20%

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

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.

It's your day, Bill

'Twas the day of the election, and there was much celebration. No one stirred in the farmhouse before noon on the following day, and the word went round that from somewhere or other the agencies had acquired the money to buy themselves another case of courage. So Moody's cut Ambac to junk. They weren't too late really. If you count in geological time.

Holding The Wrong-doers to Account

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.

Keys not judgements

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.

And now you die...

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.

Five into ten does not go

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.

When do Fannie and Freddie consolidate?

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.

Picture of the day: migration of AAA ABS CDO ratings

From FT alphaville:

TGIF...

... 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.

Management acts while pools go fetid: ratings and dynamics of loss distributions

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

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.

Bill Ackman I salute you

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...

Can a derivatives business survive a single A rating?

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?

About that model risk

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.

What embarrassment happened...

...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 this picture 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.

Fitch got there in the end

From Bloomberg:

Fitch Ratings cut MBIA Inc.'s insurance unit to AA from AAA, saying the bond insurer no longer has enough capital to warrant the top ranking.

MBIA, the world's largest financial guarantor, would need as much as $3.8 billion more in capital to deserve an AAA, New York-based Fitch said today in a report. The outlook is negative, Fitch said.

Fitch issued the new, lower rating even though Armonk, New York-based MBIA asked the ratings company last month to stop assessing its credit worthiness.

My guess would be that Moody's and S&P won't crack under this news despite the evident fillip to Fitch's reputation. Which is a shame.

Top rated fiction

What does AAA mean? Almost nothing it seems. Hot on the heals of the agencies' failure to downgrade MBIA and Ambac there is a lovely interactive graph from Bloomberg showing the collateral support for the AAA bonds in the ABX: Bloomberg concludes only 6 of the 80 deserve the rating.

Barney Frank has noticed that the disconnection of ratings from default probability is an issue for municipalities, who have been given a rating far below their PD, then charged for insuring their debt on that basis. And he wants to see some changes. According to Bloomberg:

Barney Frank gave ratings companies a month to fix ``ridiculous'' standards that they apply to local government debt, as his House committee opened a hearing today on how the firms evaluate municipal bonds.

``I am going to say to the rating agencies and to the insurers: they have about a month to fix this,'' Frank, the Massachusetts Democrat who chairs the House Financial Services Committee, told reporters in Washington yesterday. ``We're going to tell them they have to straighten it out.''

I think I like this guy...

Let's look at the prospects for the monolines then. Barney is going to ensure the good quality states and other munis are rated AAA. A lot of muni insurance business goes away because of that. Buffett will eat much of the rest. And the structured finance market has disappeared too. Hmmm, business model, what business model?

What worked, what didn't

The Senior Supervisors Group recent document, Observations on Risk Management Practices during the Recent Market Turbulence is a more interesting read than the Financial Stability Forum interim report not least because it compares leading firms who have come through recent events relatively unscathed with those that suffered some of the largest impacts.

Some of the highlight follow, with my emphasis. First the SSG identifies four firm-wide risk management practices that differentiated performance:

Through robust dialogue among members of the senior management team (including the chief executive officer, the chief risk officer, and others at that level), business line risk owners, and control functions, firms that performed well through year-end 2007 generally shared quantitative and qualitative [risk] information more effectively across the organization.

This is pure risk culture. Firms which keep risk data to the high priesthood of risk management and a few senior business leaders are not using as much of the brainpower of their organisation as they could. Further, this kind of culture tends to go with authoritarian, vertical management styles which makes it much harder to discuss issues openly and honestly.

At firms that performed better in late 2007, management had established, before the turmoil began, rigorous internal processes requiring critical judgment and discipline in the valuation of holdings of complex or potentially illiquid securities. These firms were skeptical of rating agencies’ assessments of complex structured credit securities and consequently had developed in-house expertise to conduct independent assessments of the credit quality of assets underlying the complex securities to help value their exposures appropriately. Finally, when they reached decisions on values, they sought to use those values consistently across the firm, including for their own and their counterparties’ positions. Subsequent to the onset of the turmoil, these firms were also more likely to test their valuation estimates by selling a small percentage of relevant assets to observe a price or by looking for other clues, such as disputes over the value of collateral, to assess the accuracy of their valuations of the same or similar assets.

Clearly anyone trading complex securities should have independent expertise to value them. Equally clearly once they have been valued, that value should be used consistenly throughout the firm. What's shocking here is that some leading firms - this survey comprises eleven of the largest banks - did not have these basic control processes in place.

Those firms that avoided more significant problems through our year-end review period aligned treasury functions more closely with risk management processes, incorporating information from all businesses in global liquidity planning, including actual and contingent liquidity risk. These firms had created internal pricing mechanisms that provided incentives for individual business lines to control activities that might otherwise lead to significant balance sheet growth or unexpected reductions in capital. In particular, these firms had charged business lines appropriately for building contingent liquidity exposures to reflect the cost of obtaining liquidity in a more difficult market environment.

It so often comes down to incentive structures doesn't it? If you charge businesses for actual and contingent liquidity, including writing liquidity lines to conduits, then they will make sure the firm is paid enough for these structures. If you don't, they will be pretty much given away.

Firms that tended to avoid significant challenges through year-end 2007 typically had management information systems that assess risk positions using a number of tools that draw on differing underlying assumptions. Generally, management at the better performing firms had more adaptive (rather than static) risk measurement processes and systems that could rapidly alter underlying assumptions in risk measures to reflect current circumstances. They could quickly vary assumptions regarding characteristics such as asset correlations in risk measures and could customize forward-looking scenario analyses to incorporate management’s best sense of changing market conditions. Most importantly, managers at better performing firms relied on a wide range of measures of risk, sometimes including notional amounts of gross and net positions as well as profit and loss reporting, to gather more information and different perspectives on the same exposures. Moreover, they effectively balanced the use of quantitative rigor with qualitative assessments.

This is very interesting. If you have different tools with different assumptions, you have a reasonable handle on model risk. If you have one system, or multiple systems which all use the same assumptions, then you don't. Flexible systems are clearly important, but perhaps even more significant is the mindset of looking at risk in different ways, and being sceptical about the results of any one analysis.

The report then goes on to look at three business lines where varying practices produced different outcomes. The first, unsurprisingly, is CDO structuring, warehousing, and trading businesses. Here the key issue was whether

Internal incentives were missing or inadequately calibrated to the true risk of the exposures to the super-senior tranches of CDOs.

To be fair, I doubt anyone really got this right. What may have happened, though, is that positions that were originally acquired with the intention of selling them on became prop positions when they couldn't be sold at the mark rather than being written down until they did sell.

Next, syndication of leveraged financing loans:

Some firms worked aggressively to defend or expand market share in the syndication of leveraged financing loans, and many of those that later faced challenges in this business did not properly account for the price risk inherent in the syndicated leveraged lending pipelines.

Buying business is fine. But if you are going to pay for league table position, then at least know how much you paid for it.

Finally in conduit and SIV business we find:

Several firms did not properly recognize or control for the contingent liquidity risk in their conduit businesses or recognize the reputational risks associated with the SIV business.

For me the interesting part here is the reputational incentive. All the accounting and regulatory arguments that got these assets off balance sheet depending on the risk really passing to SIV and conduit investors. Firms that recognised that their reputational risk tolerance meant that this risk really had not been transferred clearly did better than those that pretended that the accounting and regulation followed the reality.

S&P confirms FANT.W at AAA

Yes, S&P's fantasy world where the bond insurers are AAA is developing nicely. Bloomberg reports:

MBIA Inc., battling to stave off the crippling loss of its AAA credit rating, soared in New York Stock Exchange trading after Standard & Poor's said no downgrade of the bond insurer is imminent.

The insurer remains on negative outlook, meaning that any ratings move may be lower, though not any time soon, New York- based S&P said today in a statement. Ambac Financial Group Inc., which ranks second to MBIA among bond insurers, is still being reviewed for a possible downgrade pending the company's ability to raise new capital, S&P said.

This must be so frustrating for Bill Ackman. He's basically right, but the world keeps on being irrational. And this, of course, takes the pressure off Moody's to do anything about MBIA either.