Percentage of CDOs registering events of default, by presence of agency rating

TO BE NOTED: From Alphaville:

"Switch to Fitch? Posted by Sam Jones on Mar 27 15:08.

Percentage of CDOs registering events of default, by presence of agency rating:

(Chart reproduced with kind permission from a paper by Anna Katherine Barnett-Hart, Harvard)

This entry was posted by Sam Jones on Friday, March 27th, 2009 at 15:08 and is filed under Capital markets. Tagged with CDO, fitch, Moodys, Rating agencies, s&p."

And from a comment:

"Financial Times
20-May-2008
By Sam Jones, Gillian Tett and Paul J Davies

When the craze for CPDOs erupted in financial markets in late 2006, some observers quipped that these new products were like something out of a sci-fi blockbuster.

Not only was the ingracious acronym amusingly close to C3PO, one of the hapless robots from the Star Wars movies, but also like the heroes of Star Trek the products seemed "to boldly go" where no credit product had gone before.

In a time of ever shrinking returns from investments in credit at the height of a raging bull market, early versions of these highly structured and complex deals promised to pay 200 basis points - that is 2 percentage points - over Libor, or the "risk-free" rate at which banks lend to each other. And that spread came with the top-notch triple A ratings that indicate an incredibly low probability that investors could lose their money.

To put this spread in context, triple A rated European prime mortgage backed bonds at the time typically paid less than 20bps, more than 10-times smaller than the CPDO - constant proportion debt obligation - coupon, for example.

However, the triple A ratings that Moody's awarded to some early deals were based on a model that contained an error in its computer coding and these ratings should have been up to four notches lower, according to internal documents seen by the Financial Times. Billions of dollars could have been affected.

The very first deals from ABN (NYSE: ABN - News) Amro in August 2006, which were rated triple A by Standard & Poor's alone, provoked huge excitement among bankers, investors, traders in the underlying credit markets and of course the media. Moody's followed up with its first rating of an ABN Amro CPDO in late September 2006.

By December, a range of banks had copied the deal and this new kind of product had been credited by some with adding new impetus to the rally in corporate credit - a rally which meant that a number of the follow-up products could not pay the same high returns promised by the original deals.

Plenty of people thought these products sounded too good to be true.

"Once again, the rating agencies have proved that when it comes to some structured credit products, a rating is meaningless," Janet Tavakoli, an independent consultant, told the FT in November 2006. "All AAAs are not created equal, and this is a prime example."

Nonetheless, some of the first deals performed very well before the credit crunch struck and investors had already unwound them early and taken profits.

The volatility of the values and ratings of CPDOs come from the high level of leverage they applied to their bets on the performance of credit markets (See separate story for explanation of deals).

Analysts at CreditSights, an independent research house, wrote in November 2006: "The strategy is very simple and surprisingly robust when modelled. However, though we cannot pinpoint exactly where the flaw in the rating methdology is, there are a number of things that give us grounds for unease."

Beyond S&P and Moody's, no other agency ever got comfortable with a triple A rating for CPDO structures.

Fitch Ratings and DBRS, neither of which had been engaged to rate a deal, both released studies in April 2007 saying that CPDOs did not deserve triple A ratings.

"We think the first generation of CPDO transactions are over-rated," John Schiavetta, head of global structured credit at Derivative Fitch in New York, told the FT in April 2007.

"We think the structure is inherently sound and investment grade, but just not double A or triple A."

The fact that there were problems at one of only two agencies involved in rating such deals is significant. Some investors who would be in the target audience for such a highly rated product have investment mandates that require ratings from two different agencies.

Regarding their own rating, S&P said: "Our model for rating CPDOs was developed independently and, like our other ratings models, was made widely available to the market.

"We continue to closely monitor the performance of these securities in light of the extreme volatility in CDS prices and may make further adjustments to our assumptions and rating opinions if we think that is appropriate."

Also, rating agencies and their approaches to categorising and monitoring complicated structured debt of all kinds have come under intense scrutiny since the credit crunch hit.

While the credit crunch has been centred around mortgages and related products, the whole question of what a triple A rating means when applied to very different products, with very different performance characteristics has been under the spotlight.

This question over triple A ratings is especially true for highly structured credit products. "Unlike with regular corporate bonds, structured bonds are made by their rating.

"They don't exist until they're rated and they can't be sold without it ... a rating gives birth to a structured bond," says Joshua Rosner a professor of structured finance at Drexel university, and chief executive of consultants Graham Fisher.

In the case of the CPDO, the birth was a long one. It took many months for ABN to perfect a structure and methodology that would pay a high return and receive a triple A rating.

The development of the product inevitably involved many discussions with ratings agencies, although ABN and the agencies have both consistently said that such exchanges never amounted to a negotiation over the rating the product would acheive.

The mix of high rating and high return encouraged many banks to try and repeat the feat quickly.

Lehman Brothers (NYSE: LEH - News) , Merrill Lynch and Dresdner Kleinwort launched their own versions of the CPDO within months of the first ABN deals.

JP Morgan, UBS, HSBC, Bear Stearns, Barclays, Société Générale and others followed.

The huge demand from all these banks to get their own deals to market put the ratings agencies under intense pressure.

At a conference for clients in November, Moody's executives explained to frustrated delegates that the analysts were "overwhelmed" with the volume of work.

"We are working day and night to rate CPDOs," said Paul Mazataud, a managing director in Moody's European structured finance division.

By the end of 2007, agencies were inundated with proposals for myriad variations on the CPDO structure, which included using a specialist asset manager instead of relying on the constantly updated indices, and basing the deals on different asset types, such as derivatives of mortgage backed bonds, for example.

Both S&P and Moody's called a halt to rating new deals as they assessed the impact of different approaches to structuring CPDOs and ensured they were happy with their models.

It was during this time that the bug in Moody's model for rating CPDOs was uncovered. By February 2007, documents seen by the FT show that staff were discussing the issue and the impact on ratings of fixing the error.

It was nothing more than a mathematical typo - a small glitch in a line of computer code. The impact of the "bug" Moody's analysts discovered was, nevertheless, significant.

When the model was re-run it became clear that the CPDOs could no longer achieve triple A ratings, according to documents seen by the FT.

The results showed that early CPDOs might lose between 1.5 and 3.5 notches in the Moody's Metric, an internal measure, which equals up to four ratings notches.

Some Moody's analysts had concerns. With so many transactions from other banks in the rating pipeline, the code could not be left as it was. The bug was corrected.

At the same time, the documents record that Moody's staff looked at how they could amend the methodology to help the rating.

Some of the most senior managing directors in Moody's European structured finance division were involved in meetings to discuss the updating of the methodology for rating CPDO-like transactions in February.

The staff also looked at reducing assumptions about the future volatility of the credit markets so that Moody's model only anticipated minor moves in credit indices over the next 10 years.

This had the effect of reducing the negative impact on the ratings of correcting the code error.

When asked to explain the reasons for the changes to the methodology, Moody's would not comment directly, but said: "It would be inconsistent with Moody's analytical standards and company policies to change methodologies in an effort to mask errors."

Changes in the methodology, it was suggested, could be explained due to the fact that the agency was using daily and not monthly historical data, and so volatility assumptions would decrease.

The agency is conducting a thorough review into the matter.

Companies: ABN AMRO Holding NV ;Dresdner Kleinwort Ltd ;Lehman Brothers Holdings Inc ;Merrill Lynch Global Private Equity ;Moody's Investors Service Inc ;Standard & Poor's Corp ;ABN AMRO Holding NV ;Lehman Brothers Holdings Inc ;

Ticker Symbols: nl:AABA; us:LEH; NYSE:ABN; NYSE:LEH;

Subjects: Company News; Market News; Marketing; New Products & Services"

"Yields on speculative-grade bonds imply a U.S. default rate of 21 percent, higher than the record set during the Great Depression in 1933"

For the second day in a row, I've been sidetracked by a post. I should be working on my first novel, which is a philosophical horror roman. What do I mean by Philosophical Horror? Imagine taking the neurons of Stephen King and Albert Camus, tossing them in a bag, adding a few synapses, and shaking them. There. That's the start of a philosophical horror book.

Now, here's the story on Bloomberg:

"By Bryan Keogh

Dec. 3 (Bloomberg) -- Yields on speculative-grade bonds imply a U.S. default rate of 21 percent, higher than the record set during the Great Depression in 1933, according to John Lonski, chief economist at Moody’s Investors Service.

The extra yield investors demand to own U.S. high-yield bonds was 19.19 percentage points on Dec. 1, according to Moody’s. Assuming a 20 percent recovery rate, the spread implies a default rate of 20.9 percent, Lonski said yesterday in a market commentary. That compares with a rate of 11 percent in January 2001, 12.1 percent in June 1991 and 15.4 percent in 1933.

Defaults and bankruptcies are accelerating as financing options for high-yield companies dwindle amid the longest U.S. economic recession in at least 26 years. The U.S. default rate rose to 3.3 percent in October, according to Moody’s, which forecasts the rate to increase to 4.9 percent in December and 11.2 percent by November 2009.

“The default rate is going to start rising quickly, soon enough it’s going to be breaking above 10 percent,” Lonski said in an interview. “Lack of access to financial capital is a very big problem for high-yield bonds.”

Now, to me this is preposterous. It's driven by an irrational aversion and fear of risk, which can cause these kind's of scenario's to come true. Of course, I could be wrong about this, but it doesn't pass my smell test.

What's the smell test? I use my nose as a kind of Bayesian filter and take a good whiff of the probabilities that might arise. I don't believe that we'll have more defaults than the Depression. Next, you'll be telling me that the Sun is more likely to Supernova than Junk bonds not default.

Would I buy these bonds? Um, um, um, sure, why not? I'll take a hundred. Put it on my tab.

"The National Bureau of Economic Research, the panel that dates American business expansion, on Dec. 1 confirmed that the U.S. economy has been in a recession for 12 months, making it the longest since 1982. The economy shrank at a 0.5 percent pace in the third quarter after expanding 2.8 percent in the previous three months. Economists expect a 2.2 percent contraction in gross domestic product for the fourth quarter, the average estimate from a Bloomberg survey.

Three companies have sold $2.7 billion of high-yield bonds this quarter, compared with $30 billion in the same period a year ago, according to data compiled by Bloomberg. Leveraged loans arranged this year total $301 billion, down more than a third from last year, Bloomberg data show.

“There’s a lot of forced selling of high-yield bonds by hedge funds owing to the need to de-lever as well as by mutual funds in response to redemptions,” Lonski said. “You’re looking at a market where the sellers well outnumber the buyers and the reluctance on the part of buyers makes sense if only because a bottom for economic activity is not yet in sight.”

High-yield, high-risk bonds are rated below Baa3 by Moody’s and BBB- by Standard & Poor’s."

Okay. Deleveraging is a problem. But I still think this is overdone.

Now I'll probably have to talk about that Bayesian post that Hsu wrote.

"Now there's a clear conflict of interest: Companies paying agencies want a high rating, agencies have an incentive to give high ratings"

David Zetland on Angry Bear offers up a plan to clean up the ratings agency mess:

"I read yet another story on how the credit rating agencies (Standard and Poors, Moodys, Fitch, et al.) failed at their task of rating credit instruments (bonds, derivatives, etc.) to reflect the risk of those instruments.

The credit rating business works like this: Companies that want to issue instruments pay the agencies to rate them (AAA, BBb, etc.) for risk. The companies then sell instruments on the market to buyers who look at the rating when deciding how much to pay. The higher the rating, the higher the price that the companies will get, and the less risk the buyers think they are taking on.

Now there's a clear conflict of interest: Companies paying agencies want a high rating, agencies have an incentive to give high ratings (in exchange for bigger fees, more future business, etc.), but buyers depend on agency ratings.

Unfortunately, buyers cannot pay the agencies. They cannot pay in advance (they are not sure they will buy until AFTER ratings are done), and -- even if they did -- they would suffer from free-riding (if some buyers pay for the rating, other buyers can use that information without paying).

So, how do we fix the system (improving accuracy) while maintaining the current payment relationships? Change incentives in this way:

1. Set a standard fee for rating that depends on the type of instrument, the size of the issue, etc. Such standardization would remove one obvious problem (negotiated fees) while giving agencies an incentive to turn down business that's too complicated to understand.
2. Track the performance of all instruments rated by an agency in a given credit category (e.g., AA-) against all others in that category. Those that underperformed (price fell below the average) are probably riskier than the initial rating indicated, i.e., the agency was overoptimistic. Performance ratings should be weighted by the age of the instrument/rating, the size of the issue, etc.
3. Adjust each agency's fees to equal some fraction of the standard fee based on that agency's performance relative to other agencies, e.g., 80% if ratings are too high (missing hidden risk) or 110% if the ratings are too low (seeing non-existing risk).

Under this system, buyers could observe how accurate agencies are, and companies would have an explicit notion that they are paying for a rating of an agency that's often too optimistic/pessimistic, etc.

Note that this system depends on competition, so it's important to avoid cartels, oligopoly, etc. Even if standard prices are "set" (good place for a regulator), the competition will take place ex-post, when markets "reveal" the quality of the agencies' work.

Also note that #2 alone could do quite a lot to improve matters, but it's nice to link income to performance (#1 and #3).

Bottom Line: We need credit ratings, but we need to punish rating agencies that do a bad job, and the market is the best place for punishment."

I like the attempt. Here's my comment:

"There are two kinds of ratings being used interchangeably here(I'm fudging a bit):
1) Assessing an agreed upon and measurable product from a disinterested viewpoint, e.g., an engine
2) Assessing with more of a value judgment implied, e.g., a movie
If you read this quote from an interview of Eliot Janeway in the IRA, you'll see a transition:

http://us1.institutionalriskanal...pub/IRAMain.asp

""The IRA: The rating agency monopoly up to this crisis could certainly be viewed as a form of legalized extortion. There was no choice for a global issuer but to go to Moody's or S&P.

Janeway: Yes, but even so the job of the rating agencies until as little as a decade ago was to evaluate cash flows. Then came the CDO.

The IRA: Yes but Moody's and S&P were not explicitly paid to notch CDOs each month. They were paid in the primary market effectively acting as an adviser - and sharing in commissions. But there was no "issuer pay" model explicit in the CDO budget for following these deals in the secondary market."
Now, I'm taking liberties to make a point, which is that with this kind of possible conflict of interest, only Type 1 rating can work.
In other words, what credit agencies can rate safely are agreed upon standards, in which all that they are doing is presenting the analysis from outside of the company being rated. Investments like CDO's were more like Type 2, and simply weren't advisable at all to be rated by these agencies.
So, for me, although I would force the agencies to at least compete in pricing, their only use so constituted is to look over boilerplate figures and rate them. Of course, they are not responsible for the figures. The companies are.
The alternative is for investors to set up ratings agencies, which, if confined to basic analysis, I'm not so sure couldn't break through the entry problems. But how the hell do I know.
Don the libertarian Democrat | Homepage | 11.20.08 - 9:29 pm | #"

Here's his reply:

@Don: Good point, but "my" system would reduce the upward, subjective bias (your #2) because agencies would LOSE money when they were over-optimistic.
David Zetland | Homepage | 11.20.08 - 10:55 pm | #

I see his point, if this can be measured. But we still have to contend with Robert Waldmann's point about essentially ratings fixing.

"Don

In my "model" they are all equally good (or bad) because they choose to be so -- they follow each other as "about as good as the other two" is plenty good enough.

I think that, if investors are rational, the entry cost of becoming a credit rater should be huge. My complaint about them is that they gave AAA to assets which had not stood the test of time. Obviously, I would pay no attention to a credit ratings agency which did not have a decades long record. I don't think I'm the only one. I'd guess that a new agency would have to work for years or decades before anyone cared what they said and only then could begin to have positive revenues let alone profits.

The fees are, apparently, not really fees, because the agencies rate bonds even if they are not paid. That is claimed in the article I linked to as
this in "damn 'this'" upthread. It appears that 98% of firms pay for their bonds to be rated even though the credit rating agencies rate the bonds of the remaining 2%. The fees are, in any case, a tiny part of the cost of capital. I'm going to post this now then get the reference.
Robert Waldmann | Homepage | 11.18.08 - 12:03 am | #"