PrefBlog

DBRS has published its new Methodology: Rating Canadian Split Share Companies and Trusts, August 2009:

DBRS applies a combination of quantitative and qualitative analysis in its Preferred Share rating process. The quantitative analysis includes using an historical value-at-risk (VaR) framework to assess the likelihood of large portfolio losses based on historical data. DBRS uses VaR results together with qualitative analysis relating to general macroeconomic factors and to certain industries or companies to which the Portfolio will be exposed.

Due to the unique risk of structured Preferred Shares (i.e., exposure to equity market fluctuations), DBRS will generally not assign a rating in the Pfd-1 range to Preferred Shares unless a de-leveraging mechanism is in place to provide greater protection on the repayment of Preferred Share principal. If a de-leveraging mechanism is in place, a portion of the Portfolio equal to the principal amount of Preferred Shares outstanding will be liquidated and invested in cash or cash equivalents if the Portfolio NAV declines by a predetermined percentage. In addition to the de-leveraging mechanism, there are other structural features to mitigate declines in downside protection that are addressed in this methodology, including the suspension of Capital Share distributions if the NAV drops below a predetermined level.
…
When rating split share transactions, DBRS will assign higher ratings to Issuers with a Preferred Share dividend coverage ratio suffi ciently greater than 100%.

In general, DBRS views the strategy of writing covered calls as an additional element of risk for Portfolios because of the potential for the Portfolio to give up unrealized gains when the option gets called and, at the same time, as part of the Portfolio’s mandate, the security may need to be repurchased in the market at the higher price. Furthermore, an option-writing strategy relies on the ability of the investment manager. The investment manager has a large amount of discretion to implement its desired strategy, and the resulting trading activity is not monitored as easily as the performance of a static Portfolio. Relying partially on the ability of the investment manager rather than the strength of a split share structure is a negative rating factor.

DBRS uses a variation of the historical VaR method to assess the likelihood of large declines in downside protection. VaR is the amount of loss that is expected to be exceeded with a given level of probability over a specifi ed time period. For example, if a Portfolio has a one-day VaR of $1 million with a probability of 5%, there is a 5% probability that the Portfolio will lose at least $1 million in a one-day period.

Alternatively, there is a 95% probability that the Portfolio will lose no more than $1 million in a one-day period. Using the historical method, daily returns are calculated for a given Portfolio using price data for a historical period of time specifi ed by DBRS. Daily returns are then sorted from lowest to highest. If there are 100 daily returns and a probability of 5% is desired, the 5% VaR would be approximately equal to the fifth worst return.

Why daily?

The key consideration in gathering historical data is the time period used. There is a balance between collecting enough returns and avoiding irrelevant data due to a major shift in the Portfolio’s environment that may decrease the value of using data observed prior to the shift. DBRS will generally aim to use ten years of historical data to calculate the probability of a large decline in downside protection. Shorter periods will be used if ten years of data is not available for a particular Portfolio; however, the comparison of split share Portfolios will always be completed using identical time periods.

The VaR methodology used here doesn’t make a whole lot of sense to me. Why daily data? Why ten year periods? It seems to me that it would make more sense, for instance, to use all available data over time periods that at the very least approximate the time period of the prediction … that is to say, if a bank-based split share has asset coverage of 2.0:1 and 5-years to maturity, what is the probability of a 5-year loss of 50% for the index? What’s the probability of a such a loss if there is only 1 year to maturity?

What they’re doing is:

(4) Using the initial amount of downside protection available to the Preferred Shares, determine the dollar loss required for the Preferred Shares to be in a loss position (i.e., asset coverage ratio is less than 1.0)

(5) Solve for the probability that will yield a one-year VaR at the appropriate dollar-loss amount for the
transaction.

Contrary to the methodology used, I will assert that the probability of a one-year loss of 50% in a diversified bank portfolios is GREATER THAN the probability of a five-year loss of 50%.

And as for:

(6) Determine the implied long-term bond rating by comparing the probability of default with the DBRS corporate cumulative default probability table.

(7) Link the implied bond rating to the appropriate Preferred Share rating using an assumption that the
preferred shares of a company should be rated two notches lower than the company’s issuer rating.

I’m gonna keep thinking! I’m gonna keep an open mind! But off the top of my head I can’t figure out why this makes sense.

The Federal Deposit Insurance Corporation has released its Quarterly Banking Profile, Second Quarter 2009, with the following headlines:

• Higher Loss Provisions Lead to a $3.7 Billion Net Loss
• More Than One in Four Institutions Are Unprofitable
• Charge-Offs and Noncurrent Loans Continue to Rise
• Net Interest Margins Show Modest Improvement
• Industry Assets Decline by $238 Billion
• The Industry Posts a Net Loss for the Quarter
• Non-interest Income Grows 10.6 Percent Year-Over-Year
• Margins Improve at a Majority of Institutions
• Net Charge-Off Rate Sets a Quarterly Record
• Noncurrent Loan Rate Rises to Record Level
• Institutions Continue to Add to Reserves
• Overall Capital Levels Register Improvement
• Industry Assets Decline for a Second Consecutive Quarter
• Small Business Loan Balances Declined Over the Past 12 Months
• Institutions Reduce Their Reliance on Nondeposit Funding Sources
• “Problem List” Expands to 15-Year High

The Fed and related US agencies have released:

a proposed regulatory capital rule related to the Financial Accounting Standards Board’s adoption of Statements of Financial Accounting Standards Nos. 166 and 167. Beginning in 2010, these accounting standards will make substantive changes to how banking organizations account for many items, including securitized assets, that are currently excluded from these organizations’ balance sheets.
The agencies are issuing the proposal to better align regulatory capital requirements with the actual risks of certain exposures. Banking organizations affected by the new accounting standards generally will be subject to higher minimum regulatory capital requirements. The agencies’ proposal seeks comment and supporting data on whether a phase-in of the increase in regulatory capital requirements is needed. It also seeks comment and supporting data on the features and characteristics of transactions that, although consolidated under the new accounting standards, might merit an alternative capital treatment, as well as on the potential impact of the new accounting standards on lending, provisioning, and other activities.

Comments on all aspects of the proposed rule are due within 30 days after its publication in the Federal Register, which is expected shortly.

Note to OSFI: This is how professionals do it. They release a draft and ask for comments.

The text of the proposal explains:

The Office of the Comptroller of the Currency (OCC), Board of Governors of the Federal Reserve System (Board), Federal Deposit Insurance Corporation (FDIC), and the Office of Thrift Supervision (OTS) (collectively, the agencies) are requesting comment on a proposal to (i) modify their general risk-based and advanced risk-based capital adequacy frameworks to eliminate the exclusion of certain consolidated asset-backed commercial paper programs from risk-weighted assets and (ii) provide a reservation of authority in their general risk-based and advanced risk-based capital adequacy frameworks to permit the agencies to require banking organizations to treat entities that are not consolidated under accounting standards as if they were consolidated for risk-based capital purposes, commensurate with the risk relationship of the banking organization to the structure. The agencies are issuing this proposal and request for comment to better align capital requirements with the actual risk of certain exposures and to obtain information and views from the public on the effect on regulatory capital that will result from the implementation of the Financial Accounting Standard Board’s (FASB) Statement of Financial Accounting Standards No. 166, Accounting for Transfers of Financial Assets, an Amendment of FASB Statement No. 140 and Statement of Financial Accounting Standards No 167, Amendments to FASB Interpretation No. 46(R).

They point out:

In the case of some structures that banking organizations were not required to consolidate prior to the 2009 GAAP modifications, the recent turmoil in the financial markets has demonstrated the extent to which the credit risk exposure of the sponsoring banking organization to such structures (and their related assets) has in fact been greater than the agencies estimated, and more associated with non-contractual considerations than the agencies had expected. For example, recent performance data on structures involving revolving assets [footnote] show that banking organizations have often provided non-contractual (implicit) support to prevent senior securities of the structure from being downgraded, thereby mitigating reputational risk and the associated alienation of investors, and preserving access to cost-efficient funding.

Footnote: Typical structures of this type include securitizations that are backed by credit card or HELOC receivables, single and multi-seller ABCP conduits, and structured investment vehicles.

Question 2: Are there features and characteristics of securitization transactions or other transactions with VIEs, other SPEs, or other entities that are more or less likely to elicit banking organizations’ provision of non-contractual (implicit) support under stressed or other circumstances due to reputational risk, business model, or other reasons? Commenters should describe such features and characteristics and the methods of support that may be provided. The agencies are particularly interested in comments regarding credit card securitizations, structured investment vehicles, money market funds, hedge funds, and other entities that are likely beneficiaries of non-contractual support.

It is of particular interest that they are particularly interested in money market funds as beneficiaries of non-contractual support. OSFI refuses to consider the question. I have repeatedly urged that money market funds be considered securitizations; another article on the topic is, by the way, in press.

Of further interest to Canadians is:

The agencies propose to eliminate existing provisions in the risk-based capital rules that permit a banking organization that is required to consolidate under GAAP an ABCP program for which the banking organization acts as sponsor, to exclude the consolidated ABCP program assets from risk-weighted assets and instead assess the risk-based capital requirement against any contractual exposures of the organization arising from such ABCP programs. The agencies also propose to eliminate the associated provision in the general risk-based capital rules (incorporated by reference in the advanced approaches) that excludes from tier 1 capital the minority interest in a consolidated ABCP program not included in a banking organization’s riskweighted assets.

The agencies initially implemented these provisions in the general risk-based capital rules in 2004 in response to changes in GAAP that required consolidation of certain ABCP conduits by sponsors. The provisions were driven largely by the agencies’ belief at the time that banking organizations sponsoring ABCP conduits generally faced limited risk exposures to ABCP programs, because these exposures generally were confined to the credit enhancements and liquidity facility arrangements banking organizations provide to these programs.

Additionally, the agencies believed previously that operational controls and structural provisions, as well as over-collateralization or other credit enhancements provided by the companies that sell assets into ABCP programs, could further mitigate the risk to which sponsoring banking organizations were exposed. However, in light of the increased incidence of banking organizations providing non-contractual support to these programs, as well as the general credit risk concerns discussed above, the agencies have reconsidered the appropriateness of excluding consolidated ABCP program assets from risk-weighted assets and have determined that continuing the exclusion is no longer justified. Under the proposal, if a banking organization is required to consolidate an entity associated with an ABCP program under GAAP, it must hold regulatory capital against the assets of the entity. It would not be permitted to calculate its risk-based capital requirements with respect to the entity based on its contractual exposure to the entity.

The Kansas City Fed has released the proceedings of the 2009 Jackson Hole Symposium on Financial Stability and Macroeconomic Policy.

Ricardo J. Caballero, last mentioned on PrefBlog in connection with tail-risk insurance, presented a paper titled The “Surprising” Origin of Financial Crises: A Macroeconomic Policy Proposal, which, rather oddly, has been encrypted. He argues that three elements are necessary to produce a financial crisis:

• Negative Surprise (not that sub-prime blew up, but that linkages were so strong and that transmission was so virulent)
• Excessive Aggregation of Risk in systemically important leveraged institutions
• Slow Policy Response

Dr. Caballero proposes the establishment of Tradable Insurance Credits, issued and backed by the Central Bank. In normal times, these would carry no pay-off; in times of crisis, the Central Bank would make them convertible and holders would have the option of, essentially, converting them into Credit Default Swaps. This addresses the risk of Knightian uncertainty that was addressed in Dr. Caballero’s prior proposals.

Stephen Cecchetti, Marion Kohler & Christian Upper presented a paper titled Financial Crises and Economic Activity, also encrypted. Pretty gloomy stuff – he suggests that even in a best-case scenario, it will take years to make up for the current loss of output. Dr. Cecchetti was last mentioned on PrefBlog on April 10, 2008.

Carl Walsh presented a paper titled Using Monetary Policy to Stabilize Economic Activity, in which he suggests that, overall, Price Level Targetting is superior to Inflation Targetting, due to its automatic stabilizing influence. He cautions, however, that changing horses in mid-stream (mid-raging-torrent might be a better metaphor in this economy) is not advisable. Price Level Targetting was the subject of the BoC Spring 2009 Review and the paper’s respondant was BoC Governor Mark Carney.

Auerbach & Gale presented Activist Fiscal Policy to Stabilize Economic Activity. They explicity exclude “automatic stabilizers” (e.g., Unemployment Insurance, Welfare) from the discussion, focussing more on discretionary fiscal stimulus.

Update, 2009-8-26: Mark Carney’s response to the Walsh paper have been published by BIS.

A kind soul has sent me an unencrypted version of the Caballero paper:

Coval et. al. (2008) argue that the correlation between economic catastrophe and default by highly rated structured products went largely unappreciated by investors, who seemed to treat ratings as a sufficient statistic for pricing. Highly rated single–name CDSs and structured product tranches traded at very similar spreads (their data is for September 2004 to September 20 2007), despite the fact that on average the structured product tranche would likely default in a much worse macroeconomic state.

Regardless of whether this correlation was underappreciated or not, the systemic consequence of this risk was that highly leveraged institutions were bearing more aggregate risk than would have been thought from simply observing the ratings of their assets. Having the highly leveraged financial sector of the economy holding the risk with respect to an aggregate surprise proved to be a recipe for disaster.
…
A standard advice stemming from the moral hazard camp is to subject shareholders to exemplary punishment (the words used by Secretary Paulson during the Bear Stearns intervention). This is sound advice in the absence of a time dimension within crises. With no time dimension, all shareholders were part of the boom that preceded the crisis and as soon as the bailout takes place the crisis is over; the next concern is not to repeat the excesses that led to the crisis. Punishing shareholders means punishing those that led to the current crisis, and it is better that they learn the lesson sooner rather than later, the righteous speech goes.

However, this advice can backfire when we add back the time dimension. Now, the expectation that shareholders will be exemplarily punished if the crisis worsens delays investors’ decision to inject much needed capital. As a concrete example, sovereign wealth funds were much less eager to inject equity into the U.S. financial system after the Bear Stearns exemplary punishment policy (March 2008) than they were before the policy, as illustrated in Figure 6. Some of the capital injections that did take place after this, such as UFJ Mitsubishi’s $9 billion investment in Morgan Stanley in October 2008, only took place after the U.S. Treasury assured them that the investment would not be wiped out in a future government intervention. Conversely, destabilizing speculators and shortsellers saw the value of their strategy reinforced by the policy of exemplary punishment.23 Moreover, from the point of view of future crises, memories of this intervention may also hamper any chance of a private sector resolution as new equity will be less likely to attempt to arbitrage the initial fire sales. In other words, once the within-crisis time dimension is considered, the anti-moral hazard strategy may morph into a current and future crisis enzyme.