Saturday, June 30, 2007

Weekend Special: Who Watches the Watchers?

Lost in the noise and administrative drudgery of quarter end was a remarkable article from Bloomberg that winged its way across the information superhighway yesterday:

S&P, Moody's Mask $200 Billion of Subprime Bond Risk

Among the choice quotes from the article include the following:

``We're taking action as we see it,'' said Brian Clarkson, Moody's global head of the structured products in New York. ``We're not doing knee-jerk responses.'' Hmm. Perhaps they didn't see that subprime foreclosures rose from 3.86% in Q3 of last year to 5.1% in Q1 of 2007.

Fitch is ``deliberate'' in its actions, John Bonfiglio, the firm's head of U.S. structured finance ratings, said in an interview in his New York office. Fitch is a unit of Paris-based Fimalac AS. ``I would not say we were slow.'' Deliberate? You mean deliberately trying to screw investors who rely on your ratings, John? I also wouldn't say that you're slow. "Glacial" is perhaps a more accurate representation of your response time.

S&P abandoned seven-year-old criteria for determining a bond's protection against default in February.

Under the old guidelines, S&P said a bond's ``credit support'' must be twice the rolling 90-day average of the sum of value of mortgages delinquent by three months or in foreclosure plus real estate that has been seized by the lender.

Of the 300 bonds in ABX indexes, the benchmarks for the subprime mortgage debt market, 190 fail to meet the credit support standard, according to data released in May by trustees responsible for funneling interest payments to debt investors.

Most of those, representing about $200 billion, are rated below AAA. Some contain so many defaulted loans that the credit support is outweighed by potential losses. Fifty of the 60 A rated bonds fail the criteria, as do 22 of the 60 AA rated bonds and three of the 60 AAA bonds.

All but five of 120 securities in BBB or BBB- rated portions of the mortgage-backed securities would have failed S&P's criteria, according to data compiled by Bloomberg.

None have been downgraded, though S&P and Moody's have parts of three pools of securities linked to the index under review for a downgrade. Fitch has downgraded parts of three mortgage pools tied to the ABX and put four on watch for downgrade.

``Don't misunderstand me: I'm not saying these others are performing great,'' Robert Pollsen, a director in S&P's residential mortgage surveillance in New York, said in an interview last month. ``And they certainly might warrant our attention several months from now, which obviously we're going to do.''

What can I say? To abandon a credit-standard test just as it starts to bite is the height of irresponsibility. And the comments from Mr. Pollsen are so lame, they need a cane.

It really seems to have come to the point where we need to ask "Who watches the watchers?" It seems relatively clear that the ratings agencies do not have the best interests of investors at heart in their ratings activities.

Macro Man would therefore suggest that we create a new ratings agency to rate the existing ratings agencies. Investors can use the new agency's ratings to gauge the accuracy of the CDO ratings of Fitch, Moody's, and S&P.

After careful consultation with a battery of analysts, Macro Man has derived the following ratings agency ratings via a proprietary quantitative methodology, blah blah blah. To clarify the ratings, they will be assigned in the familiar school-grade format, with a C or better required to pass:

Fitch: C- At least they've actually downgraded something.
Moody's: D- Very, very poor.
S&P: F- Abandoning the credit support criterion is just poor. If S&P were a student, it would get left behind to repeat the seventh grade.

As an aside, is anyone else struck by the following coincidence:

The US has $200 billion worth of overvalued CDO junk.

Voldemort has $200 billion to invest in "risky assets".

Are you thinking what I'm thinking?



5 comments:

Banker said...

This becomes a bit more concerning everyday. Stocks try to rally but seem to close at the lower end of the range, and this sub prime mess doesnt look like it will end anytime soon. For a "Yield Monkey" like myself, It makes me stop and think.

dryfly said...

This becomes a bit more concerning everyday.

Hello banker - It is getting interesting anyway.

I like MM's 'suggestion'... $200B Chinese reserves targeted toward risky assets & $200B risky assets in USD denominated CDO. A marriage made in heaven... now will it happen in time to 'save Christmas' that's what I want to know?

David said...

The ratings agencies have it tough. They have two sets of clients that want different things -- some want ratings to shift frequently in order to respond to market conditions, while others want long-term ratings that reflect only structural shifts in the creditworthiness of the securities.

All that said, the ratings agencies are so conflicted that if it weren't for investment policy guidelines, and regulators relying on them (the insurance industry, for example) their business prospects would be much reduced. Remember, they survived their last crisis 2001-2003, and MCO and MHP's stock prices are decidedly higher. They will probably survive this as well. Caveat emptor.

David Merkel
Alephblog.com

Macro Man said...

I suppose the crux of the issue is that the agencies have de facto oversight of credit markets without the de jure responsibility to execute that oversight in an impartial and responsible manner.

History suggests that you're right about the future of the agencies, but as I mentioned on Brad Setser's blog I wouldn't be completely surprised if some enterprising politico goes after them if structured credit markets suffer a dislocation and pension funds lose money as a result.

eric said...

Moralizing about the rating agencies reminds me of Captain Renault being "shocked; shocked to find that gambling is going on here."

The institutional market's giant agency problem requires a "cya" assurance function in order to operate and the rating agencies are simply serving that market. They moved away from the role of serving the public (under who's authority they appreciate their very profitable oligopoly power) to serve their shareholders and primary clients, the issuers, long ago.

In this, they share about as much defacto oversight of their markets as, say, Fannie and Freddie do. Which is to say not much. They are just as caught up in it as anyone.

However that hardly makes institutional buyers innocent victims of rating agency mal-practice. Appetite for paper of all risk levels has exploded over the last decade as the macro playing field and industry incentives are skewed towards promoting and prolonging the credit bubble. This is just an aspect of the game everyone is playing.

Should the reluctant but inevitable downgrades result in a large enough amount of pension fund assets running afoul of investment guidelines and becoming unmarketable at the same time, I suspect legislation will change investment policy guidelines to allow holding the junk (with government backstops of course)until inflation and the next financial growth industry, CDO workouts, have worked through the problem.

Of equal concern but less likely to benefit from public sponsorship of a bailout are the levered players, in particular the investment banks, whose reliance on "model based" valuations - for themselves and the clients they have extended leverage to - exposes the financial system to that systemic risk we all keep hearing about.

An individual player's rational action in the environment it faces - say with Merrill just following market practice by loaning money to the Bear Stearns sub-prime funds based on a purchased agency investment grade rating of the assets that uses sparse historical data and weak diversification arguments, and then trying to be the first counterparty to liquidate collateral to get their cash back when the funds suffer a loss - can snowball into disastrous consequences when repeated across players and across markets. I think it's safe to say the market is starting to appreciate this possibility more fully.

In light of Warren Buffett's repeated warnings about a looming derivatives disaster with global consequences, it is ironic that the rational competitive actions of Moody's, one of his own holdings, have aided and abetted the kind of unchecked expansion in derivatives leverage and risk taking that he is so concerned with. It just shows how tough these big picture issues are to manage.