With the economy showing signs of recovery, the exotic financial products are springing back.1The demand for derivatives is once again growing as investors are trying to capitalize on the low interest rates. Notwithstanding the crisis, derivatives will continue to be useful and will serve as good hedging tools. The banks may continue to develop innovative products, even in a more regulated environment. At this juncture, it is important that the market entities take a step back to review the prevailing practices
Being a former Structured Finance rating analyst of a leading Rating Agency in the years leading up to the crisis, I feel compelled to educate the readers on the intricacies of the market in the pre-crisis years. Since the financial crisis, I have been actively following the developments in the market and my efforts have been more geared toward studying the importance of risk assessment and its management. I have come to realize that the market, going forward, primarily needs a holistic view of risk tolerance. I am not writing this article with the intent of assigning responsibility for the crisis on any particular entity. However, as a former rating analyst, I consider myself uniquely placed to objectively present the idiosyncrasies of the market during this period. This should hopefully illustrate the importance of understanding risk to foster prudent investment decisions.
As a professionally competent analyst within the group, I was viewed as one capable of analyzing complex and intricate CDO transactions with ease. I rated several hybrid CDOs that often times incorporated abstruse features, which were quite frankly, interesting to analyze. The increased risk appetite of the investors and the positive market sentiment encouraged the banks to come up with more complex derivative products. The period was marked by intense brainstorming sessions within the group. Everyone involved in the rating process was trying to get a grip on the features and their impact on the transaction "deal", in order to suitably incorporate them into the analyses. At this point, I wish to elucidate a few of the qualitative features that increased the complexity in rating these products, particularly the hybrid asset-backed CDOs:
1. A large proportion of the CDOs' Collateral began having synthetic references in the form of CDS (credit default swaps). While this was widely prevalent even in the past years, the transactions leading up to the crisis predominantly referenced sub-prime mortgage backed securities. The ease of having assets in the portfolio without physically owning it and with no constraint on the notional amounts had become increasingly appealing. In order to account for the credit risk and the liquidity risk, these hybrid CDOs needed liabilities in the form of super-senior swap arrangements or note purchase agreements through a variable funding note. These agreements, while trying to shield the deal from having to take huge losses, were intended to also give regulatory-capital relief.
2. The Issuer (the seller of protection) serviced its obligations on these swaps through the use of "eligible collateral" that took the form of GIC (Guaranteed Investment Contracts), TRS (Total Return Swaps), Repos, other highly rated liquid assets that also included triple-A rated structured finance obligations or a combination thereof.
3. Sometimes the deals also comprised of a percentage of "synthetic shorts" where the Issuer, under this arrangement, was the protection buyer. The primary motivation for these types of securities was to partially hedge a long exposure. The deals even had naked (uncovered) shorts wherein the portfolio did not include any long credit exposure to the reference entity. This was intended to mitigate the overall credit risk associated with the long or cash portfolio. However, if the swaps have unintended consequences the deal could get over-leveraged.
When one is evaluating a deal with all of the aforesaid features, which are only a few of the many, their aggregate impact further augments the complexity of the transaction. For a rating analyst, the analysis typically involved extensive review of swap agreements/confirmations in addition to the deal documents. The combined effect of multiple swap agreements to a transaction of this nature cannot be underestimated. The transactions also had complex cash-flow mechanisms "waterfalls" which needed be explicitly modeled in accordance with the agency's methodologies, while simultaneously accounting for the qualitative features. The robustness of the market necessitated appropriate methodology changes at the agencies. However the crisis has made it apparent that these changes did not totally account for the inherent risks in these securities. This could partly be attributed to the absence of sufficient historical data pertaining to the market at that time.
The ramifications of these transactions on the market players, given their interconnectedness, have been humongous resulting in the financial crisis. The core of the crisis has only led us all to believe that the risks associated with these kinds of securities demanded a more in-depth understanding by the market.
The rating agencies have understandably been under intense scrutiny by the market. Numerous other entities will also need to take responsibility for the fallout. As the growth in the Structured Finance market became rampant, the incentives for various players in the market started to get misaligned. As far as the rating analysts are concerned, there has always been a demand to churn deals out expeditiously. The analysts were rating a plethora of transactions prior to the crisis. These complex transactions were often tailored to meet the risk-return objectives of a specific class of investors that ironically possessed limited knowledge regarding these securities. To a certain extent, the proliferation of these complex transactions is consistent with over reliance on the rating agencies. Over-reliance without adequate fundamental analysis by the users can be detrimental. In order to make wise investment choices, the ratings need to serve as a complement to multiple data sources.
The past few years since 2008 serve as abundant history, making it imperative for all concerned to take necessary actions to prevent such crises in the future. Regulators are making efforts through reforms to mitigate any potential crisis. The rating agencies need to continually review, revise and communicate their methodologies explicitly to the market. While there may not be a panacea for systemic risk, the effective way to mitigate risk will be through integrated efforts and cooperation among various market entities (structural, analytic and regulatory).
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.