle.

The film describes Charlie’s (ultimately successful) efforts in leading Congress to support Operation Cyclone, the largest-ever CIA covert operation, which supplied weapons to the Mujahideen during the Soviet war in Afghanistan. But the movie ends on a somber note, citing the U.S.’s premature exit in the epitaph to the film:

“These things happened. They were glorious and they changed the world ... and then we f----d up the endgame.” – Charlie Wilson

(The result: the Mujahideen eventually flowered into the Taliban and backed Osama bin Laden's war against the U.S.)

Our situation is hopefully not as drastic, but the point remains: even if we feel we have survived the crisis -- and that unemployment and default rates are leveling off -- we still need to implement the necessary reform measures to avoid the creation of a different monster in future.

With this in mind, we’ve put out our first paper on rating agency reform. The piece ends:

“The ultimate objective of this reform is to encourage financial market transparency and responsibility, from which liquidity will inevitably follow.”

Read it; criticize it; share your thoughts.

- PF2

The CLO Also Rises

2009-08-25T13:35:00.002-04:00

The May/June rally and subsequent stabilization of CLO tranche values has shown us that despite times of deep distress, culminating in loan downgrades and defaults, CLO managers on average have been at least temporarily able to build OC coverage. In sum, the par they were able to gain by way of their discount purchases, together with loan price appreciation and the ability to offload certain CCC assets, served as a greater combined force than the dual impositions of portfolio downgrades and defaults.

But one other item has become more readily apparent since May: that investors are increasingly differentiating between AAA CLO tranches (or, at least, between what were originally AAA CLO tranches), resulting in their trading within a wider bracket. As we shall see, not all AAA CLO tranches were created equal.

The complexities in evaluating CLOs, or even CDOs in general, are not limited to making long-term assumptions on a potentially dynamic, managed pool. Nor are the complexities limited to the modeling of each deal’s intricate structural features, such as pro-rata sequential paydowns or BBB tranche turbo features. The language of the indenture – the CLO’s governing document – brings with it a host of nuances in interpretation.

Our most recent piece explores one of the more timely nuances: the varying natures of CCC-rated loan haircuts.

The full report can be read here: Special Report: CLO CCC Buckets - Key Variations in Terms and Performance

An excerpt from the piece:

"... an investor looking for exposure to a CLO that does not have aggressive deleveraging provisions would want a CCC bucket has some or all of the following features:

- is as large as possible (at least 10%);

- references Moody’s loan rating not CFR in determining which securities are in the CCC bucket (and that has as “flexible” a definition of Moody’s rating as possible);

- includes only purchased CCC securities in the CCC bucket;

- haircuts excess CCC securities to MV (with as “flexible” a MV definition as possible);

- is ambiguous on which securities fill the bucket first (or even allows low MV securities to fill first); and,

- diverts cash‐flow for reinvestment and never for deleveraging.

In contrast, an investor looking for exposure to a CLO that has aggressive deleveraging provisions would want a CCC bucket that has all of the following features:

- is as small as possible (no more than 2.5%);

- references Moody’s CFR and not Moody’s loan rating in determining which securities are in the CCC bucket (and that has an “unambiguous” definition of Moody’s rating);

- includes all CCC securities (including both purchased and downgraded CCCs) in the CCC bucket;

- treats excess CCC securities the same as Defaulted Securities and haircuts them to the lesser of MV and recover value (and that has a strict definition of MV);

- clearly fills the CCC bucket with only the highest MV securities first; and,

- diverts cash‐flow for deleveraging only and not for reinvestment."

For Whom the Capital Flows

2009-08-19T10:30:00.007-04:00

Thanks to some data mining on Bloomberg, we were able to put together a chart showing the slowing participation by U.S. banks in the Treasury's Capital Purchase Program.

As you can see from the table to the right, only approximately $1.2bn has been drawn down since mid-year, roughly 6% of the speed of the $134.2 bn NET participation witnessed since the inception of the program in October 2008. This is perhaps surprising given the increasing frequency of bank failures -- now bordering on an annualized rate of 1.5% for FDIC-insured institutions -- but may be indicative of the sharp demands made, and restrictions imposed, by the government upon its investment.

All numbers in this blog are NET of the $70.22 bn of capital contributions that had been made but have since been repaid by 36 banks, including repayments made by JPMorgan Chase, Goldman Sachs, Morgan Stanley, State Street, BoNY and U.S. Bancorp. (The most recent repayment came in January 2009.) Wells Fargo, Citigroup, BofA, Regions Financial, SunTrust and KeyCorp are among the institutions who have received large capital injections which they are yet to repay.

The following chart breaks up the capital injections by transaction type. You may notice -- after substantial squinting -- that very little investment has been made (only $0.15bn cumulatively) in pure preferred stock, without any warrants.

(Click on graph to enlarge)

Some are born investment grade, some achieve investment grade, and some have investment “grade-ness” thrust upon them

2009-08-06T18:53:00.008-04:00

Morgan Stanley’s recent repackaging of a downgraded Aaa CDO tranche into a new Aaa and a subordinated Baa2 tranche caused quite a stir and what we feel is perhaps an unwarranted outrage. See for example Morgan Stanley, Goldman Sachs Plan To Rebrand Failure As Success and Turning Junk Into Treasure.

Rather, we would argue, the form of these restructured credit ratings -- the very essense of structured finance itself -- if performed correctly will share the common success of Viola’s makeover in Shakespeare's Twelfth Night: each transformation, despite causing initial confusion, will ultimately benefit all parties involved and hurt none, even if at first they may not appear to have done so. (One could argue that poor Malvolio was "most notoriously abused" but, well, it was a comedy after all.)

When the rules of the game change, one must adapt to them. Nobody was injured by the repackaging. No damage was one. And, thankfully, de minimis non curat lex.

It remains a bane of our economy (and a systemic risk) that credit ratings are so deeply intertwined throughout its workings. Thus, there are many reasons, aside from pure regulatory capital arbitrage designs, that may drive an investor to restructure her downgraded tranche. For example:

Fund-level Minimum Rating Criterion
Funds or companies (e.g., mutual funds, insurance companies) may not – according to their investment criteria -- be allowed to hold the tranche at the downgraded rating.

Fund-level Minimum Average Rating Criterion
Funds or companies (e.g., certain fixed income funds, hedge funds) may have mandated weighted average rating thresholds for the entire fund or for certain sections of the fund which may be compromised if they maintain the downgraded security.

Absent the ability to restructure, either of these two criteria alone might encourage or even force the holder to sell her security - and in this illiquid environment, being a forced seller typically translates into suffering a substantial loss on selling. Thus, the ability to repackage potentially stops the investor having to realize a larger-than-necessary loss.

We believe we’re seeing a mixture of the above in the repackaging of the G Square Finance 2007-1 Ltd.’s A-1 tranche.

Back in March, we wrote about how this original Aaa tranche was repackaged into an investment grade tranche (23%) – rated BBB(low) by DBRS -- and a subordinated note (77%). See Regulatory Capital Arbitrage.

As G Square Finance 2007-1 Ltd. continued to suffer credit deterioration in its underlying portfolio, we fear the holder of the note realized that her newly-structured investment-grade tranche, too, may be downgraded to sub investment-grade status.

We suspect that the tranche holder’s fund documents entice her to maintain as much of her portfolio in investment-grade securities (for criteria limitations or regulatory capital purposes, or otherwise), encouraging her to return to DBRS to re-repackage her original A-1 tranche, again trying to achieve as much investment grade as possible out of this declining security. The new breakdown is investment grade tranche (14.89%) – rated BBB(low) by DBRS -- and the remainder is essentially a subordinated note (85.11%).

(While the original A1 tranche was rated by Moody’s and S&P, the repackaged tranche can be rated by whichever rating agency the investor chooses. In this case, the rating agencies are in the ignonomous position of having to compete, among others, on (1) fees charged, (2) quality of service provided, and (3) amount of subordination they require to achieve the investment-grade rating desired – the less subordination the better for the investor.)

In sum, neither Morgan Stanley's nor Viola's approach was exactly what we would call transparent (shout out for the PR department), for which both parties temporarily suffered, and though these repackagings don't immediately create a new source of supply they keep the markets alive and the holders breathing. CDOs are intended as and designed to be long-term par-value products after all, and so almost any institution or implementation that increases the owner's ability to hold them through the illiquid times, and hurts no other party, ought to be met with open arms.

The End

Postscript: Incidentally, G Square Finance 2006-1 Ltd.’s Class A-1 Notes have also been restructured, synthetically, to allow the senior note (38%) to retain an investment-grade rating -- again, BBB(low) by DBRS.

Rating Agency Reform ... continued

2009-08-06T17:30:00.006-04:00

An excerpt from our colleague Mark Froeba's testimony before the U.S. Senate Committee on Banking, Housing, & Urban Affairs' hearing on Proposals to Enhance the Regulation of Credit Rating Agencies (August 5, 2009):

-----

"First, [the rating agencies] enjoyed an effective monopoly on the sale of credit opinions. Second, and more importantly, they enjoyed the benefit of very substantial government-sanctioned demand for their monopoly product. (A buggy whip monopoly is a lot more valuable if government safety regulations require one in every new car). Third, the agencies enjoyed nearly complete immunity from liability for injuries caused by their monopoly product. Fourth, worried about the monopoly power created by the regulations of one branch of government, another branch encouraged vigorous competition among the rating agencies. This mix of regulatory “carrots” and “sticks” in the period leading up to the subprime melt-down may have contributed to making it worse than it might have been. Thus, a third goal of rating agency reform should be to untangle these conflicting regulatory incentives. Here are some proposals that I believe will help with all three reform goals.

First, put a “fire wall” around ratings analysis. The agencies have already separated their rating and non-rating businesses. This is fine but not enough. The agencies must also separate the rating business from rating analysis. Investors need to believe that rating analysis generates a pure opinion about credit quality, not one even potentially influenced by business goals (like building market share). Even if business goals have never corrupted a single rating, the potential for corruption demands a complete separation of rating analysis from bottom-line analysis. Investors should see that rating analysis is virtually barricaded into an “ivory tower,” and kept safe from interference by any agenda other than getting the answer right. The best reform proposal must exclude business managers from involvement in any aspect of rating analysis and, critically also, from any role in decisions about analyst pay, performance and promotions.

Second, prohibit employee stock ownership and change the way rating analysts are compensated. There’s a reason why we don’t want judges to have a stake in the matters before them and it’s not just to make sure judges are fair. We do this so that litigants have confidence in the system and trust its results. We do this even if some or all judges could decide cases fairly without the rule. The same should be true for ratings. Even if employee stock ownership has never actually affected a single rating, it provokes doubt that ratings are disinterested and undermines investor confidence. Investors should have no cause to question whether the interests of rating agency employees align more closely with agency shareholders than investors. Reform should ban all forms of employee stock ownership (direct and indirect) by anyone involved in rating analysis. These same concerns arise with respect to annual bonus compensation and 401(K) contributions. As long as these forms of compensation are allowed to be based upon how well the company performs (and are not limited to how well the analyst performs), there will always be doubts about how the rating analysts’ interests align.

Third, create a remedy for unreasonably bad ratings. As noted above, the rating agencies have long understood (based upon decisions of the courts) that they will not be held liable for injuries caused by “bad” ratings. Investors know this. Why change the law to create a remedy if bad ratings arguably cause huge losses? The goal is not to give aggrieved investors a cash “windfall.” The goal is to restore confidence — especially in sophisticated investors — that the agencies cannot assign bad ratings with impunity. The current system allows the cost of bad ratings to be shifted to parties other than the agencies (ultimately to taxpayers). Reform must shift the cost of unreasonably bad ratings back to the agencies and their shareholders. If investors believe that the agencies fear the cost of assigning unreasonably bad ratings, then they will trust self interest (even if not integrity) to produce ratings that are reasonably good.

My former Moody’s colleague, Dr. Gary Witt of Temple University, believes that a special system of penalties might also be useful for certain types of rated instruments. Where a governmental body relies upon ratings for regulatory risk assessment of financial institutions — e.g. the SEC (broker-dealers and money funds), the Federal Reserve (banks), the NAIC (insurance companies) and other regulatory organizations within and outside the US — the government has a compelling interest and an affirmative duty to regulate the performance of such ratings. Even if other types of ratings might be protected from lawsuits by the first amendment, these ratings are published specifically for use by the government in assessing risk of regulated financial institutions and should be subject to special oversight, including the measurement of rating accuracy and the imposition of financial penalties for poor performance.

Fourth, change the antitrust laws so agencies can cooperate on standards. When rating agencies compete over rating standards, everybody loses (even them). Eight years ago, one rating agency was compelled to plead guilty to felony obstruction of justice. The criminal conduct at issue there related back to practices (assigning unsolicited ratings) actually worth reconsidering today. Once viewed as anticompetitive, this and other practices, if properly regulated, might help the agencies resist competition over rating standards. Indeed, the rating problems that arose in the subprime crisis are almost inconceivable in an environment where antitrust rules do not interfere with rating agency cooperation over standards. Imagine how different the world would be today if the agencies could have joined forces three years ago to refuse to securitize the worst of the subprime mortgages. Of course, cooperation over rating analysis would not apply to business management which should remain fully subject to all antitrust limitations.

Fifth, create an independent professional organization for rating analysts. Every rating agency employs “rating analysts” but there are no independent standards governing this “profession”: there are no minimum educational requirements, there is no common code of ethical conduct, and there is no continuing education obligation. Even where each agency has its own standards for these things, the standards differ widely from agency to agency. One agency may assign a senior analyst with a PhD in statistics to rate a complex transaction; another might assign a junior analyst with a BA in international relations to the same transaction. The staffing decision might appear to investors as yet another tool to manipulate the rating outcome. Creating one independent professional organization to which rating analysts from all rating agencies must belong will ensure uniform standards — especially ethical standards — across all the rating agencies. It would also provide a forum external to the agencies where rating analysts might bring confidential complaints about ethical concerns. An independent organization could track and report the nature and number of these complaints and alert regulators if there are patterns in the complaints, problems at particular agencies, and even whether there are problems with particular managers at one rating agency. Finally, such an organization should have the power to discipline analysts for unethical behavior."

Mark's complete testimony can be viewed here.

A Practical Proposal for Rating Agency Reform

2009-08-03T09:06:00.001-04:00

The premise behind most proposed regulatory regimes for rating agencies – managing conflicts of interests between issuers and investors – is misguided. The conflicts of interest faced by rating agencies are not qualitatively different than those faced by many other industries, such as the accounting or brokerage industries. The problem is actually more pedestrian – product quality versus profit. Regulating outside influences will not work if the source of the problem is internal.

The conflict stems directly from the concentration of power at the rating agencies. They create rating methodologies, assign ratings based on the same and then judge their own performance. There is no “separation of powers” in the credit rating world – the agencies act as judge, jury and executioner, and are not required to justify their actions to any regulator or other third party. This concentration of power, combined with regulatory demand for ratings, makes it too tempting to alter methodologies and procedures to maximize revenue.

Imagine, for example, if accountants could be the sole arbiters of what counts as income or expenses for a company’s financial statements. Imagine further that their word was final and not even the authorities could appeal the verdict. No one would be surprised by the resulting decline in accounting standards.

My solution is to reduce the concentration of power within the agencies. The proposed template would be based on the regulatory apparatus for other third party information providers in the capital markets – accountants and attorneys.

Like credit rating agencies, accountants and attorneys are private parties competing for business in the capital markets. While no one would argue that these parties are paragons of virtue, their ability to generate profits through manipulation of analyses and opinions is limited. One key safeguard is that neither party sets its own methodological standards. Accountants take their cue from national or international standards and the relevant regulators. Lawyers likewise only interpret and offer advice on legal standards set by authorities.

Standardized Methodology

Rating agencies should follow a standard set of methodologies as well. A body similar to the FASB could be empowered to set various standards for the rating agencies. These could initially include some credit basics such as the definition of ratings (e.g. what is the default probability of a AAA at 5 years), the frequency of surveillance updates and the types of data required to be presented for ratings.

The proposed central credit policy body would have two major effects in improving credit quality:

First, the central approach would stop the methodological “race to the bottom” that was at least partially responsible for today’s credit crisis. Mistakes will still be made, but rating agencies will no longer have to the incentive to play “one-upmanship” in order to maintain their market share.

Second, a standard methodology can be used to actually match the ratings with their regulatory usage. For example, the risk profile of a given rating should match the capital weight assigned to it – this is not the case today. Likewise, if the Federal Reserve requests that only securities rated AAA be allowed in a financing program, the quantitative (e.g. probability of default) measures will have a consistent meaning across the agencies. This is not the case today.

The rating agencies will argue that standardizing methodologies will lead to a loss of independent opinion. This is simply not true; despite the differences in methodologies, the bankers made sure that the ratings issued in structured finance were nearly identical. Moreover, the supposedly different methodologies used by the rating agencies prior to the crisis did nothing to prevent it. If a rating agency had actually proffered a different methodology, especially a more grounded, more conservative analysis, it would have been run out of business.

In fact, the rating agencies do not have to give up their current methodologies and approaches. What they can be asked to provide is a new “regulatory rating” which fits the needs of regulators. This would be no different from having different accounting standards for different tasks. For example, GAAP accounting and tax accounting. Each can produce different results, but is tailored to the needs of the requisite purpose. Lawyers, too, deal with a multitude of jurisdictions and conflicting laws. Ratings should be no different.

Central Ethics Body

Another function that is currently in the sole control of the rating agencies is the adjudication of ethics and professional codes. The International Organization of Securities Commissions has promulgated a code of conduct for the ratings industry. While it is a very good code, the enforcement of its principles is left entirely to the rating agency itself. There are no appeals or penalties for non-enforcement. This is another example of concentration of power within the rating industry. Other professionals in the capital markets (stockbrokers, accountants and lawyers) are subject to ethical standards which can be and are enforced beyond the employer itself. In my personal experience the lack of enforceability leads to precisely the result one would expect – loose or non-existent enforcement.

A central ethics body needs to be established with the authority to adjudicate violations of the IOSCO or any other code of ethics for the ratings industry. The proceedings of this body need not be public, but they should be known to the regulatory bodies with proper jurisdiction such as the SEC.

In order to empower this body to fairly enforce its rulings, a fine-tuned remedy is required. I propose that rating agency analysts be licensed individually to provide “regulatory ratings” only. A licensing requirement would put rating analysts on par with their colleagues in the securities industry. Removal of an individual’s ability to provide ratings is a sufficient punishment for most violations of conduct within the ratings agencies. The knowledge that one may lose her livelihood will increase the incentives for analysts to behave ethically.

One additional benefit of licensing would be increased understanding of regulatory requirements within the rating agency. I have been surprised and frustrated by analysts’ lack of knowledge of applicable regulation or even securities laws. Other regulatory licensing standards (e.g. Registered Representative) require the candidate to have a basic understanding of the legal environment surrounding her profession.

Conclusion

I believe that the two proposals above, the creation of standardized methodologies and the use of ethics bodies, would significantly improve the quality of the work performed by rating agencies. They would also allow regulators to more efficiently discharge their responsibilities. Additionally, these proposals would also be simple to implement and would cause a minimal amount of capital market dislocation.

- Former rating agency analyst

Critique of Impure Reason: CDO Anyone? I'll Take Two, Please!

2009-07-29T09:46:00.009-04:00

In a perfect world CDOs would have been the perfect investment: for the same level of risk (as distinguished purely by rating, of course) you get more reward, by way of the additional spread or yield on your investment.

Where certain investors -- including pension funds from the US to Europe to Australia -- saw the word "ARBITRAGE" flash in bold red across their screens and quickly rushed to beat the market, others lingered and assessed the risks more closely.

Wisely and slow. They stumble that run fast.

In sum, some investors looked around to find the highest yielding asset that fits their fund's rating criterion (and so they'll necessarily outperform the market, at least for the short-term, and perhaps secure themselves a pat on the back and an increased bonus). Others asked themselves: "Well, even if I can come to terms with the rating agencies' approach to rating these assets -- that the have accurately measured default probability or expected loss, as the case may be -- what else am I paying for, say, relative to a corporate bond? And is it worth it?"

CDO Risks

Without further ado, here's what they're paying for, in terms of risks and expenses, over-and-above the vanilla corporate bond alternative:

liquidity, or illiquidity risk;
model risk and/or complexity risk;
spread or yield risk (somewhat similar to that of a corporate bond);
interest rate risk;
payment timing risk (prepayment, extension risk, lumpy payment risk);
tranche pricing volatility;
rating methodology changes (given the "newness" of the asset class);
a slew of operational costs (to monitor/model/mark your position); and
a host of accounting risks and legal risks that we'll leave for another day

Additionally, certain CDOs brought with them foreign exchange risk, certain basis risks and portfolio market value risks. Leveraged accounts, buying CDOs, took the burdensome funding risk and rating downgrade risk. (This is all not to mention the risk that the rating agencies may be wrong in their assessments of default probability and loss given default.)

While you can't necessarily model the "cost" of each of these risks, and what you should be paid for absorbing each, individually, they are nevertheless quite tangible risks. Especially now.

Ideally, perhaps, a sophisticated investor with strong analytical capabilities might model the deal, run various sensitivity scenarios based on her internal opinion, interview the manager -- and decide that upon sufficient review of the documents and the various "dangers" they allow for, she is is willing to take the risks involved in the investment relative to the yield it provides. It would be suboptimal to say, well, "this looks good to me and geez it pays a whole lot of yield at that rating level, so let's buy it, close our eyes, and hope for the best."

Why? Well essentially you're being paid a hefty reward for being right in your modeling assessment of the deal and in your determination that you can, as a fund, stomach the collective risks of the instrument. If you don't perform the necessary credit analysis, you're not earning your wage: you're rolling the dice or guessing. Tough times, and the volatility they bring, have a sneaky way of separating the guessers from those who performed a thorough analysis, bringing to the fore any portfolio-level risk or support weaknesses, and thereby magnifying certain of the risks of OTC instruments:

increased illiquidity particularly hurts those buyers who are holding their securities as available for sale (AFS);
low interest rates decrease payments derived from bonds with LIBOR-based coupons; and
payment uncertainties, model complexities, and accounting and legal risks and costs accentuate the imbalance between buyers and sellers, driving prices further down. (To compound the matter, lawsuits may discourage both the sale and the purchase of complex securities.)

"Unmodeled," almost qualitative, risks proliferate

- S&P has corrected its ratings on, among others, Founder Grove CLO Ltd., Archstone Synthetic CDO II SPC, and WISE 2006-1 PLC's CDO Notes. Their reason: modeling errors

- S&P has corrected its ratings on, among others, Lorally CDO 2006-2, Tranched Investment-Grade Enhanced Return Securities 2004-11, Longshore CDO Funding 2007-3 Ltd., and Quartz CDO (Ireland) PLC. Their reason: administrative errors

- Moody's and S&P have both confessed to finding errors in their CPDO models

Resources:

(P.S. Feel free to share in the comments section below if you feel we've failed to mention any major risks.)

The KYSS Principle

2009-07-17T10:39:00.003-04:00

We're coining a new phrase on this bright-n-sunny summer morning:

KYSS - Know Your Super Senior

Or Know Your Senior Secured. Either way, knowing who's above you in the capital structure can be immensely useful, particularly in the world of defaults.

We've been seeing this in ABS CDO space for a while now, as the contrasting interests and demands of the controlling class holders have determined whether defaulting CDOs were liquidated or accelerated.

And we recently spoke about this in the leveraged loan world too (click here for the full transcript) where banks and CLO managers have possibly different agendas in the corporate loan amendment process:

The big difference is when banks are the lenders the relationship between the borrower and the lender often goes back many, many years and may include businesses like bond underwriting and cash management and other types of solutions that the banks offer. And so the banks are going to be even more incentivized than usual to grant covenant relief and find a solution that allows for continued revenue generation. With institutional investors, on the other hand—and we’re talking CLOs, prime rate mutual funds and the like— they’re “transactional lenders.” In other words, their relationship doesn’t go any further back than the individual loan in question here and so their incentives will be naturally more immediately self‐serving.

Thus, as a prospective subordinated bondholder (i.e., purchaser) it might be wise to find out who is holding the senior secured loan. What would the amendment process look like? What sort of acquisition restrictions will be imposed on the borrower post amendment, and amendment fees and charges will leak to the senior lender. (See for example Richard Kellerhals' recent piece Investors Fume as Banks “Extend and Pretend.”)

So go ahead and KYSS - it may even change the way you see the bond you currently hold.

Impact of amendments on CLOs

2009-07-02T11:04:00.004-04:00

Your good friend GP was recently interviewed on the state of corporate loans and CLOs amid the flurry of credit agreement amendments.

You can download the full podcast here.

Collateral Managers and Takeover Opportunities

2009-06-04T11:15:00.005-04:00

Collateral managers banding together...here's a link to the report we sent out last week. Enjoy.

Collateral Managers and Takeover Opportunities

Is your CDO Leaking

2009-05-14T11:30:00.010-04:00

CDO noteholders, pay close attention to your monthly trustee reports. These are complicated deals and trustees make mistakes. Most of the time, these mistakes cost you nothing but every now and then they'll cost you millions.

For example, a mistake we picked up today revolves around an incorrect implementation of the “CCC Haircut Amount.” It's responsible for leaking approximately $4 million to equity when that amount should have been used to pay down senior notes.

The details...

Here's the definition from the O.M :

Click to enlarge

In simpler words, if this CDO has too many poorly rated assets then it has to carry a portion of these (“The Excess”) at market value (vs. par) when computing the numerator of this CDO’s overcollateralization tests. (The ensuing lower numerator increases the likelihood of an overcollateralization test trip. If such a trip occurs, cashflows that would have otherwise gone to subordinated tranches are redirected to pay down more senior tranches.)

Additionally, the definition specifies that The Excess should consist of those poorly rated assets with the lowest market values (this is typical) but the trustee made a mistake and picked the ones with the highest…

WHAT HAPPENED / WHAT SHOULD HAVE HAPPENED?

Click to enlarge

This misapplication of the CCC Haircut Amount definition causes the class D overcollateralization test to pass when it should in fact fail. Because this test passes, cashflows are leaked out of the deal to equity when they should have been used to pay down the senior tranches in an effort to cure the failing test.

While this is the first distribution date during which the impact of this mistake is felt, chances are that the trustee will keep making it moving forward, ultimately sticking millions in losses to the wrong group of noteholders.

Here are the details of the CCC Haircut Amount calc.:

Click to enlarge

We’ve got a handful of these examples; we’ll try writing more of these in the future if there is an interest…

Assumptions Assumptions Assumptions

2009-04-27T09:44:00.006-04:00

"During the recent foolish-extension-of-credit period, I think there was altogether too much reliance on black boxes. Something that comes out of the computer looks quite official; it looks quite precise down to all these little digits. But the fact is, any kind of computer-based model inherently has as its basic assumption that tomorrow will look quite a lot like yesterday. The unfortunate truth is that when you get to a major inflection point, it's precisely because tomorrow does not look very much yesterday." - Wilbur Ross

The rating agencies, among other market participants, have to walk a fine line between maintaining their "long-term" views on long-term securities and being overly adaptive to changing market conditions.

I certainly don't envy them their position: A false step in either direction, and they'll be criticized from Wall Street to Washington.

Before we investigate this double-edged sword, let's consider the original premise or thought process or unspoken truth at the time of the original rating of, say, a CDO tranche. It goes a little something like this:

this rating is a long-term rating
given the lengthy maturity (usually more than 10 years away) of the asset, we expect it will go through different economic cycles and so our assumptions should speak neither to the peaks nor the troughs, but to the averages (based on historical data) with some volatility -- i.e., stresses -- built into our assumptions
as long as the manager behaves as she should relative to the constrictions of the indenture, and as long as the portfolio collateral quality remains within the bounds described, we shall not downgrade you!

Now we return to the question of changing assumptions. As you can imagine, any change in assumptions may precipitate a change in ratings, and so ought to be accompanied by transparency describing the methodological change. A change in rating affects, among other things, the regulatory capital that the holder needs to post against the rated asset and the ability of certain funds to continue to hold the asset. In other words, downgrades precipitate deleveraging. And supply. And price. And therefore recovery. And I could go on and on but this circle is vicious.

From their April 23 press release:

S&P: Criteria Changes And Stressed Collateral Performance Affect TruPS CDO Ratings

We have published several revisions to our ratings criteria for TruPS since the July 2008 trust preferred CDO CreditWatch placements as a result of our observations regarding performance trends and worsening economic conditions, and our view regarding the effect those conditions might have on the performance of TruPS CDOs:

-- "Criteria: Revised Correlation Assumptions For Rtng CDO/CDS Exposed To Financial Intermediaries" published Oct. 3, 2008; this modified the correlation assumptions used for financial institutions held within or referenced by CDO transactions, including bank TruPS CDOs.

-- "Criteria: Correlation Assumptions Revised For Rating Global CDOs/CDS Exposed To Insurance Cos.," published Nov. 6, 2008; this modified the correlation assumptions used for insurance companies held within or referenced by CDO transactions, including insurance TruPS CDOs.

-- "Criteria: Prob Of Default, Correlation Assumps Revise For Glbl CDOs/CDS Exposed To REITs/REOCs," published Nov. 6, 2008; this modified the default and correlation assumptions used by CDO Evaluator for REITs and real estate operating companies (REOCs) held within or referenced by CDO transactions, including REIT TruPS CDOs.

-- "Global Methodology For Rating Trust Preferred/Hybrid Securities Revised," published Nov. 21, 2008; this modified the assumptions Standard & Poor's uses when rating TruPS CDOs generally.

-- "Assumptions: Standard & Poor's Reclassifies Insurance Companies That Issue Debt Securities Owned Or Referenced By Rated CDOs And CDS," published Dec. 23, 2008; this modified the industry classifications used in CDO Evaluator for insurance companies held within or referenced by CDO transactions, including insurance TruPS CDOs.

Stepping back, we're seeing at least five assumption revisions since October 2008. Is this too much? Too little?

Back on April 14, on being downgraded yet again by Moody's, Ambac Assurance responded as follows:
- "While Ambac believes that Moody's is entitled to its opinion of Ambac's financial strength, it notes that this is the tenth such opinion change since January 2008."

As we've described with the current regulation environment, in Hegelian fashion, one tends to over-regulate as a means of "compensating" for under-regulation. Each can be harmful, and hitting the sweet middle-ground is the key. Here we're seeing the responsiveness to severe criticism relating to maintaining static assumptions in a changing environment. The response, naturally, is to proactively rate.

Damned if you do, damned if you don't.

Distress Testing

2009-04-20T10:44:00.004-04:00

The Economist put out a piece on the psychology of trading in stressed environments, such as those facing floor traders.

The piece brings to the fore the idea that, in deciding between a low-probability major loss and a high-probability minor loss, the stressed conditions encouraged participants to roll the dice with the major loss.

This theory -- which culminates in traders taking profits too soon and being unwilling to realize losses while they're still manageable -- is consistent with the "loss-aversion winning over utility theory" pieces that stock-trading-psychologist-guru Phil Pearlman writes (see here and here for example).

The nuts and bolts: if a trader has a 100% probability of winning 1 unit, versus a 60% probability of winning 2 units, the theory suggests that the trader often chooses the former option, against the principle of utility theory (since 60% x 2 units = 1.2 units, which is greater than 1).

The alternative is, however, much more troubling especially as it relates to pension funds and government intervention implementation: the willingness to roll the dice and risk a major problem, rather than suffer a sure, minor blow now. On the government level, this "theory" may manifest in an unwillingness to cut rates or even to draw down on the credit line available from the IMF. The United States was a front-runner in cutting rates in early H2, 2007, but some even criticize the U.S for cutting too slowly, too late, with the downturn having begun in 2006. A more rash action may have qualmed fears sooner, and nipped the problem -- now massive -- in the bud.

This trend remains "watchworthy" as companies like Ford reap the rewards of raising capital sooner rather than later and the Japanese banks continue to resist their governments attempt to inject capital, despite their relatively massive exposure to the stock market. Post the G20 meeting, it will be interesting to see how the Balkan (and particularly Baltic) countries differ in their approach towards relying on the IMF.

While it may be acceptable for smaller hedge funds to play ball on the downside, it's incrementally detrimental if systemic-risk-issue-companies, and governments themselves, don't carefully avert losses on the downside.

UPDATE April 22 (Bloomberg): Fitch says Japanese banks may need, yet avoid, public funds

Japan’s biggest banks may need to accept funds from the government as bad debts increase and investors demand higher capital ratios, according to Fitch
Ratings Ltd.

“Capital pressures are growing,” David Marshall , a managing director at Fitch in Hong Kong, said in a Bloomberg Television interview today. Capital weakness and loan losses “might even pressure some of the bigger Japanese banks eventually to have to turn to the government,” he added. “That’s something they’ll resist as long as they can to avoid that stigma.”

UPDATE April 23: Despite wider-than-estimated fourth-quarter loss -- as bad loans spiraled and the global financial crisis cut the value of its investments -- Japan’s second-largest bank Mizuho Financial Group Inc. did not announce any plans to raise money.