One constituency that has taken a lot of heat during the subprime meltdown, bond rating agencies, have largely been called to the mat because of potential conflicts of interest. And I do believe it is an issue that warrants additional scrutiny.
However, one aspect that has received less attention are the ratings models themselves; are historical analytical frameworks and paradigms used for corporate and municipal bonds applicable to derivative structures like mortgage-backed securities and their variants? An interesting article in Saturday's Wall Street Journal raised some interesting issues that got me thinking, and I thought I'd share some of my thoughts with you.
From Saturday's WSJ; I have bolded phrases and sentences that are particularly noteworthy:
When it comes to bond ratings, all triple-A grades aren't created equal.
That's one reason debt-rating companies such as Standard & Poor's, Moody's Investors Service and Fitch Ratings have met such criticism over their role in the subprime-mortgage crisis.
The trio of rating companies -- owned, respectively, by McGraw-Hill Cos., Moody's Corp. and France's Fimalac SA -- has served as bond-market gatekeepers for decades, publishing letter grades designed to keep nervous investors out of risky bonds. But as the bond market has grown more complex, ratings have evolved to mean different things, depending on what's being rated.
While all ratings refer to the likelihood of default, some newer, more complex bonds don't default in the same way -- or at the same pace -- that old-fashioned corporate bonds do.
The proliferation of triple-A ratings has made it easier for pension funds and other investors to pile into newfangled bonds that recently have been losing market value at an alarming rate.
The sheer volume of these ratings is noteworthy now that investors across the globe have lost confidence in the ratings and values of some bonds. Hundreds of mortgage-related bonds have been downgraded in recent months amid a decline in housing prices.
Over a few days in August, S&P lowered the rating on two hard-hit structured vehicles from AAA to CC, a rating on the brink of a default. An S&P spokesman said that type of deal was rare.
"The corporate rating is tried-and-true," says H. Sean Mathis, an executive at valuation-advisory firm Miller Mathis. Ratings on structured-mortgage products, by comparison, were created recently "as the product of a model."
A Credit Suisse study found that ratings on asset-backed securities, which include some mortgages, were more stable than corporate-bond ratings but were more likely to fall sharply when downgraded.
Some observations and comments:
"...ratings have evolved to mean different things, depending on what's being rated." If this really is true, this is not a good thing. Ratings, as long as I've been in and around the markets, have always had an absolute meeting with concrete standards for achieving a given rating. If there is now some "relative" ratings concept in play, where a AAA-rating on a corporate bond is different than a AAA-rating on the senior tranche of a CMBS vehicle, then I believe the entire underpinning of the ratings system is in jeopardy. S&P, Moody's, Fitch and your peers - say it ain't so. Please.
While I don't necessarily like the use of a pejorative term like "newfangled," and think it detracts from the strength of the argument, the point itself is valid: investors rely on ratings and generally view ratings as being fungible across asset types - corporate bonds, municipal bonds, structured bonds, structured vehicles, etc. So it is hard to overstate the role rating agencies play in permitting certain instruments to be purchased by certain classes of investors. And a AAA-rating simply opens the floodgates of potential demand for a particular instrument. So once again, ratings need to be consistent, fungible and valid, because if they're not the entire system of investment guidelines being linked to ratings will crumble like a house of cards.
"The proliferation of triple-A ratings has made it easier for pension funds and other investors to pile into newfangled bonds..."
Now, onto the really interesting stuff.
"...more complex bonds don't default in the same way -- or at the same pace -- that old-fashioned corporate bonds do.
"Over a few days in August, S&P lowered the rating on two hard-hit structured vehicles from AAA to CC, a rating on the brink of a default."
"...ratings on asset-backed securities, which include some mortgages, were more stable than corporate-bond ratings but were more likely to fall sharply when downgraded."
I was reading this and thought to myself, this all makes sense. Given the embedded optionality and complexity of the instruments underlying these structured vehicles, there is no way the analytical models used to gauge default for more vanilla bonds can possibly used here. And I'm sure (I hope?) they're not. But why is this? If you look at the comments above, the rapid decay in credit quality of certain structured vehicles and the conclusion of the Credit Suisse study, the answer becomes clear:
The nature of the risk inherent in these vehicles is convex and, as such, subject to rapid changes in value over short periods of time.
And the more I thought about this, I began to couch risk in derivative risk management terms. It is not that a property of asset-backed securities [ABS] default risk is volatility; in fact, the Credit Suisse study highlighted the stability of asset-backed securities ratings relative to corporate bond ratings. It is that a defining property of ABS default risk is gamma. And the more I thought about it, I started to draw a parallel between the nature of ABS default risk (and, therefore, a key component of its rating) and out-of-the-money [OTM] put option risk.
In this case, the investor in the ABS vehicle is long an asset and short an OTM put option, the pricing of which appears to be wrong given what has played out in the subprime market. If an investor puts money in AAA-rated ABS security, their returns will bubble along and they will collect a premium relative to investing in Treasuries. But, one day they might wake up and find that their AAA-rated security is now trading at 92, and not only that, but that there is no depth at a 92 bid. Not exactly what they were counting on. Now, there is a correct price for this type of risk and a correct rating that takes into account the non-linear nature of this exposure. But this requires both sophisticated scenario-based modeling (because any model using normal distributions in this circumstance should be thrown out, since that is not the nature of the risk being priced) and experience in pricing and managing these high gamma risks. Basically, the major rating agencies should all have top-flight derivative risk management professionals on their staffs, because these are exactly the types of risks they are purporting to rate.
I know that I never really took the time to think about structured vehicle risks this way, but I am pretty sure I'm onto something here. And I'd be interested to see how these OTM put prices impact ratings, especially now that we have some history to serve as a guide. But I suspect what we'll see is that, indeed, not all AAA-ratings are created equal. That a bunch of stuff that has been called AAA that should have been rated AA or worse. And that the embedded losses in investors' portfolios are in the tens of billions, and they're not getting it back. And that this is the real reason for not being too happy with the rating agencies. Because unless they are pricing risks this way, they've missed the boat. Maybe I'm wrong. But just maybe I'm not.