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.
Tuesday, September 29, 2009
Thursday, September 24, 2009
Rating Agencies: The More the Moroser
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:
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
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 KolchinskyCompetition 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
Monday, September 14, 2009
Step 1: Rating Agency Reform
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:
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:
- PF2
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
Tuesday, August 25, 2009
The CLO Also Rises
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:
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."
Wednesday, August 19, 2009
For Whom the Capital Flows
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)
Thursday, August 6, 2009
Some are born investment grade, some achieve investment grade, and some have investment “grade-ness” thrust upon them
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
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.
-----
"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.
Monday, August 3, 2009
A Practical Proposal for Rating Agency Reform
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
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
Wednesday, July 29, 2009
Critique of Impure Reason: CDO Anyone? I'll Take Two, Please!
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?"
Without further ado, here's what they're paying for, in terms of risks and expenses, over-and-above the vanilla corporate bond alternative:
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:
(P.S. Feel free to share in the comments section below if you feel we've failed to mention any major risks.)
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
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:
- 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.)
Friday, July 17, 2009
The KYSS Principle
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:
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.
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.
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