Risk - Discombobulated

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)

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

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

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

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

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

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

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.