It's the Models, Stupid: Interview with Josh Rosner

by: Christopher Whalen

"I also expect that the Board will soon consider an NPR on qualified financial contracts (or QFCs), which include derivatives and some other financial contracts. When a bank fails, the FDIC has only one business day to decide how to treat the bank's QFCs. In addition, we must decide whether to accept or repudiate all positions held with an individual counterparty. When a bank has a large volume of QFCs, this can be challenging. Banks may not keep their QFC records in a way that provides the information we need quickly. I anticipate that the NPR would specify the information that troubled banks would have to maintain on QFCs and how it would be provided to the FDIC. We will also seek comment on whether all banks should be held to some minimum recordkeeping requirements on their derivatives portfolios." (Sheila Bair Chairman, Federal Deposit Insurance Corp., Remarks by FDIC Chairman Sheila Bair to the Exchequer Club of Washington D.C., June 18, 2008)

Last week, Moody's (NYSE:MCO) belatedly caught up with the rest of the ratings world and downgraded MBIA (NYSE:MBI) from "Aaa" to "A2" and Ambac (NYSE:ABK) to "Aa3" from "Aaa." While we continue to believe that the "fair value" GAAP accounting disclosure by these companies overstates the economic reality, the fact is that the markets react to corporate earnings statements.

Whether you look at the situation facing the larger commercial banks, the bulge bracket broker dealers, monoline bond insurers or Buy Side investors, all are tormented by an illiquid market structure that exaggerates valuation issues and gives little weight to capital or management. Fear, rather than objective analysis, seems to rule at present. Perhaps this is because, as our own work on the banking industry suggest, we are still early in the adjustment process.

To get an update on the situation facing the monolines and the ratings agencies both, we spoke to Josh Rosner, principal of Graham-Fisher in New York. We last interviewed Josh earlier this year (A Global House of Cards: Interview with Josh Rosner, April 7, 2008).

The IRA: Josh, have you been watching the latest fun and games in Washington with the scandal concerning Senate Banking Committee Chairman Chris Dodd (D-CT) and the "Friends of Angelo," a reference to members of Congress favored by Countrywide Financial (NYSE:CFC) CEO Angelo Mozillo?  It seems that the former Democratic presidential candidate has stepped on his appendage yet again.

Rosner: There have long been rumors in DC that Fannie Mae (NYSE:FNM) had a program where they gave special mortgage loan rates to members of the Hispanic and Black Caucus members on Capitol Hill.

The IRA: Yes, it's called legalized bribery.

Rosner: Why is Dodd's situation any different than what FNM and Freddie Mac (NYSE:FRE) have been doing for years? I think it is a bit unfair to try and single out Dodd for what seems to be business as usual in Washington.   

The IRA: It's not. Dodd's situation is just another example of the corruption that is SOP for Washington.  Until we reform campaign finance laws so that politicians won't have to sell their votes to the highest bidder, we'll continue to see examples like the "Friends of Angelo."

Rosner: Right, but isn't it funny that nobody in the big media talks about the influence peddling by accounting scandal ridden GSEs?  Remember, FNM went so far as to have a Senator demand an investigation of its regulator in an attempt to influence its regulation.

The IRA: As Bob Feinberg said to me last week, instead of the "Keating Five" we now have the "Fannie and Freddie 535." The "Friends of Angelo" is obviously a subsidiary of this group. CFC was simply imitating the way that FNM and FRE incentivize members of the Congress.  Yesterday the New York Sun asked us about the two fund managers from Bear, Stearns who were being prosecuted. Our response was that we'd feel better about the prosecution if former Fed Chairman Alan Greenspan and members of Congress were also being held accountable for their role in creating the subprime mess. We commented on same shortly after our last discussion (The Subprime Three -- Rubin, Summers & Greenspan', April 28, 2008).

Rosner: Ha! Look, the only difference between Ralph Cioffi and the rest of the folks at Bear, and any other investment bank, is that the government stepped in to prevent the other ibanks' businesses from failing. Other than the fact that their funds went into forced liquidation, in terms of what they did, how they overstated, how they mis-marked, they do not seem to have done anything particularly different from nearly anyone else on Wall Street.

The IRA: That's right. It's sad that the Bear and its employees are still being picked on and made the fall guys while the other Sell Side houses get a free pass. We wonder if that won't be an issue in the prosecution.  If you applied the standard described in the indictment of Cioffi to the rest of Wall Street, most of the industry would collapse.

Rosner: I said that on Bloomberg last week. If I were Bear's lawyer I would point out in my defense in the Bear prosecution "look what almost everyone else did with their disclosures and marks. Are your prosecuting them?"

The IRA: Let's change topics now to the monoline insurers and ratings agency reform. Tomorrow, June 24th, you and our colleague Sylvain Raines are going to be participating in a session on the ratings agencies organized by Alex Pollock at American Enterprise Institute (How to Improve the Credit Rating Agency Sector). We notice that MCO finally moved on downgrading MBI and ABK. And once again, MCO and Standard & Poors, a unit of McGraw Hill (NYSE:MHP), seem to be acting as lagging indicators for changes in default probability, changes that other ratings agencies have recognized for months. Wilbur Ross told Bloomberg on Friday that he thinks the downgrade will help municipal issuers, but we don't see it. Do you differ?

Rosner: The thing which troubles me is that the NY State Insurance Commissioner is clearly picking winners by favoring municipal issuers over other entities covered by MBI and ABK insurance. Frankly, in my conversations with Eric Dinalo's office, they have said that they would rip up the credit default swap contracts before they allowed them to affect the ability to pay on municipal bond insurance.

The IRA: So the article in the New York Times last week suggesting that there is a dilemma facing Dinalo in terms of a trade-off between the muni issuers and the holders of CDS contracts is, in fact, not an issue.  BTW, did you see the comment by FDIC Chairman Sheila Bair last week?  She reminded banks that they need have all of their CDS documentation in good order because the under the statute the FDIC only has 24 hours to decide whether or not to reject a contract after a bank closure.  We feature an excerpt from her speech at the top of this issue of The Institutional Risk Analyst.  People in the CDS market need to read that speech.

Rosner:  Well, precisely.  That is the very same issue raised by Dinalo, who is statutory receiver for a failed monoline insurer domiciled in New York. Thus the question: what event or series of events is going to take down the monoline at this point?  There is a broad misunderstanding that because the CDS contracts issued by the monolines can be accelerated they will be accelerated in the event a monoline becomes insolvent. I doubt the investment banks and commercial banks who are CDS counterparties with MBI and ABK have any interest in accelerating these claims. It's not that they won't have a basis for acceleration under NY's insurance laws, but rather it would force them to take mark-to-market losses on their own books, losses that the banks don't want to take.

The IRA: Correct. It's sad to say, but the pain from fair value accounting in terms of mark-to-market is not yet over.  One of our readers chided us last week for not offering positive solutions to this mess, but we're still trying to find the bottom of the proverbial pond.

Rosner: This raises another issue, namely the prospect for further problems for the bank CDS counterparties down the road. If, in fact, the banks do not pursue claims against the monolines when they could, the shareholders of the banks may have a basis for claims against bank managers and the auditors for mis-marking their books and therefore not recouping shareholder assets. The banks may be leaving money on the table.

The IRA: Absent that issue of mark-to-market, do you think that the banks should be pursuing acceleration now?  Is the statutory accounting for MBI or ABK as dire as the GAAP accounting suggests? MCO and S&P certainly seem to think so.

Rosner: Those are two separate questions. To me, in economic terms, given the current mark on these contracts, the banks naturally should be pushing for acceleration. They would likely get paid out a lot more today than at maturity.  New York insurance law suggests two triggers for insolvency, one being claims paying ability and the other being the ability to reinsure. There seems to be claims paying ability at the present time for MBI, but at this point the company does not seem to have the ability to reinsure its entire book.  So in terms of economic interest, if the banks were being cutthroat and aggressive, they probably could and should push for acceleration. That is why I believe the NY Insurance Commissioner needs to require that the $900mm held by MBI be pushed down to the insurance company. Sure it is only incremental capital, but it would probably stabilize the rating and, if the parent company ends up in dire straits, they wouldn't then be able to move the capital.

The IRA: But given that the ibanks and the monolines are essentially in the same boat when it comes to valuation, there is not likely to be acceleration. So what happens to the monolines? Do you expect further downgrades?

Rosner: Unless they can figure out a clever way to write new business and use that incremental revenue to reinsure their existing book, I think there is a good chance that both MBI and ABK will be downgraded further. They are in a different situation than CIFG or FGIC, to some degree, but remember that those companies hit almost every single ratings notch on their way down to junk. Once you fall below AA or AAA, every notch below becomes a lot harder to hold onto.

The IRA: So is this a good bank/bad bank type situation where the underwriter in both of these cases cannot write new business and must start new vehicles?

Rosner: Yes. Other than perhaps reinsurance, I don't expect that either MBI or ABK will be able to write new insurance business anytime soon.

The IRA: So is this a runoff situation where the existing portfolios must simply be managed as the underwriters are liquidated?

Rosner:  Of the existing entities?  It appears so.  The question is how will management accept responsibility to the existing companies? What will the NY State Insurance Commission require of them? My sense is that Dinalo is really interested in playing for today instead of for two years from now.

The IRA: But doesn't the State of New York realize that with these downgrades most muni issuers will not be interested in doing business with them? What can MBI and ABK do to restore their ability to write new business?

Rosner: Set up a new company, but I don't see how, without a lot of new capital, they will be able to obtain the required ratings on that new insurance company.

The IRA: So if you were Dinalo, you'd be looking for MBI and ABK to wind-down the existing unit and seek a better rating for the new underwriter?

Rosner: Yes and reinsure the existing unit. I would expect that the New York Insurance Commissioner will want MBI and ABK to set up a new company or cede premiums to a new player to reinsure their books.  If there were a way to get a sufficient rating on a new insurance subsidiary my preference would be for the new unit to be under or "stacked" beneath the existing insurance company so that any future profit from new business supports all of the existing policy holders and that the equity in the newco would also support the existing policy holders.

The IRA: Do you think that MBI is going to be forced to downstream the capital provide by Warburg Pincus to the existing insurer?

Rosner: No, because I think the New York State Insurance Commissioner is dancing a very fine line - at the moment.  I think that what MBI CEO Jay Brown wants to do is set up a new sister company in parallel with the existing underwriter.

The IRA: But isn't that the way it needs to be? Would you write new business with a subsidiary of the existing underwriter - assuming that it is not able to fully reinsure its book, including the CDS exposure?

Rosner: The parent has the same problems. The parent of MBI has a lower rating than the underwriter. There is another problem because there is a risk sharing agreement between MBI and its underwriter affiliate. If the insurance company files bankruptcy, then the parent must as well. This may be why Jay Brown has been resisting setting up a newco as the daughter of the operating company.

The IRA: So you want to keep all of the eggs in one basket?

Rosner: If you are the State of New York, you want to make sure that any new business or new capital accrues to the benefit of existing policy holders.  And you want to make sure that it is a lock box. If MBI can demonstrate claims paying ability and write some reinsurance, then over time it may be able to get back on its feet and eventually improve its rating with MCO and S&P.

The IRA: But isn't it going to be very hard for MBI to write new business when they are competing with Wilbur Ross and Warren Buffet?

Rosner: Of course. But the New York State Insurance Commissioner has already missed the boat here. It essentially has allowed MBI to hold onto the $900 million provided by Warburg Pincus, apparently with the thought that MBI would start a new underwriter and the newco would ensure part of the existing subsidiary's book. I think that you are exactly right that it may be too late for such a solution now that ratings downgrade has occurred.

The IRA: So let's switch gears and talk about the ratings industry. What are you going to be saying at AEI tomorrow?

Rosner:  The proposed solutions that we've seen from the global securities regulators are soft and senseless approaches. While I don't question the sincerity of the efforts or their intentions, I have to question to their understanding of the problem. It is very clear to me that the solutions do not require hundreds of pages of analysis. There are some very clear, simple and elegant solutions, but nobody is talking about them in the regulatory community.  The failure to do so is ultimately going to force the political leadership in the US and Europe to reconsider the role of the rating agencies. We will see assets other than RMBS and CDOs having troubles and it will become increasingly clear that the rating problems are spreading across most structured assets classes.

The IRA: Do you see the EU moving to set up their own quasi-governmental rating agency?

Rosner: It is unclear at this point. What is clear, though, is that unlike the US legislature, the European Commission recognizes that there may be no way to do a global solution. The UK is a holdout, for example and is still pushing for a global solution.

The IRA: Well, the UK was the chief culprit in constructing most of the rancid CDOs that have caused the crisis, so their abstention is no surprise. Nobody has focused on the fact that most of the private label securitizations that have caused hundreds of billions in losses to global financial institutions came out of the City of London, not New York.  And look at the breakdown of the "global" process around Basel II.

Rosner: Right. And since the US SEC and UK Financial Services Authority have different approaches to regulation, I'm not sure how you could accomplish a global approach even if there were the political will to do so. We are rules based and they are principles based so what they could interpret as rules from the principles in the IOSCO Code only become suggestions here in the US.

The IRA: Agreed. There is a huge political backlash building in the US against the ratings agencies and Wall Street that should come to a boil around Election Day. We got a really scary call from a reporter in Wisconsin yesterday.  It seems that several of the largest school districts in the state decided to borrow short-term and buy CDOs to help finance future health care liabilities - obligations that the state school system cannot fund. This is financial engineering, zaitech pure and simple. Now that the ratings on these CDOs have fallen, along with the market value, the cost of the debt has gone up thanks to an "innovative" trigger provision crafted by a certain large ibank we won't mention. Why these school districts were even allowed to borrow to fund interest rate speculation is unclear. The WI AG reportedly is investigating both the members of the school district boards and the dealers involved.

Rosner: Yikes.

The IRA: Just imagine that example multiplied by all of the state and local agencies around the country and you get a sense of the potential political firestorm headed for the ratings agencies.  So on that happy note, give us your list of sensible ratings reforms.

Rosner: First, starting from the bottom of the list, it seems to me that like Section 206 of Sarbanes-Oxley, there should be a cooling off period for ratings analysts before they can go to work for an investment banking team that structures deals, for a period of one or two years.

The IRA: We'd be happy to say two years. What else?

Rosner: This seems to me to be a much better way to deal with ratings conflicts than saying that they cannot accept more than $25 in gifts from an ibank.

The IRA: Yes, like the Friends of Angelo. Maybe we should have a cooling off period for members of Congress before they can become lobbyists for the corporations who buy their votes. Barrack Obama (D-MI), incidentally, has now done a complete reversal and has decided not to accept public funding.

Rosner: I've never heard of an analyst being bought-off for a large seven layer cake.

The IRA: What's next on your list?

Rosner: Second, I would say that banks, mutual and pension funds can only invest in rated, exchange traded structured assets. This proposal would address the issues of transparency and liquidity by narrowing the bid-offer spread on these securities. The fact of being exchange traded would require SEC registration. This public disclosure would help investors in structured assets be less dependent upon ratings for making investment decisions.  Could you have an exception to the exchange-traded rule for structured assets? Yes, but the bank or fund must be able to demonstrate how their internal credit risk models supports that investment. The funds would have to prove to their regulators that they understood and could model the structures independent of the rating agencies or dealers. But as a practical matter, we are talking about moving most of structured finance onto the exchanges.

The IRA: So you agree with our view that we fix the problem with the ratings agencies by fixing the market structure issue?

Rosner: Yes. I don't have a real problem with how MCO or S&P rate corporates. It is only in the conflicted world of structured finance where a problem exists, where the company being rated exists only after it has been rated.

The IRA:  What else?

Rosner:  Next is the issue of liability.  Where a rating agency knowingly rates a security which they helped to structure and were aware of -- or should have been aware -- of potential fraud in the collateral pool, then they should lose their current regulatory liability exemptions.

The IRA: Haven't the courts in the Southern District of New York already done that?

Rosner: No, they have only ruled on the claim of journalistic privilege in the context of discovery.  The courts have ruled that the ratings agencies cannot hide behind a claim of journalistic privilege for advisory activities. In the American Savings Banks v. UBS litigation, the Court in May of 2003 ruled that the rating agency personnel were not acting as journalists but instead were acting as advisors and therefore could not assert their journalistic privilege. The exemption from liability has not yet been defeated but it really hasn't yet been tested in the wake of the structured securities scandals.

The IRA: No, but the stage has clearly been set by the findings of fact in the American Savings Banks v. UBS ruling.

Rosner: Correct. When the ratings agency acts as advisor, then they should have a fiduciary role to the investors who buy the paper.

The IRA: Yup. If they act as investment bankers and get paid like investment bankers, then they have a duty to both the issuer and to the end-investor.

Rosner: Next, when a rating agency changes its model, it must be required to go back and, in a timely manner, re-rate the securities that were rated in the primary market using that model.

The IRA: Haven't the ratings agencies been forced to do this with the disclosures of model errors?

Rosner: No, they have not. When the ratings agencies change the model they typically only apply it on a prospective basis. They wait until the problem is obvious with a given transaction, only then do they tend to apply the new model to current ratings. They do not change the rating approach that was applied to all of the deals priced with that model in the primary market.

The IRA: That is incredible. We can hear the dinner bell ringing for the trial lawyers now. Just imagine the fun the plaintiffs will have with discovery on deals where a modeling error was admitted but no change was made to the secondary market assessment.

Rosner: Lastly, in the secondary market, the ratings agencies should be required to automate that they use their originally assumed loss curves and original at issuance assumptions tied to the monthly remittance data, to re-draw the loss curve. This would cause a natural "truing up" of the loss curve and the rating, reducing volatility and market risk. Now here's the problem: The SEC, like the other securities regulators say that they do not want to tell the rating agencies what models to use or how they should operate. My response to that is reminiscent of a comment in a presidential debate that is very simple: It's the models, stupid.

The IRA: Sounds like a title.  Chris Cox will be out in a couple of months and we may have a new commission appointed by Barrack Obama.

Rosner:  One of the first issues that the SEC needs to consider after the November election is whether the "hands off" approach by the SEC to modeling should be reconsidered.

The IRA: Well, duh. If the model is used for pricing a security, rating a security and, in a larger sense, for all of the asset allocation decisions made by Buy Side investors, then the SEC has a statutory responsibility to supervise the use of models.  This just shows, yet again, that the SEC does not fully understand the markets that they are required by law to supervise.

Rosner: Now, to preempt the objections from our conservative friends who think we are all socialists for asking the SEC to extend regulation to models, consider this. If we are going to remove the statutory requirement that investors, especially banks, insurance companies and pension funds, use ratings to guide asset allocation decisions, then not only should there not be regulation of models but investors really should treat ratings as just journalistic opinions, like stories they read in newspapers.  But if you view the ratings agencies as exercising authority outsourced by the SEC and other regulators, then the companies should be well regulated.

The IRA: Of course. It is clear that the ratings agencies are part of the infrastructure of the investment world and are essentially standards setting bodies via the ratings process.

Rosner: If we legislate what regulators can do then we should be able to legislate what the ratings agencies do when they act, in essence, as agents of the government in terms of setting standards and the basic rules for the investment process.

The IRA: Agreed. We'll leave it there, Josh. Give our best to Alex and the folks at AEI.