Wednesday, December 15, 2010

More on Ratings Agencies and Consultants - What a bunch of quants!

More on one of our pet themes. After Moody's fun with the US yesterday they have turned their attention to Spain now. If the ratings agencies don’t state anything new but only officially "time stamp" what we know already on the risk curve, why do markets insist on step change moves in response to their announcements? Are there really investors so comatose that they don’t react until a ratings agency announcement tasers them out of their torpor? Yes, apparently there are and people even pay fees to these people to manage their money. How do they justify these fees? Well, dear investor, it's called Benchmarks and, to paraphrase the Sex Pistols (and to nick a chapter heading from from a friends book), "Never mind the benchmarks". Because benchmarks are indeed bollox.

It's all part of the cycle of unintended consequences. The investor tries to protect himself from risk by insisting that his money only be put in "safe" investments, but who decides whether they are safe or not? Enter the ratings agencies who then carve up a normal curve of risk into thick histogram buckets with Hoover Dam-like edges. The difference in real risk between a top BBB+ rated bond and a single A- may be non-existent in reality. But to the benchmark-driven, ratings agency-dependent passive bond fund, investment dicta handed down from a board of fund trustees made up of laymen advised by "consultants", it can make a difference on the order of 1000bp of performance (just look at where the crossover indices got to in 2008). Does that reflect TRUE risk? No, it reflects a self-inflicted market distortion, which just adds risk to the very portfolios that introduce these rules to try and reduce it.

What is more, as the rest of the investor community can see the ratings agency changes coming a mile off, it means that any portfolio changes based on their actions hit a market that has already discounted them, undermining performance even further. But the really magic trick is that it doesn’t matter because performance is measured against a benchmark of similar passive funds that have to follow the same rules! And as a benchmark reflects the average, then on average, they are average. Collect the fees and shrug.

That is the case for passive managers. But there are examples of active investors doing their proper bottom up research on assets, discovering that they are hugely undervalued despite the risk of downgrade, but can't take the risk of buying them, because in the event of a downgrade the contract they have with the client (usually advised by a top consultant) makes them a forced seller into the "mark-to-market" price freefall. To make things worse this is the moment the supposed risk-taking "Market Maker" suddenly backs off, becoming an "agency broker" on commission! Or in the case of a bank, the regulator forces them to increase the amount of "risk-weighted capital" held against the asset following the downgrade, making the original investment case untenable. What is more, the derivatives of ratings agency-dependent products have their margins and haircuts set against the same ratings, creating a horrible negative feedback loop in response once a downgrade occurs.

This is exactly what happened with the ABS/MBS market and in particular the genuinely high-quality end of the US MBS market, where ratings agencies changed their methodology on rating bonds for the potential of default. Despite the fact that an MBS might only suffer a projected default over its life of 1 dollar, the security was rated sub investment grade, destroying the investment thesis of even a good researcher and closing a massive investment opportunity to bond fund managers and the back books of banks alike.

The fundamental problem is there is a total disconnect between the "risk taker" and the "risk controller". In this case the "risk taker", the real name for whom in the modern market is "investment manager" and the risk controller, i.e. the legal rules and compliance depts set up to control the dangerous risk taker (because as we all know taking any kind of risk is far too dangerous for the masses) and "protect" the capital of the end investor. The good investment manager does the research, finds the asset, works out the fair value, compares this to the market price and, if the market price is cheap to fair value, should be able to buy as much as possible within his level of prudence and conviction. But then in steps the risk controller who has no more information than an arbitrary set of rules thereby emasculating the investment manager and guaranteeing that the investor's capital is put at higher risk than it needs be.

This is all the more pertinent because we are only a gnat's crotch away from some regulating do-gooder kicking the plug from the comatose UK public sector pension's life support system. It has been noted that the deficit has doubled in the last 3 years to £100bln and we know what happens next by looking back at what Myners did to the UK Pension funds in 2001/2. Scream outrage at the losses occurring, look at where the funds were invested and regulate that they are no longer allowed to invest there at the absolute bottom of that market. So with the "consultant" on the radio today complaining that 70% of these UK local funds' money is in equities, you can be pretty sure the next move will be to tell them they have to go into bonds. RIP.


Charles Butler said...

As usual for the last while, that high pitched jingling sound you hear behind the Moody's roar emanating from the press monolith accompanies the handing off of soon-to-be-tired positions. ES 10's and 5's up 10 and back to square one in five hours.

That pink blog mocked her this morning, but the wise might take to heart Ms. Salgado's most recent comments. Hard to win at blackjack if you can't remember the cards that were dealt.

Leftback said...

Apparently the fun is not yet over in US fixed income for 2010, as the steepener continues to grind despite today's sizzling 0.1% CPI number.

2s10s is 282 bps. [300 bps is the limit].
10s30s is 111 bps. [125 bps is the limit?].

The long end is starting to scream BUY ME. Am I the only one expecting another soft patch in US retail and industrial production? When reality returns in January do we see a resumption of the Bull Flattener?

Anonymous said...

What would be the solution for replacing rating agencies?

It seems like they have done a lot of damage in marking things up AAA when they shouldnt have and as your post suggests are doing the same on the way down.

Anonymous said...

@ anonymous 5:47

How about due diligence and some personal accountability/staked reputation on fund managers?

Nemo Incognito said...

LB, I am part of the treasuries hate squad but I recently bought some 30 years and covered the 10 yr short. This is getting completely effing insane. You had to be smoking crack to buy over 130 but south of 120 you better be damn sure we're going to fiscal apocalypse next year. Keeping the JGB short though - aging = pension withdrawrals = no one to roll your turds as maturities come due. Can't say we are quite there yet in the US, though with the current political environment it might take a 105 print on USA to get those guys' attention.

Leftback said...


We are the new Japan. Our yields will grind lower in a series of zig-zag steps, as US savings rates increase, and Us housing continues to drift down or sideways, until we reach a state something like the present JGB yield curve.

The periodic reversions in the bond market will become an annual rite, as a bearded man appears to announce the pagan festival of Quantitative Easing, triggering an outbreak of self-flagellation by bond investors as they seek risky assets in anticipation of The Great Inflation, that somehow never actually materializes.

Markets take the stairs up, and the elevator down.

Charles Butler said...

Yes, but if were only to release our inner Alvin Tofflers... Concentrate.

FX said...

Well,I know which team this year caught the short end of the crissy pom poms.....

Merry Christmas, PoLIMEC , the stayers and EVERYONE out there.

mr potato said...

yeap… the world of finance is a long string of uninteded consequences arising from "prudent" accounting and "prudent" behaviour. my all time favourite is implied 15y forward start 15y maturity usd libor vs aud fix, as it was back at the end of 2008. you could receive 90bp aud and receive usd libor as well (don't know if you could call it a "swap" any more), and pv implied by curves was zero. stayed like that for about 3 months too, for everybody to see. guess markets are extremely efficient, but only at showing accounting profit before the next bonus payment date. very probable gains beyond that date suddenly get discounted at 90% or so, to account for the probability of the trader being fired by then.

I am not sure it's the disconnection between the risk controller and investment manager that is doing the most harm. my guess is that it's more to do with the reward system based on simplistic accounting, which has several unintended consequences, one of which is making almost everybody a short term investor. with such incentives, no wonder banks have found the path of least resistance to accounting profit in the form of complex long dated derivatives. it would never have been possible to show all that dodgy profit in the first place without the zeal of the supporters of "mark to market" accounting, precisely the people who want the world to be a better place, but don't quite get what is really happening.

I'll receive some long end US, and a bit of PA as well in the futures.