PrefBlog

DBRS has issued a press release, DBRS Clarifies its Approach to Rating Bank Subordinated Debt and Hybrid Instruments.

I love the word “clarifies”. It should mean “make clearer” or “resolve ambiguity”, but is nowadays used by smiley-boys to mean “changing our position while hoping you don’t notice”.

The interesting bits are as follows:

DBRS does not view the ability to defer payments as a credit risk, but rather, a risk that holders of the deferrable instruments have agreed to as per the contractual terms of the instrument and DBRS does not consider “deferral” as being equal to “default”.
…
Notching for Deferral or Skipping of Payments

DBRS will add an additional notch when instruments with discretionary payments defer or skip. This notch will be applied as long as discretionary payments are not being made. This additional notch serves to differentiate between instruments that are still making payments from those that are not paying, but otherwise meeting the instrument’s terms and covenants. As noted already, DBRS does not view the exercising of the right to defer or skip payments as equivalent to default. Typically, a bank that defers or skips discretionary payments is usually in significant difficulty, so that its senior debt rating is already under pressure and its rating has likely been lowered. That results in lower ratings for subordinated debt. Recent examples, however, have illustrated occasions when a bank may defer or skip due to regulatory events, but retain significant strength and remain investment grade. In these circumstances, the senior debt rating remains the principal driver of the likelihood that payments will be resumed and insolvency avoided.

This represents something of a change from their treatment of Quebecor World:

While the cumulative nature of the Series 3 and Series 5 preferred shares affords Quebecor World the flexibility to suspend dividends, provided dividends are paid in arrears, DBRS notes preferred shareholders maintain a level of expectation that these dividends will be paid in a timely manner, and this expectation is reflected in the preferred share ratings. Having not met the expectation of preferred shareholders, DBRS notes the preferred shares are more reflective of a “D” rating.

What’s right or wrong? There is, of course, no right or wrong.

DBRS is definitely in the wrong, though, for changing their policy under the banner of “clarification” and for not specifying just what does constitute a default under their terminology. When does a Straight Perpetual default? Not when it skips a payment, under the new policy. So when? When it enters CCCA protection? When it’s written down or otherwise has its claim on assets extinguished? When?

James Hamilton of Econbrowser has republished a paper he wrote for the UCSD Economics Department’s Economics in Action, with the title What Went Wrong and How Can We Fix It?.

He makes a few assertions which I dispute:

The institutions that originally made the loans sold them off to private banks or to the government-sponsored enterprises Fannie Mae and Freddie Mac. This system created moral hazard incentives for the originators, encouraging them to fund unsound loans. When private banks bought the loans, they packaged them into complex securities that were in turn sold off to private investors, an additional step that permitted the securitizers to profit, even if the loans were poor quality.

Increased regulation of securitization is certainly a very sexy issue nowadays, and it appears that tranche retention of some kind will be mandated in the future. Why not? It’s a nice simple story, easily understood by the man in the street and makes it look as if regulators are Taking Action. But does it mean anything?

The UK’s Financial System Authority says, in its Financial Risk Outlook 2009 (previously reported on PrefBlog:

Hence, the new model of securitised credit intermediation was not solely or indeed primarily one of originate and distribute. Rather, credit intermediation passed through multiple trading books in banks, leading to a proliferation of relationships within the financial sector. This ‘acquire and arbitrage’ model resulted in the majority of incurred losses falling on banks and investment banks involved in risky maturity transformation activities, rather than investors outside the banking system. This explosion of claims within the financial system resulted in financial sector balance sheets becoming of greater consequence to the economy. Financial sector assets and liabilities in the US and the UK grew far more rapidly as a proportion of GDP than those of corporates and households (see Chart A7 and A8).

There’s a good chart … somewhere, produced by somebody … that conveys this information in visual form, but I can’t remember where I saw it!

Anyway … since that’s what happened, what good is mandated tranche retention going to do? The banks collectively believed in their collective product and held it. If it had, in fact, been forced down the throat of poor innocent pension funds because the banks considered it a hot potato, we’d have a global pension fund solvency crisis right now and we don’t – at least, not much worse than usual.

Additionally, tranche retention is simply another excuse for the lazy not to do any work. Seems to me that if you’re buying a billion dollars worth of mortgages, maybe you should have a look at what you’re buying, regardless of whether the seller holds a 5% tranche or not. But perhaps I’m just old-fashioned that way.

I also feel Dr. Hamilton’s statement regarding AIG is imprecise, while not being incorrect:

Entities like the insurance giant AIG were allowed to write huge volumes of credit default swaps that purportedly would insure the holders of these mortgages against losses, even though AIG did not remotely have the financial ability to fulfill all the commitments it made

The issue is not that AIG wrote so much protection, but that regulators allowed banks that held it to offset risky positions without collateralization (in fact, the only financial institution with enough brains to demand collateralization, Goldman Sachs, is regularly vilified for doing so in the gutter blogs).

Regardless of one’s views on whether a central clearing house for derivatives is a good idea (I don’t think it is), it should be apparent that the driving force behind the idea is a regulatory smokescreen. Fully collateralized, so what? The regulators could have demanded full collateralization a long, long time ago – and should have: any uncollateralized exposure should have soaked up the exposed bank’s capital – but they didn’t.

I think he misses a point about Fannie and Freddie:

In the cases of Fannie and Freddie, the government created an asymmetric payoff structure in which the profits went to private investors while the losses were picked up by the taxpayers.

True enough, but that’s not the whole problem; perhaps not even the real problem. Fannie & Freddie depressed mortgage rates due to their implicit government guarantee. When Agency paper trades right on top of Treasury’s, what profit is left for private enterprise? It’s fairly well accepted at this point that one reason why Canadian banks have been so resilient is because they can earn economically satisfactory returns by holding residential mortgages (see IMF Commentary and OSFI commentary, as well as commentary on Australian banks) – they didn’t need to reach for yield.