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A New Kind of Risk
Thursday, July 28 2011 | 08:52 AM
Chief Executive Officer & Co-Founder,
|While the global markets are preoccupied with how to account for obvious risks such as breaching the US debt ceiling, Greece default and their domino effects. There are many risks that are not even in the minds of many investors let alone being priced-in by the markets.
There is a real risk of potential cyber attacks targeting companies or attempting to paralyze the global financial systems as a whole to achieve radical political goals. The recent Sony and Lockheed cyber attacks illustrate the degree of vulnerability of even some of the most technologically advanced companies. Given the lack of comprehensive models of cyberspace and absence of general appreciation of the overall financial markets’ vulnerability to a widespread attack, investors don’t seem to be so much focused on the risks and pricing that in their valuation. Just the fear of it will create regulatory, operational and legal risks that will cost companies a great deal in both capital and management distraction. We are far from fully understanding and pricing of cyber attack risks and the possible implications for the overall global markets.
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Greece and the Sovereign Debt Crisis
Wednesday, June 01 2011 | 10:37 AM
Chief Executive Officer & Co-Founder,
|European Union finance officials are discovering the benefits of financial engineering in considering Collateralized Bailout ("CBO") as an alternative to sovereign debt restructuring. As the European Union finance chiefs explore various options to deal with the worsening Greece sovereign debt crisis, some EU countries suggest making any additional aid collateralized with national assets.
At this point officials deny any particular options. Given public opinion in Germany and Finland has been against further outright aid to Greece, any option to mitigate the impact of a Greece default would be attractive to the officials. Asset sales by governments to avoid default or raise needed cash have a long history, with an example being that a significant portion of the geographic area of the United States, such as Louisiana, was acquired through sale of land by other governments for cash. Yet a sovereign bond collateralized by a specific land or a national monument would be new. Structured finance traders may joke about a due diligence trip on a new "Apollo CBO" if it was a sovereign bond of Greece collateralized by Mykonos Island, though Greek nationals may not find that quite as funny. Given the financial conditions, we may also see collateralized or structured debt solutions considered in other public finance cases such as US municipal markets.
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Rating Agency Reform: The Real Problem That Has Not Been Recognized
Monday, March 14 2011 | 09:39 AM
|The most important and the most basic issue related to ratings and rating agencies has not been recognized or addressed in reforms announced so far. Here’s a new idea on a practical solution to address this most fundamental issue, which also addresses the conflict of interest issue that has received the most attention so far.
Ratings agencies have been criticized heavily by many for their role in the U.S. financial crisis, in particular over conflicts of interest and their failure to recognize the high risks inherent in complex structured products. They have also been blamed for throwing fuel onto the fire of crises by belatedly and aggressively ratcheting down ratings. Numerous proposals have been put forward to reform the rating process to avoid these issues.
The US Congress, after resolving the differences between the House and Senate versions last week, is on the path to pass a sweeping financial regulatory reform bill aimed at increasing oversight and regulation of the US financial system. Among the issues addressed is reform of credit rating agencies. However, the compromise bill avoids most of the stronger proposals. The bill directs SEC to conduct a two-year study to determine if a board overseen by SEC should be setup to help pick which firms rate asset backed securities (the Senate version of the bill had required such a regulatory board). The bill also adopted a softer version of proposed liability provision than was in the house version of the bill (investors must show a company “knowingly or recklessly” failed to conduct a “reasonable” investigation before issuing a rating). The compromises are better than the extreme versions of proposals even though it means that the proposed regulations may not do much to change how the agencies operate.
Earlier, in mid April, SEC made some changes. In the update of Regulation AB, it eliminated the involvement of rating agencies in the shelf registration process by removing the requirement that the ABS be rated investment grade. This clearly has no impact on the rating process.
SEC also promulgated the Rule 17g-5, which went into effect on June 2, to address perceived conflicts of interest with issuer-paid ratings provided by nationally recognized statistical rating organizations (“NRSROs”). The rule aims to increase the number of ratings and promote unsolicited ratings for structured finance products. To achieve this goal, the rule requires issuers and hired rating agencies to maintain password-protected websites to share rating information with non-hired rating agencies. The concept is good, but if implementation means rating agencies will have to share all information with other agencies, they may have less incentive to dig deeper and find more data.
None of these changes are radical overhauls or even proportionate to the amount of criticism that was leveled at the agencies (Calpers has sued the three major bond rating agencies for $1 billion in losses it said were caused by “wildly inaccurate” risk assessments) or the wide ranging calls for ratings reform. In some ways, it is good that some of the more extreme proposals have not been adopted. But why is it so difficult to reform the rating process?
The Power of the Rating Agencies
One reason that makes it very difficult to make changes to the ratings process is that ratings are heavily embedded in almost every part of the financial systems around the world. They are used in investor’s charters defining what they can buy. They are used for calculation of capital charges for banks, insurance, and other financial companies. They are used in loan covenants and triggers on corporate debt. They are used to calculate haircuts on repo lines, along with many other uses.
Also, despite the recent failings, they serve a very useful purpose. Not everyone has the expertise and resources to analyze every security in detail. Presence of credit rating agencies gives smaller investors a starting point for analysis that they may not otherwise have.
This embedding of ratings in the financial system and reliance by so many participants on the ratings gives the nationally recognized statistical rating organizations or NRSROs tremendous power as ratings changes can have significant impact on companies, and even nations.
There are numerous examples of the impact that ratings changes can have. One recent one was during the onset of the 2010 European Sovereign Debt Crisis. What clearly played a role in triggering and escalating the crisis, even though it was not the cause, was the downgrade of Greece’s credit rating by three steps from investment grade BBB+ to junk rating of BB+. This came minutes after S&P downgraded Portugal by two steps to A- from A+. The announcement came at a sensitive time as the European Union policy makers and the International Monetary Fund were trying to hammer out measures to ease the panic over swelling budget deficits and create a financial rescue package for Greece. S&P followed the next day cutting Spain’s rating by one step to AA, and keeping the outlook as negative, reflecting the chance of further downgrades, with its projection of just 0.7% average real GDP growth annually from 2010 to 2016. Markets reacted violently to the cuts as investors worried about the safety of the debt of these countries, and contagion spread from Greece to other countries. Stock markets tumbled worldwide, and bond and currency markets had big moves and became very volatile.
Another way ratings impact markets is via the feedback loop between the markets and ratings through portfolios tied to indexes mandating certain holdings of particular debt. For example, the Barclays Euro Government Bond Index includes Greek debt as 4% of index, but only if the bonds maintain a certain credit quality based on lower of the rating from S&P and Moody’s. Greece had been 4% of that index but was excluded starting May 1, due to S&P’s downgrade. That in turn likely forced selling from investors tracking that index.
Critics assailed rating firms for fueling woe in Europe and Europeans criticized debt-rating agencies, accusing them of spooking the markets and worsening the plight of financially stretched governments such as Greece, struggling with heavy debt loads.
There are several other examples where a company needing to raise more debt in capital markets finds it cannot do so, or not at a reasonable cost, once it has been downgraded even while it was attempting to raise capital to improve its financial situation. The downgrade increases cost of financing as investors demand more yield reflecting lower rating. The downgrade may also result in existing investors having to sell holdings, further increasing the yields in the market. It can become a vicious circle increasing the likelihood of default. The downgrade reflects rating agency’s opinion of the outcome, but it also becomes a causal factor in determining that outcome. The rating agencies in effect become the judge, jury, and the hangman for the company.
The Real Problem That Has Not Been Recognized
In the current system, the rating agencies’ opinion can become a causal factor in making that opinion become reality. Time and again, in structured products and otherwise, it has been clear that the rating agencies are not infallible in their judgment, and do not have any special powers of predicting future. Their failures in predicting subprime mortgage performance have been appalling. But even if you look at the forecasts of defaults in corporate bonds, the predictions do not match the actual outcome, and the predictions themselves change over time, as they should.
So, if ratings are heavily embedded in the system and are needed, and yet rating agencies are not smarter than everybody else, and if they do not have special predictive powers about the future, how do we avoid giving their subjective opinions so much importance and extraordinary power?
The answer lies in recognizing the real problem – one that has not been addressed in any of the proposals so far. The real problem is that the rating agencies are combining two roles into one. First role is to provide a rating based on statistical analysis and past performance of the assets – remember that SR in NRSROs stands for Statistical Ratings. The second role is that of a research analyst to provide an opinion on what might happen in the future. Currently, rating agencies combine the two. The ratings are a mix of statistical analysis and somewhat subjective opinion on the future. This allows rating agencies to downgrade companies or countries even while they are in the process of attempting to improve their financial condition. At the same time, it leaves rating agencies open to criticism if they do not act and the feared worse outcome becomes reality before their downgrade. This also allows subjectivity and flexibility in ratings process that creates perceived conflicts of interest in issuer paid ratings.
The logical solution is to separate the two roles. NRSROs should be doing Statistical Ratings – based on past performance of assets, known facts, events that have already taken place, and statistical models and methods that are well disclosed. They can put bonds on watch for upgrade or downgrade if a financial event is in progress or expected, but cannot downgrade or upgrade till the event actually happens. So they will not be precipitating events, and cannot be blamed for not downgrading sooner. This role will be limited to those approved as NRSROs.
The second role of providing credit ratings in the form of opinion on future performance should be separated from the NRSRO role, and should be open to any research provider, including NRSROs. These credit ratings could be designated as Informational Ratings without any legal or official role impacting investor charters, debt covenants, etc, which will only use the ratings designated as NRSRO Ratings. This will take the non-NRSRO rating agencies back to sort of where rating agencies started – as market researchers, selling assessments of corporate debt to people considering whether to buy that debt.
The information provided to NRSROs should be made available to all NRSROs and other non-NRSRO rating agencies, in a manner similar to password-protected website required under SEC Rule 17g-5. However, to promote competition and improve quality, the other rating agencies should be free to gather more information and not have to share it with others.
The conflict of issuer paid rating could be avoided if issuers were required to pay a fixed fee based on deal type (maybe to a group set up by the SEC or an industry association for that purpose) which would be divided between all NRSRO raters informing issuers of their decision to rate the deal after the issuers post the information on the password-protected website for credit raters. This will avoid ratings-shopping by issuers even though the agencies will be indirectly paid by the issuers. The NRSRO Rating will be provided to investors without any charge. The NRSROs will only provide the current rating, along with disclosing their rating methodology to investors. They will not provide any opinions or qualitative information.
For more qualitative information and opinions, investors will look to the Informational Ratings and more details from research providers (including NRSROs and non-NRSROs). This will be paid for by the investors looking for enhanced information and research. This will be the main source of income for credit raters and will incentivize them to compete with others for investor subscriptions and produce quality results.
Separating the two roles avoids the issues of rating agencies precipitating events if they act or facing criticism if they do not. It avoids the perception of conflict from issuer-paid ratings, by allocating costs between the issuer and the investors. It also preserves the role of rating agencies where its needed, while encouraging the investors to do more work on their own and look for third party unbiased research and opinion.
Note: Versions of this article were published in Structured Credit Investor and Seeking Alpha.
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