Bloomberg reproduces the following chart of Moody’s ratings of major banks with and without government support.
You could read this at face value: the claim would then be that an unsupported BofA and Citi are junk. But really, is this credible? The BB+ one year default rate averages, depending on period, somewhere around 1 – 1.5%. A fair credit spread, without liquidity premiums or other compensation, and assuming a Lehman-type 25% recovery would therefore be at least 1%, with the actual credit spread being bigger than that.
This does not seem credible to me. The PDs are high; the spreads are high; perhaps it is the stand alone ratings that don’t make sense?
From the Daily Mash:
Credit rating agency Standard & Poor’s has upgraded itself to Triple-A Plus Super Fantastic.
(I was going to go with Philip Stevens’ somewhat more sober post on a similar theme in the FT, but I can’t resist the Daily Mash’s nuanced, balanced stance.)
Now, before we go, let’s remind ourselves as to what the collateral looked like behind the mortgages in some AAA tranches…
Last year, several banks structured some CDO-squared, or Re-remic deals. These were typically repacks of old RMBS which had eroded in quality: the point of the repack was to produce a new AAA tranche by introducing more credit enhancement.
Bloomberg now reports that this did not work so well. What was AAA last year is now junk.
So what? Well, it seems that some people who appear not to understand structured finance are upset. Felix Salmon says
S&P knew, when it was rating these re-remics, exactly where it had gone wrong in the first round of structured-credit ratings, yet somehow was unable or unwilling to fix the problems in that group.
A rating can be right last year, and wrong today. This is especially true in structured finance, where deals are typically highly robust for a certain level of stress, but then fail catastrophically beyond it. While a corporate bond might degrade slowly; 100, 99, 98, 97, 96; a structured finance deal is more like 100, 100, 100, 100, 40. If the probability of getting the 40 is low enough, the deal can (and often both was and is) be rated AAA. All this shows is the foolishness of trying to encapsulate the whole CDR/CPR risk space in a single letter grade.
A nice article from FT alphaville reporting a publication by Moody’s:
In the current market conditions, it is common for notes issued by a structured finance issuer to be acquired by the related originator and used as collateral under a central bank repo.
As the sole noteholder, an originator may direct the trustee and issuer to waive breaches of transaction documents or consent to the modification of transaction documents.
Given that originators are typically parties to various transaction documents, they may pass noteholder resolutions that are favourable for them in some other capacity and potentially prejudicial [detrimental] to the credit quality of the notes.
But it is OK, because so long as the notes remain rated BBB-, they still count as collateral at the ECB window. So that’s OK then. After all, ratings will always be a completely reliable and timely indicator of credit quality, right?
20% June 30, 2009 at
No, not my standard broker’s commission, but the average level of credit enhancement in CMBS before 2003. FT alphaville, commenting on the forthcoming tsunami of CMBS downgrades, reprints this enlightening table from S&P:
This very clearly shows how investors let their standards slip in the hurt for yield during the Boom years. Not everyone was convinced though: from 2004 the practice of splitting the AAA into two or more tranches became commonplace. The top tranche, amusingly, is called super duper AAA.
S&P want at least 19% credit enhancement for AAA going forward. At least this is generating a nice repack business as banks take junior AAAs and resecuritise to keep most of the notional at AAA. The Americans call this a Re-Remic* — which isn’t nearly as cool sounding as super duper AAA.
* Real estate mortgage investment conduit, or CDO-squared to its friends.
GE cut January 28, 2009 at
The downgrade of GE has long been coming, and long deserved. Now it seems that the agencies will finally do something: see here for Reuters on Moody’s warnings and here for Bloomberg on S&P.
As Jonathan Weil says:
The credit-rating companies say they’re cleaning up their act. That will be a tough sell as long as they keep saying General Electric Co. is AAA.
Given how much of GE is GE Capital, Weil has a point. The Egan Jones rating for GE is A-. ’nuff said.
Update. Felix Salmon is insightful on GE too, here. He points out that GE needed its own FED bailout, that GE trades wide (I’m guessing the CDS are at more than 300 today), that GE has more than half a trillion dollars of liabilities, and that GE’s accounting need be less robust than it would have to be if it was a bank. I’d add in the lack of a consolidated supervisor for the whole group.
On a day when piffle seems to be widespread, Bloomberg reminds us that there may well be a case to answer in some quarters:
Frank Raiter says his former employer, Standard & Poor’s, placed a “For Sale” sign on its reputation on March 20, 2001. That day, a member of an S&P executive committee ordered him, the company’s top mortgage official, to grade a real estate investment he’d never reviewed.
Understandably, reform of the ratings agencies has taken a back seat to the Paulson bailout. But it does need to be done. Furthermore we do need to look back in anger at the doings of the Greenspan boom and, where there is good evidence of malfeasance, hold the perpetrators accountable. If Raiter is correct in his account, the case against S&P appears to be strong.
Update. The second part of the Bloomberg series is also interesting (if marred by the most annoying pop-up I have come across in a while). A highlight:
An S&P executive urged colleagues to adjust rating requirements for securities backed by commercial properties because of the “threat of losing deals.”
A modern day version of the Pecora Commission is clearly required.
What were the ratings agencies doing really? Frank Portnoy writing in the FT, tells it like it is:
the rating business has shifted from providing information to selling “regulatory licences”, keys that unlock financial markets. Consider Constant Proportion Debt Obligations, the financial Frankensteins that the agencies’ flawed mathematical models said were low-risk. Does anyone believe parties paid for triple A ratings of such instruments because those ratings gave them valuable information? More likely, ratings were valuable because they permitted investors to buy something triple A-rated that paid 20 times the spread of other triple A-rated instruments.
In other words ratings can only really be objective when they are not used for anything. The SEC has already removed reliance on ratings from many of its rules, but I am not holding my breath waiting for Basel to do the same. However sensible an idea it might be, I doubt regulators are willing to admit how ill-conceived the Basel credit risk rules really are.
This was my favourite blog title of the day: And now young monoline… you will die. Accrued Interest makes some good points, and indeed it must be frustrating trying to run a monoline when one’s de facto regulator, the ratings agencies, keep changing the capital model. However:
- It was clear that the capital models used up to mid 2008 were flawed, and so volatility in capital required for a AAA was to be expected.
- One of the key parts of an insurer’s business model is time diversification. Business underwritten in one year diversifies that written in another, and losses in one year – subject to enough capital being available to continue – can be offset by higher premiums the next year. For the monolines though this does not work any more as there is much lower demand for muni wraps and those that are getting done are mostly being written by Berkshire. So the agencies are right to account for this change in their re-rating of the monolines.
Anyway, Bill Ackman might fancy being able to buy another small country, so it is about time for another wave of monoline downgrades.
Bloomberg points out:
The [U.S.] debt limit is $9.815 trillion and the current outstanding public debt subject to that limit is about $9.4 trillion, according to the Treasury.
In other words, actual US borrowing is within $415B of the maximum permitted by Congress. Now while more or less everything I know about the US budget process comes from an episode of the West Wing, it does seem clear that this $400B ceiling limits Hank’s ability to do much meaningful for Freddie and Fannie. And comparing $9.4T with $5T makes the impact of bringing the agencies’ $5T of mortgages onto the government balance sheet clear. Hank must be hoping the markets bought his `we’ll fix it’ speech because if he actually has to do something, is room for manoeuvre is limited.
A question to anyone who knows _a lot_ about public sector accounting. Just how much help exactly can the U.S. provide to Fannie and Freddie before those $5T of mortgages consolidate onto the government balance sheet? And would the US still be AAA with another $5T of liabilities?
Update. Bloomberg has caught up with this one.
There’s nothing sacrosanct about the U.S.’s AAA rating, no matter what dogma and orthodoxy might suggest. Many financial assets that claimed AAA status before the credit crunch turned out to be irredeemably tarnished; there’s a non-negligible risk that Treasuries will prove to be similarly spoiled.
The ten year CDS spread on US treasuries settled in Euros is now more than twenty basis points.
TGIF… June 20, 2008 at
… or perhaps not if you are a monoline. Especially a press officer at a monoline. There’s lot’s of steam to generate as this list of current press releases from Bloomberg admirably demonstrates. Oh yes. Long coal, short insurers.
I have been reading a fascinating (if long) article Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions by Joseph Mason and Joshua Rosner. There is an awful lot in the document, but here I want to concentrate on one issue they raise which I had not thought about before, namely the shape and trajectory of the loss distribution through time.
Consider a corporate bond. For a holder of the bond, the (hold to maturity) loss distribution has a big lump of probability in the 95%-100% return bucket corresponding to the likelihood that they will get their money back. Then there is a gentle bell curve lower down corresponding to the distribution of recovery values. Two observations:
- As the credit quality of the corporate declines, this shape moves but typically those moves are slow. The big lump gets a little smaller and default gets a bit more likely, fattening out the curve around the expected average recovery.
- One of the reasons that moves are slow is that the company has management. Default is bad for these folks so they try to avoid it by altering their strategy or the capital structure and/or by asset sales. They have strategic options which they exploit, often saving the company.
Now consider a typical tranched ABS backed by a pool of collateral. Here tranching and other credit enhancement means that default is unlikely for the rated tranches. However:
- The shape of the distribution is different. In particular, the average loss given default can be much higher.
- The time evolution of the distribution is different: most static ABS pools evolve so that for a given tranche, default becomes either certain or vastly improbably.
- Thus if the pool behaves a bit better than expected, most or all of the rated tranches will be money good. Mason and Rosner say this `wastes’ credit enhancement, which I don’t really see, but certainly even lower tranches can become risk free in some deals fairly fast.
- On the other hand, if the pool behaves even a little worse than expected, the impact on the lower tranches can be severe. Therefore ABS downgrades, when they come, are often multiple notch downgrades.
- Note that this is partly because most ABS has no asset diversification and no time diversification: unlike a corporate, there are no strategic options for the issuer to do something that doesn’t lose as much money as their current approach.
None of this means that ABS ratings are wrong, necessarily, but it does mean that the users of ratings need to understand the key differences in the time evolution of credit risk between corporates and ABS.
Rated Wrong June 13, 2008 at
It was obvious in 1999 when the first consultative paper on Basel 2 came out that using ratings as the basic risk assessment tool for regulatory purposes was a mistake. Belatedly it seems that the supervisors have realised their error. From the FT:
US regulators on Wednesday raised concerns about their own reliance on the credit ratings that are hardwired into the global financial system as they revealed new proposals aimed at addressing conflicts of interest in the industry.
Christopher Cox, chairman of the Securities and Exchange Commission, said the agency would soon consider whether to reform many of its rules “that make explicit reference to credit ratings”.
The problem is if they don’t trust firms own internal assessments what will they use instead? Credit spreads? That would be even more procyclical. I wonder if it is time for a bring back 8% of notional campaign.
S&P lowered Ambac and MBIA to AA today. They are under review from Moody’s. Fitch, only six months late rather than the year or so of the other two agencies, downgraded them in January. Bill Ackman made another big pot of money. And there’s a nice opportunity opening in zombie monoline runoff…
Merrill and Lehman were downgraded to single A yesterday: Morgan Stanley is at A+ according to Bloomberg. If only one of them was being downgraded, the news would be catastrophic. As it is, is the new standard for a derivatives counterparty becoming single A? And if not, how will the broker/dealers derivatives business survive?
On Monday I said:
The combination of leverage and complexity is a massive concentrator of model risk
By Wednesday we find in the FT:
Moody’s awarded incorrect triple-A ratings to billions of dollars worth of a type of complex debt product due to a bug in its computer models…after a computer coding error was corrected, their ratings should have been up to four notches lower.
The product was CPDOs. But that doesn’t matter. This kind of thing will happen with leverage and complexity. A bug in the ratings model for French yoghurt companies might change the rating of Danone by one notch. But for structured stuff, it’s likely to be a much bigger error.
…to Japan some years ago and now might just possibly be on the cards for the U.S.? Losing their triple A. The WSJ reports:
The performance of government-sponsored enterprises like Fannie Mae and Freddie Mac could have a direct impact on the national economy and, more importantly, U.S. credit standing.
So-called GSEs enjoy implicit government guarantees and could cause the U.S. to lose its sterling triple-A rating if the government were forced to come to their rescue, Standard & Poor’s said in a report Monday.
Add the FHLBs into that mix, and you do have a combustible mixture.
Update. FT alphaville has the picture opposite to show the importance of the GSEs portfolios to the banking system.
Just look at how that river of mauve is widening across the page. Meanwhile the WSJ estimates the cost of bailing out Fannie and Freddie at 10% of GDP.