Withdrawing, Confidently

As structured finance deals wind down and the asset pools grow smaller, the situation often arises that the effectiveness of outstanding tranche ratings – previously based on a portfolio-level diversification – can hinge on the performance of one or two bonds. The problem is compounded, of course, in that many of the models work best for large, diverse, portfolios and often break down when the portfolios become arbitrarily small.

The question then becomes, if a rated tranche can just as easily be rated AAA or D, what does one do?

This tricky situation, now part skill, part luck, calls into question the predictive content of highly sophisticated ratings models when the outcome is really not a model-driven result, but simply a short-term occurrence (e.g., a payoff or a default) or the lack of an occurrence, in a credit-default swap environment.

Moody’s and S&P suffered severe blushes in January when a well-structured CDO, backed heavily by other CDOs and RMBS (including substantial subprime, yes subprime), paid off in full ­– with their outstanding ratings on all tranches having been in the CC to CCC range. What was interesting was that both ratings agencies had visited this deal as recently as June of last year.
From our conversation with analysts at one of the agencies, what happened here was simply that as the deal was winding down, the manager was able to sell the few remaining assets at prices high enough to pay down all the notes, rendering irrelevant the Monte Carlo default simulation trials being run by the raters. In other words, the model let them down.

In an interesting, perhaps prudent decision, S&P took a different course in an announcement they made earlier today, entitled “S&P Takes Various Ratings Actions on 30 U.S. RMBS Deals.” As certain deals dwindled down, compromising the predictive content of their ratings, they chose to simply withdraw the ratings.

“We subsequently withdrew our ratings on certain affected classes that are backed by a pool with a small number of remaining loans. If any of the remaining loans in these pools default, the resulting loss could have a greater effect on the pool's performance than if the pool consisted of a larger number of loans. Because this performance volatility may have an adverse affect on our outstanding ratings, we withdrew our ratings on the related transactions.”

While it may cause frustration to note holders to see the ratings withdrawn, it augurs well that a rating agency is able and willing to say that it cannot have confidence in the outcome, and therefore chooses to withdraw its rating rather than have investors rely, perhaps falsely, on a rating in which it does not have confidence.