Credit Ratings Reversals

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.



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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

“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

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

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

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

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

“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

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

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

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.