Not for Profit Sovereign Ratings Become a Reality

Last week, the Bertelsmann Foundation issued ratings and supporting research for five sovereign bond issuers – Brazil, France, Germany, Italy and Japan. The individual country reports, a summary and a description of the rating methodology are available at http://www.bfna.org/.

The publication of these reports marks a substantial milestone. The Foundation has delivered on the ideas outlined in its April 2012 blueprint for an International Non-Profit Credit Rating Agency (INCRA). It has shown that a not-for-profit organization can produce quality sovereign credit research competitive with that offered by incumbent rating agencies. Further, unlike commercial players, this not-for-profit agency consistently implements a transparent rating methodology.

Last week’s reports show that the Bertelsmann Foundation can produce very detailed research. This should not come as a surprise, since the Foundation has experience in producing comprehensive research in support of its Sustainable Governance Indicators and Bertelsmann Transformation Index. Many think tanks and academic research groups produce reports that compare multiple governments and other institutions. The data collection and interpretation processes used by these non-profits are analogous to those required to rate sovereign governments.

The consistency and transparency of the reports is also noteworthy. The Foundation scores each country according to several dozen macroeconomic and forward looking indicators. The score for each indicator is reported, a published algorithm is used to aggregate the scores and the composite score is converted to a letter grade via a standard mapping.

It is not clear whether the Bertelsmann Foundation plans to issue more sovereign rating research. Comments from organizational leaders suggest that this set of reports constitute a pilot and further steps would have to be taken by a new organization – ideally one supported by an endowment to the tune of $400 million. The endowment would enable the rating organization to operate free of the need to generate income and the temptations for bias such a need entails.

My own view is that biases can be addressed through transparency. If others can look under the kimono, assumptions and procedures that introduce bias can be flagged - placing pressure on the rating issuer to correct them. Since $400 million is not likely to be found in the NGO world, there has been some discussion of securing INCRA funding from the G-20. But a group of sovereigns funding a sovereign rating process could be an invitation to bias.

Rated vs. Unrated Bonds

One of PF2's experts recently testified that a rated bond is worth more than an unrated bond. Was he right?

Let's consider this from the perspective of structured finance. One often hears the question: "how can you take all this sub-prime and make AAA out of it?" Of course, that's the whole premise of structured finance - that one can take a portfolio of (more) credit risky assets and create at least some less credit risky (AAA) assets out of it. 

But if we dig deeper into what's happening, we see it's simply a ratings transformation that's taking place. The securitization process enables a bundle of unrated securities (e.g. mortgage loans or credit card receivables) to be "converted" into a set of (tranched) rated notes. 

The rated notes - in higher demand, more liquid, and demanding less regulatory capital - are cheaper to issue, creating the so-called "excess spread." In sum, acquiring a cheap rating enables the wider dissemination of all sorts of securities, through the securitization process. 

The rating provides this value - liquidity, increased demand, lower capital requirements. And so a rated bond is worth more than an unrated bond. What do you think?

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Note: Keep in mind the argument is not that ALL rated bonds are worth more than ALL unrated bonds, but that all things equal the rated bonds are worth more: that the rating, reliable or not, provides a value.

Canadian Provincial Debt

Marc's recent research on the financial strength of the Canadian provinces was (finally) published yesterday and is getting some good attention today. 

If interested, have a look at the Wall Street Journal's coverage here.

- PF2

Bringing Academic Rigor to Government Bond Ratings

Since peaking in July, yields on Italian and Spanish long-term bonds have dropped by about 150 basis points. While the headlines attribute this sharp adjustment to the availability of a new ECB bond buying program, neither country has expressed an intention to use it, so perhaps the headline writers are missing something. Looking back, our July 23rd research note concluded that the spread between Italian and German bond yields was excessive given the low probability of an Italian sovereign default.

A Problem of Information

Market volatility is compounded when market participants lack the information necessary to appropriately value investment securities. When rumors and announcements penetrate the information vacuum, investors often overreact. If this vacuum is instead filled with high-quality information and analysis, volatility and mispricing diminish.

Equity market investors can obtain research and analysis from numerous banks and brokerage firms. While much of this research suffers from conflicts of interest, it also contains large volumes of fact and analysis that investors find useful.

For government bonds, the traditional source of analysis has been the major credit rating agencies. Unfortunately, these firms have faced widespread criticism in recent years, leaving their reputations in tatters and their guidance in doubt. Although the highest profile failures have been in structured finance, critics have also questioned whether incumbent rating agencies have sufficient staffing and resources, adequate procedures, and the intellectual capability to meaningfully gauge sovereign default risk.

Potential Ways Forward – A Call to Academics

A number of parties have recommended alternatives to the incumbent rating agencies, including at least four not-for-profit initiatives offering sovereign ratings.

To have a beneficial impact, a non-profit rating agency will have to gain credibility with investors. After all, if ratings don’t guide investment decisions, what value do they have? A not-for-profit credit rating agency can gain credibility by having a strong methodology and solid institutional support. Both of these factors can be advanced by the academic community. Economists, political scientists, statisticians and financial engineers associated with a major university could generate the kind of quality, branded sovereign research that would command the attention of investors.

In hopes of focusing more academic attention on government credit risk, I have contributed an article to the new issue of Economics Journal Watch – a peer-reviewed economics journal freely available online. The article describes problems with the rating agency model, surveys some of the previous literature on government default probability modeling, and offers a research agenda as well as one possible solution.

Academics can deliver the intellectual rigor missing from both status quo rating analysis and some of the alternatives we have been seeing. The thorough data collection procedures, advanced modeling techniques, and peer review practices employed by social scientists can raise the level of sovereign risk analysis.

One Bond, One Price

The contemporaneous "scandals" recently covered in the media - the alleged manipulation of LIBOR and the possibility that JPMorgan used its VAR model to help disguise the riskiness of its portfolio - return us directly to the very shortcomings that led to, or exacerbated, our financial crisis. 

They provide ready examples of the frailty of our financial controls, and acute reminders of what can happen when financial institutions have the incentive, and capacity, to massage financial data and disclosures. 

It ought not to surprise anybody that, when trying to maximize their gain under a poorly-designed incentive structure, financial market professionals might choose to manipulate valuations or massage disclosures to their advantage. Would not most players maneuver to their benefit? 

The problem here, of course, is their capacity to massage important data on a large scale. Back in 1994, Kidder, Peabody's Joseph Jett was purportedly able to exploit an anomaly in Kidder's accounting system, booking substantial profits in the absence of any genuinely profitable trades. 

Almost twenty years after the "Kidder Scandal," our system remains open to abuse. 

The lack of transparency in our reporting, and the ability to finesse asset valuations, create an environment in which the value of a bank's assets quickly becomes whatever the bank wants it to be. Banks and funds need little incentive to inflate their asset prices: higher asset valuations typically lead to improved performance, which enables banks or funds to raise more capital at reduced rates. Imagine if mortgage borrowers could value their own houses and have their mortgage rates reduced based on their own inflated appraisals! 

It is time to realize that the current system does not work - it cannot. We can no longer rely on an institution to accurately evaluate its own assets, while being knowledgeable of the many and material conflicts it faces. We also cannot blindly trust the auditing firms to catch the cover-ups. Their success rate has been too low. 

One advantage of the ratings-based system - a system from which we're energetically moving away - is that it provided a single rating for each bond. It is true that banks may reserve different amounts of capital against each rated bond, but at least we knew that it was always one bond, one Moody's rating.  

Right now, however, there is virtually no pricing control - no consistent mechanism for the valuation of complex and illiquid transactions. One bond can have many prices, depending on who provides the price. We see regular examples of traders who mark their own portfolios, while earning bonuses and promotions based on their self-constructed performance. We often find that two similar banks, supervised by the same regulator, can hold the same security at materially different prices. JPMorgan itself was recently reported to have held the same bond in two different divisions at different prices. Banks can "shop" for opportunistic evaluations, just as they could actively seek the highest ratings, which precipitated a lowering of ratings standards. How does this all promote shareholder confidence, or cross-institutional comparability? 

Goldman Sachs, Wachovia, Bank of America, Citigroup and others have recently been accused of mispricing securities in one way or another. Traders at UBS, Deutsche Bank, Credit Suisse, RBS have been criticized for mismarking bonds. Hedge funds and asset managers have been accused of overvaluing their funds' positions and the audits of Deloitte, PwC and KPMG have all come under scrutiny for their failure to capture their clients' misrepresentations and securities mispricings. 

The list keeps growing. In last week’s case filing In re Lehman Brothers Holdings Inc., et al v. JPMorgan Chase Bank NA, the Lehman plaintiffs argue that the JPMorgan entities’ derivatives claims are inflated as a result of procedures including “the inconsistent valuation of trades to the JPMorgan Entities’ advantage.” 

While the problem of inconsistent, utility-maximizing pricing is overwhelming, the solution is simple. It only requires the political power for its implementation. All financial institutions should be forced to carry the same bond at the same price. Any digression from market pricings should be accompanied by appropriate disclosure that describes the reason for, and magnitude of, the deviation. Furthermore, any internally-marked positions should be open to public scrutiny especially for those institutions considered "Systemically Important Financial Institutions" (or SIFIs). What is there to hide, anyway? 

Supervisory authorities would have only to decide on the framework for deriving the ultimate price. There are several options available, not the least of which is to follow the precedent set by the National Association of Insurance Commissioners. The NAIC selected PIMCO and Blackrock Solutions, respectively, to help it determine risk-based capital requirements for insurers’ holdings of residential and commercial mortgage-backed securities. Rather than calculating capital reserves, one could implement an algorithm that produces a price. Another approach would be to create a central pricing repository which would accept a range of prices submitted by regulator-approved price providers. The final price could then be determined by applying an averaging process, for example, or by taking the median of the submissions. 

Pricing transparency, and a forum for the provision of feedback to the extent assets are being mispriced, would enhance investor confidence in the reliability of banks' balance sheets. Confidence and transparency, of course, lead to market liquidity. After the crisis of confidence we have had, and the associated liquidity freeze, wouldn't that be nice? 

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Additional Resources 

• Floyd Norris: Bad Grades Are Rising for Auditors 
• Database of Contested Asset Valuations
• The Price is (not that) Right

This Just In: Thousands of Secret Municipal Bond Defaults

The Washington Post, New York Times and other media are reporting on a Federal Reserve blog post revealing the existence of over 2500 municipal bond defaults not previously reported by the major rating agencies. Before municipal bond investors panic, we need to consider several points.

First, this large number of defaults should be considered in the context of the number of issuers and the length of time examined. There are approximately 60,000 municipal bond issuers and this number has not changed that much in recent decades. The Fed data contains 2521 defaulting issuers for the 42 year period ending 2011. That represents an average of about 60 defaults annually and an average annual default rate of roughly 0.1%.

Second, similar default statistics have been reported before. Anyone who subscribes to Richard Lehmann's Distressed Debt newsletter and database knows that he has cataloged about 3500 municipal bond defaults since 1980 (this number refers to the number of defaulting bonds rather than bond issuers - which is one reason that it is higher than the Fed's number). Lehmann's data was summarized in a 2011 Kroll Bond Rating Agency Municipal Default study that I co-authored. So the Fed's findings really aren't news.

Third, as mentioned in the Fed blog post and elsewhere, the vast majority of the defaults are not General Obligation or tax supported issues of states, cities, counties, towns or villages. Instead, they are mostly revenue bonds financing specific projects or facilities. So these situations should not be conflated with the cases of Stockton or San Bernadino.

Finally, most of the defaulting issuers are quite small. For example, as Bloomberg reported recently, a large concentration of municipal bankruptcy filings occurred in Nebraska.

Almost all of these filings were by Sanitary and Improvement Districts (or SIDs). Approximately 45 of these districts have filed municipal bankruptcy petitions since 1982. The bulk of these bankruptcies have occurred in Douglas and Sarpy counties. Douglas County includes the City of Omaha, while Sarpy County includes most of Omaha’s southern suburbs.

SIDs finance sewer, lighting, paving and other improvements in unincorporated areas selected by developers for the creation of new subdivisions. Costs for these improvements are financed by special property tax assessments on lots within the subdivisions. Bonds are often financed by the SID with special assessment revenues, typically collected over a period of ten years, generating funds to redeem the bonds. SIDs are typically quite small, encompassing one subdivision or a small number of subdivisions. Most of the bankrupt SIDs I examined had fewer than 200 lots. Their size is thus similar to that of a Home Owners Association, although the range of services provided differs.

So the conclusion is that a lot of small revenue bond issuers have defaulted over the years. This is not news and should not fundamentally alter the perception that municipal bonds in general - and tax supported bonds issued by states and larger cities - have relatively low default risk.

Agency Shortcuts and Shortfalls

Investors in certain "AAA" resecuritizations won't be happy. Late last night, Moody's downgraded a bunch of securities, even though they are supported by Agency-guaranteed RMBS.

Many of these were downgraded from Aaa to junk (some at Ba1, others all the way to B1) in one fell swoop, while others went only to A1.  (It looks like S&P still carries most of these securities at AA+, which is lower than Moody's Aaa as S&P has downgraded the United States to AA+.)

What's most interesting here is the reason.  It's not the case that either Fannie or Freddie hasn't paid up on their guarantees, but it looks like the deals may not have been modeled (possibly ever!) - or at least may not have been modeled correctly.  According to their press release, the resecuritization vehicles seem not to have the necessary protections in place to support the bonds issued, or the ratings provided.  Some of these deals were structured in 2007 and even late 2008.  Many of these deals are already suffering shortfalls.

From Moody's press release:

"The downgrade rating actions on the bonds are a result of continual interest shortfalls or lack of adequate structural mechanisms to prevent future interest shortfalls should the deals incur any extraordinary expenses."

... and ...

"Interest due on the resecuritization bonds is not subject to any net weighted average coupon (WAC) cap whereas interest due on some of the underlying bonds backing these deals is subject to a net WAC cap."

... and ...

"Since the coupon on the resecuritization bonds is currently higher than that of the underlying bonds, the resecuritization bonds are experiencing interest shortfalls which on a deal basis are accruing steadily."

Total issuance of $483mm affected, according to Moody's. Deals are of Structured Asset Securities Corp. and Structured Asset Mortgage Investments shelves.

Relevant CUSIPs Downgraded Last Night
86363TAA4
86363TAC0
86363TAD8
86363TAF3
86363TAG1
86363TAB2
86363TAH9
86363TAJ5
86365HAA8
86365HAB6
86365HAD2
86365HAG5
86365GAA0
863594AA5
86359LPA1
86359LPB9
86359LPC7

Marc Joffe Discusses Pros of Open Source Rating Models for Sovereigns / Munis

On Friday night, PF2 consultant Marc Joffe was profiled on The Lang and O’Leary Exchange, a popular Canadian business program.



http://www.cbc.ca/player/News/Business/ID/2258963934/

LIBOR and Transparency

Americans obsessing over last week’s healthcare decision or zoning out ahead of July 4th may have missed the latest episode in the financial industry corruption soap opera. Last week. Barclay’s agreed to pay a $453 million fine for misreporting the rates at which it borrowed funds to the British Bankers Association, thereby distorting the value of the London InterBank Offer Rate (LIBOR). The bank’s Chairman and COO have both stepped down.

This instance of financial industry malfeasance appears to lack the compelling narrative needed to upset the general public. For those advocating on behalf of the “little guy”, this scandal may lack appeal, since most of the LIBOR manipulation appears to have been downward -thereby lowering mortgage rates paid by ordinary borrowers. Financial industry critics seem less concerned by the fact that many “little guys” who directly or indirectly invest in LIBOR-based vehicles were cheated out of some income. Journalists and bloggers have thus focused their ire on the rich and powerful individuals who have been caught cooking the books. This is unfortunate, because chopping off a few heads is not the real solution. As we will see in the coming days and weeks, misreporting of bank borrowing rates was pervasive. It is simply too tempting for most of us mortals in the financial industry to resist.

Rather than focus on the people involved or expect bank executives to morph into Mother Theresa, we should instead direct our attention to fixing the institutional framework. The problem is with how LIBOR and many other financial market prices and rates are estimated and reported. The systems we have are too easy to game and the benefits of gaming them are simply too great to resist.

In the case of LIBOR - as with bank loan prices and CDS spreads - the mechanism involves dealers reporting their bids and offers to a data aggregator, like Thomson Reuters or MarkIt. The aggregator then averages the reported quotes, often dropping the highest and lowest marks from the composite. As we’ve now seen, these dealer quotes are subject to manipulation. In less liquid markets, they may not be updated regularly since the dealer does not see new bids or offers. In either case, the composite marks reported by the aggregator do not reflect actual value.

This should concern everyone (who pays taxes to bail out banks), because it means that we don’t really know what most bank assets are worth. A better alternative would be to require all bank transactions to be reported and made publicly available. Reporting should be real time, easily accessible on the internet and as detailed as possible. Specifically, consumers of the data should be able to identify inter-dealer trades that may be executed for the purpose of manipulating mark-to-market prices.

Comprehensive transaction reporting will not be welcome by many in the financial industry. Although the major complaint may revolve compliance costs, these should be minimal, since banks already have to collect all of the transaction data for their internal systems. The real concern will be the loss of income suffered by traders, who realize significant gains from the opaqueness of many markets. Of course, that issue is much less of a concern for the rest of us.

With a few spectacular exceptions, prices of equities and other exchange traded products have proven trustworthy because of their relative transparency. By making markets for bank funding, asset backed securities, derivatives and exotic fixed income instruments more transparent, we can restore trust in quoted prices, enhance liquidity and increase the stability of our financial system.

Rather than simply scapegoating those who were caught, let’s use the LIBOR scandal as an opportunity to provide more transparent and reliable pricing not only to the market for short term bank financing, but to all markets touched by our “too big to fail” financial institutions.

One Bond - Three Prices

The challenges of appropriately pricing illiquid assets have returned, with JPMorgan reportedly having valued the same trades at different prices in separate departments of the bank.  To be fair, the current pricing regime enables these types of discrepancies to occur, and it makes it difficult to catch them.

But this time, the problem was big enough to get some attention.  From Bloomberg's JPMorgan CIO Swaps Pricing Said To Differ From Bank:

The discrepancy between prices used by the chief investment office and JPMorgan’s credit-swaps dealer, the biggest in the U.S., may have obscured by hundreds of millions of dollars the magnitude of the loss before it was disclosed May 10, said one of the people, who asked not to be identified because they aren’t authorized to discuss the matter.

We've been writing about this problem for while - that in some cases hedge funds, banks and insurance companies can all carry the same asset at a different price. In illiquid markets, the price differential between two price providers can be extraordinary, creating an opportunity for lesser-regulated financial institutions to profit handsomely from the regulatory arbitrage available, at the expense of their more heavily-regulated counterparts.

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

In yesterday's Financial Times, Michael Mauboussin and Alfred Rappaport added to the conversation on pricing transparency. A solution they put forward is to add more meaningful disclosure around the asset pricing, rather than reporting a single estimate. Their approach isn't novel, but it's worth consideration.  They suggest a three-pronged approach: 

This type of controversy vanishes when there are three estimates. Fire-sale prices are appropriate for the pessimistic estimate if it is likely that creditors or regulators will force the bank to sell assets to stay afloat. The optimistic scenario reflects the present value of holding the securities until market prices recover. The most-likely estimate lies in between. This disclosure acknowledges that there is no right answer, only a range of possibilities.

We're interested to hear what you think.

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For a list of problematic asset pricings, click here.
For our suggestion of one solution to the problem, click here.
For more on this, including Citi CEO's Vikram Pandit's proposal and that of Barclays' Group Finance Director Chris Lucas, click here.