Something's Fishy in S&P's Bond Gradings

by: The Prudent Investor

Rating agency Standard & Poors (S&P) appears to do all it can to further wreck its status. According to a Bloomberg story from Tuesday, S&P had downgraded three AAA-rated commercial mortgage-backed debt papers only a week ago to BBB-, the lowest investment-grade rating. Lower ratings than BBB are considered junk issues.

On Tuesday S&P reversed course and upgraded the bonds again to AAA in a move destined to downgrade its own reputation. The move coincided with new proposed legislation sent to Congress that would require rating agencies to observe a raft of new disclosure rules and restrictions, writes the Financial Times.
From Bloomberg:

Standard & Poor’s backtracked on ratings cuts issued last week and raised the ranking on commercial mortgage-backed debt from three bonds sold in 2007.

The securities, restored to top-ranked status, had been downgraded as recently as last week, making them ineligible for the Federal Reserve’s Term Asset-Backed Securities Loan Facility to jump start lending.
S&P lowered the ratings on a class of a commercial mortgage-backed bond offering from AAA to BBB-, the lowest investment-grade ranking, on July 14. The New York-based rating company reversed the cut today, S&P said in a statement. In a related report, S&P said it adjusted assumptions on the timing of projected losses on the mortgages.

It is a stunning reversal and certainly raises questions concerning the robustness of their revised model,” said Christopher Sullivan, chief investment officer at United Nations Federal Credit Union in New York. “It may engender further uncertainty with respect to ratings outlooks.”
Debt rated below AAA isn’t eligible for the Federal Reserve’s TALF. Investors sought $668.9 million in loans from the Fed to purchase so-called legacy commercial mortgage-backed bonds on July 16, the first monthly deadline to finance the purchase of the securities.

If you are confused about the alphabet soup liquidity measures of the Federal Reserve since the onset of the credit crunch, William D. Cohan, author of "House of Cards: A Tale of Hubris and Wretched Excess on Wall Street" came up with a cute TALF explanation:

Imagine if you were not really in the market for a house but the government came along and said that it would finance 94% of a home's purchase price with a mortgage rate of less than 3%. Still not interested? Wait, Uncle Sam has some additional sweeteners: if you do the deal and buy the house for only 6% down, you also get the equivalent of rental income every month to the tune of at least an annualized yield of 10% of the purchase price.

But wait there's still more: if, say, after two years, you decide you don't want the house any longer, you can just walk away from it. No need to pay the balance of the mortgage (it won't affect your credit rating), and you can keep the rental income received to date.
That's essentially the deal that Treasury Secretary Timothy Geithner has offered qualified professional investors who participate in the so-called TALF (Term Asset-Backed Securities Loan Facility)...

The way the TALF works in practice is this: The amount of equity an investor has to put up, or the "haircut" as the TALF documents call it, depends upon the assets involved, the term of the loan or lease of the underlying asset (say, a car) and the credit quality of the underlying borrower. A loan to buy a three-year security backed by a group of credit-card receivables from high-quality borrowers would require an investor to put up 6% of the capital -- a 6% "haircut" -- and then can borrow the rest from the TALF through his brokerage account. To buy a two-year high-quality credit-card receivable security, a borrower would put up 5% of the face amount of the securities purchased. Auto receivables require as 12% equity investment for a three-year security. Small business loans require 5% down. Student loans require 10% down for a three-year deal.

An investor interested in a $10 million slice of three-year credit card receivable would put up 6% of the money -- $600,000 -- and borrow the balance of $9.4 million from the TALF at a rate of three-year LIBOR plus 100 basis points (Attention K-Mart shoppers, that's 2.85% at this moment.) Depending on all sorts of assumptions, the yields on these investments are said to be in the 11% to 15% range, especially attractive since the TALF loans are non-recourse to the borrowers -- you can just walk away and lose only your underlying equity investment and the collateral but you are not held responsible for the unpaid portion of the TALF loan itself.

In addition, the TALF loan is not marked-to-market so if the underlying collateral deteriorates in value, the investor is not required to put up more equity. What's more as the car payments or credit-card payments on the underlying security are made, the payments are distributed to the government and the investor on equal footing -- that means the investor starts getting paid back at the same time as the government even though the government is the senior secured creditor and even though an investor has put up only a small fraction of the original money. One private equity investor, who would not normally have looked at investing in such a deal but did, called this particular aspect of the TALF "shockingly good."

This short refresher course leads back to the absurd business model of rating agencies who have not missed out on a single blunder in the past 4 decades.
Their pay to play model now raises the question about their input data to assess the risk of securities. Reducing a rating by three grades from AAA to BBB and then retracting it one week later does not exactly help ironing out the current imbalances in ratings.

I assume as long as the $$$,$$$ roll in for their work, rating agencies are willing to take hits from enraged investors. Rating agencies have certainly helped to globalize securities trading, especially in the fixed income (what a misnomer these days) sector. Fund managers like the trade too, as it offers them a scapegoat in case something goes wrong with their presumably well-rated holdings.

An unnamed fund manager explains his view,

"How else could I invest into foreign ABS (asset backed securities) or MBS (mortgage backed securities)? I can't travel the world to assess the quality of my holdings. This is why we need a rating agency."

But he agrees that recent zig-zags of ratings often cannot be explained with underlying fundamental changes,

"one week down, the next week up does not instill confidence in the grading mechanism of the agencies. This recent move by S&P smells fishy. I think there were less formulas applied but rather some phone calls from authorities like the Fed or the Treasury."

Given the tendency of the Fed and the Treasury to play under a sheet of secrecy, this sounds plausible and brings up the fundamental question whether the rating agencies should not be shut down for good.

This could have helped non-US investors avoid hefty losses who were drawn to the fairy tale land of investment grade ratings which offered a nice spread above other high-grade bond issues, e.g. sovereign bonds.

The Treasury's new plan is aimed at reducing conflicts of interest at rating agencies, boosting the regulatory authority of the US Securities and Exchange Commission over the agencies and reducing the financial system’s reliance on credit ratings.
From the FT:

Barney Frank, head of the chairman of the House financial services committee, on Tuesday endorsed measures that would overturn requirements that require the use of the credit ratings agencies.

“There are a lot of statutory mandates that people have to rely on credit rating agencies. They’re going to all be repealed,” he told Reuters.

The business models at Moody’s Investors Services, Standard & Poor’s and Fitch Ratings – which are paid by the companies whose debt securities they rate – remain largely intact.

Defending the Treasury’s decision not to heed calls by some for a fundamental overhaul, Michael Barr, assistant Treasury secretary for financial institutions, said there were conflicts inherent in alternative models too.

Tuesday’s proposals would bar ratings agencies from providing consulting services to any company they rated and would require them to disclose fees for a rating. It also attempts to stem “ratings shopping’’ in which a company solicits “preliminary ratings’’ from multiple agencies but only pays for and discloses the highest.

Ratings agencies would be required to use different symbols for structured finance products, which are perceived to be riskier, than for corporate bonds...

The SEC has created special examiners to oversee ratings agencies, and last year passed rules prohibiting activities such as executives providing both ratings and advice on how to structure securities, and barring those who evaluate the debt from discussing fees, as well as limiting gifts from debt underwriters to rating agency employees.

S&P said it was studying the proposal. Moody’s said it supported the goals of “increased transparency and enhanced ratings quality’’. Fitch said the plans were consistent with its views on transparency.

An Overbanked World

Looking at the global picture with the advantage of hindsight, rating agencies have dramatically contributed to the internationalization of securities trading. But as we have arrived in a period where the whole world has become over banked one can safely assume that this long cycle of over-investments in the financial sector will reverse too. Desperate moves by governments to keep all their domestic banks alive will only lengthen the unavoidable process of shrinking the industry. So far banks have an advantage as they can convince politicians that they are the arterial system of the economy. This will certainly change once the broad mass finds out that their rising tax payments are used to keep the banks alive who had embarked on a greed-trip not seen since the last depression in the 1930s.

There is no reason why banking could not be reshaped and resized. I can't find the source anymore, but I remember to have seen a study that concluded that banks' profitability growth since the 1960s has left all other industries in the dust far behind.

It would have cost the world a lot less had bankers stayed with their 3-6-3 business model: Borrow at 3%, lend at 6% and make sure to be on the golf course by 3PM.