Thursday, January 01, 2009

More autopsy results...

I had to read some paragraphs several times, but if you want to get some handle on the role ratings agencies like Moody's played in the financial meltdown, this article is a good start.
The agencies got so much more wrong than that (for example, they didn’t rate the quality of servicers or originators of loans, which you would think would be important in assessing the credit quality of the mortgages in a securitization). But the thing they got most wrong was ignoring the quality of their own data set. The sub-prime mortgage market was still young when the agencies began rating securitizations dominated by such mortgages. And the structured finance market was in its infancy when the agencies began rating CDOs backed by asset-backed securities backed in turn by sub-prime mortgages. There is simply no way that the agencies had an adequate data set to justify rating these deals at all. And I can best illustrate the agencies’ disregard for the quality of their data sets by reference to a product unrelated to mortgages: the constant-proportion debt obligation, or CPDO.
This obscure little product was launched in late 2006 to great fanfare. And it was, indeed, an ingenious little fraud of a product. Here’s how it worked.
Some clever structurer noticed that, historically, investment-grade companies don’t default very often. Rather, they deteriorate for a while first, get downgraded to junk status, and eventually they default. That’s why the short-term ratings for relatively low-rated investment-grade companies may be reasonably high: even BBB companies are generally good for the next 90 days; if they weren’t, they wouldn’t be rated BBB. And this suggested the possibility of a trading strategy.
What if you bought a portfolio of investment-grade corporate debt and, every six months, purged it of the bonds that were downgraded to junk, replacing these with new investment-grade bonds. Obviously, you’d expect the downgraded bonds to underperform the remainder of the pool, so you’d have losses you need to make up, so assume you also sell out of a handful of bonds that have done well, and replace these with higher-yielding bonds that are still investment-grade, thus keeping your yield relatively constant. You’d still expect some losses if you wanted to keep your average rating relatively constant, though. So you need some excess yield to make up for these losses.
You find that yield by leveraging the portfolio. After all, it’s an investment-grade portfolio, very unlikely to default in the short term. You can borrow very cheaply short-term, invest in longer-term bonds, and earn the spread differential. If the bonds go against you, that’s OK, because you’re going to hold them to maturity and you’ll always be able to roll your short-term borrowing. And, if you can get a high enough degree of leverage, the excess in current yield from the differential between where you borrow and the yield on your portfolio should more than pay for the cost of rolling out of your losers every six months. And if you do that successfully, you’ve got a trading strategy that never loses principal, but has a surprisingly high expected yield. Sound good?
Well, it sounded great to the ratings agencies, who blessed this strategy by giving it a AAA rating.
Leading to this conclusion at the end:
This collapse of confidence is having a material impact on the ability of the credit markets to find their footing. I don’t want to minimize the impact of other factors – rates held too low for too long, Wall Street greed, an Administration with an ideological aversion to regulation – but I want to emphasize this one because of its unique contribution to this particular bubble and because I don’t see an obvious solution to it. The old model is permanently broken, and we have not yet come up with an alternative. Right now, we’re in the low-trust environment that is the reality when the libertarian fantasy of eliminating the market-distorting regulators actually comes to pass. The market is inevitably focused on a short time horizon, fickle and volatile by its very nature. We want major financial institutions – banks, insurers, etc. – to look beyond the market to longer term risk metrics. Without the agencies as an independent arbiter of what these might be, the market is all we have left. Trust is a very hard thing to rebuild, and structural changes – having the agencies be government-sponsored, or paid by investors rather than issuers – are insufficient solutions (government-sponsored entities are also capable of seeking to monetize their position – look at Fannie Mae – and investor-sponsored agencies would be subject to the same pressures to facilitate the business that investors want to do).
Note the comment about rebuilding trust.  I'll post about how hard that might prove to be later.

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