Wednesday, July 11, 2007

A Ratings Agency Toolkit

As many readers will no doubt be aware, there's been a bit of market volatility over the past twenty four hours. The dollar is weaker, equities are lower, credit is wider, and govvys are bid. While these developments had been percolating for a few days, they received fresh impetus yesterday on the new that Moody's has downgraded a small pile of subprime rubbish and that S&P has put another, slightly larger pile of subprime garbage in the queue to be downgraded.

This, combined with heavy private and public sector activity yesterday, helped propel EUR/USD to new all-time highs and taken the DXY within a whisker of 15 year lows. When Big Ben failed to offer out a rate cut lifeline in yesterday's speech, US equities extended the early-session losses to finish sharply lower. This morning, credit has continued its recent rout, with the European crossover index briefly touching a spread of 300, a significant widening from the 197 level posted just 3 weeks ago.

Unsurprisingly, Macro Man's FX carry filter flashed red this morning, and he jettisoned the basket on the opening. While many of the carry crosses have actually come back so far today (the dip-buyers cannot be crushed so easily!) , one would have to believe that another day or two like yesterday could finally generate the dip that you don't want to buy. Insofar as ratings agency action may force liquidation from funds constrained by investment guidelines, yesterday's downgrade action does represent a new factor in the risky asset equation.

Macro Man has been around long enough that he has developed a network of contacts throughout the financial industry. One of his moles in the ratings agencies was kind enough to pass along his firm's "Subprime Analyst Toolkit" in response to Macro Man's query on their rating methodology.

Macro Man was actually quite impressed by the three-pronged approach taken by the agencies, as well as the degree of sophistication embedded in the technology. Fortunately, he received permission to share the contents of the toolkit with his readers:

The most important piece of technology is the pillow. This part of the toolkit is the most actively used by analysts, as they tend to spend most of their time asleep. Some agencies apparently prefer violins (allowing the analysts to fiddle while the market burns), but a pillow is clearly state-of-the-art technology and is now industry standard.


Of course, analysts cannot spend all of their time asleep. At some point, they need to wake up and actually study the merits of various subprime issues and credit structures. Fortunately, they are provided with this alarm clock that rouses them from their slumber. The alarm has a built-in link to credit speads and ABX indices, and triggers when the market has almost fully discounted agency ratings downgrades. For the comfort and convenience of the analysts, the alarm clock is equipped with a handy 'Snooz' button that allows them to catch an extra few weeks of sleep should they so desire.

Once the analysts are finally awake, however, they still must perform an evaluation of the merits of the various securities and structures within their bailiwick. Fortunately, the agencies equip their analysts with a rearview mirror so that they can see for themselves what has already passed and act accordingly. The rearview mirrors got a particularly heavy workout in late 2001 and 2002, for example, with the debt of firms like Enron and Worldcom.
So there you go! For those readers looking to enter the exciting and renumerative world of credit analysis, your chances of getting hired by the major agencies are apparently enhanced if you show up for your interview with the above listed items.
Good Luck!


Quarrel said...

Yes, sadly for us the ratings world is renumerative.

Of course if they were remunerative they could keep their good talent from their 'clients' it wouldn't be nearly so much fun.

Fun post. While the pillow and clock are well-timed digs, I worry that they'd be proud of the rear vision mirror.


Macro Man said...

Sadly, what most of us would call 'inertia' or 'ineptitude', they evidently label as 'prudence.'

tmcgee said...

nice photos. i'm getting jealous. but the question still is: is this news? that subprime mortgages are crap? should markets be reacting to the rearview mirror? are that many investors waiting for the rating agencies to tell them to sell? obviously i'm more full of questions than answers, but i am just back from the sun and surf.

Macro Man said...

I don't think it's news that subprime is crap. The great unknown, however, is what happens when a spade is correctly identified as a spade in hedge and pension fund portfolios. Certainly the latter could be forced sellers because of investment guidelines, and the market has been a-chattering about margin calls and reduced credit lines to the former once their portfolios were properly valued.

It seems to me that markets are wobbly in anticipation of a potential stress test, though whether that stress test actually materializes remains unknown. As for the dollar...see my new post.

Charles Butler said...

It's hard to know the immediate outcome of the mess (witness the hyperventilating euro stock markets today), but in the longer term the coming baby boom retirement disaster gets one step further from solution without recourse to very regressive politics.

Ryan said...

Whose P/L sheet is that?

Macro Man said...

Ryan, it's mine. Part of this blog is a portfolio of trades whose performance is posted every day that both I and my systems are working. At the beginning of every month I do a post-mortem of the prior month's performance. Note also the disclaimer attached to my profile...

Anonymous said...

Sounds like a "Mission Impossible" marketing kit to wannabe "rookie" analysts -- or shall I say "can't touch that". BTW MM, "thumb up" for great web infomercial.

Hat tip!
Asian Man

Ryan said...

Wow. Very impressive. Not a minus sign anywhere. What does "touch" mean? For example, in this text: "5,000,000 GBP/USD 1.70 touch, 2017". And what does the "2017" mean? You're not planning on keeping this trade open for ten more years?

Congrats on your record.