PrefBlog

Bloomberg reports:

Ratings companies face rules including one prohibiting them making recommendations on the way products they grade are structured, the Madrid-based International Organization of Securities Commissions said today. IOSCO, the main forum for more than 100 securities regulators worldwide, said there should also be independent reviews of the way firms assign ratings.
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Ratings companies will have to “differentiate ratings of structured finance products from other ratings, preferably through different rating symbols,” the regulators said in an e- mailed summary of the code.
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Fitch said April 29 it received “limited interest” from market participants in adopting a different rating scale.
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Market participants who responded, including investors together holding more than $9 trillion in fixed income securities, “overwhelmingly” rejected the idea of a separate rating scale for asset-backed securities, Moody’s said May 14.

Nobody in their right minds really cares about a different rating scale for structured instruments – this is simply cosmetic nonsense, invented to persuade the gullible public that the Wise Regulators are Taking Firm Action. I would certainly not expect any regulator to pay the slightest attention to the overwhelming majority of credit professionals who think the idea is just a touch on the rinky-dink side.

In their “Global Structured Credit Strategy” report of May 13, 2008, Citi’s Structured Credit Products Group opined:

So we repeat the plea that we made in our earlier note4 when discussing rating agencies’ proposals for reforming their criteria in light of substantial ABS CDO downgrades. We see the emphasis on expected loss — and the comparability this creates between structured and flow credit ratings — as a tremendous advantage. Unquestionably, give analysts greater powers, and create governance procedures to make them more independent. By all means, add additional dimensions (or even pictures of return distributions) to capture tail risk. (We were thus more supportive of Moody’s proposals for providing an additional “volatility” dimension, leaving the “core” rating still intact yet providing important new information).

This makes sense … I would consider a second dimension in credit ratings to be valuable advice and I would take such advice seriously when formulating my own views. This would, however, require some thought and consideration on the part of third parties to be useful, and requiring such thought and consideration would make it virtually impossible for untrained bank tellers to sell the product; and one purpose of regulation is to make all investments plain vanilla, so they can be sold efficiently with huge profits by banks, which will in turn enable them to hire even more ex-regulators.

This is important! IOSCO notes in its press release announcing changes to the code of conduct:

CRAs should … establish policies and procedures for reviewing the past work of analysts that leave the employ of the CRA

The actual report states:

A CRA should establish policies and procedures for reviewing the past work of analysts that leave the employ of the CRA and join an issuer that the analyst has rated, or a financial firm with which an analyst has had significant dealings as an
employee of the CRA.

Sauce for the goose is most emphatically not sauce for the gander, is it?

Another howler from IOSCO’s press release is:

CRAs should … to discourage “ratings shopping,” disclose in their rating announcements whether the issuer of a structured finance product has informed it that it is publicly disclosing all relevant information about the product being rated;

Now, you’ll never hear me complain about too much disclosure, so I don’t have any major problems with this one … but I’d like to hear a discussion of just how well the philosophy behind this recommendation ties in with Regulation FD and National Policy 51-201.

Somewhat to my surprise, their actual report manages to come up with a sensible comment about the relationship between credit quality, liquidity and price (emphasis added):

The subprime market turmoil has also highlighted another common misperception that credit risk is the same as liquidity risk. Historically, securities receiving the highest credit ratings (for example, AAA or Aaa) were also very liquid – regardless of market events, there could almost always be found a buyer and a seller for such securities, even if not necessarily at the most favorable prices. Likewise, prices for the most highly rated securities historically have not been very volatile when compared with lower-rated securities. Indeed, in some jurisdictions regulations regarding capital adequacy requirements for financial firms implicitly assume that debt securities with high credit ratings are both very liquid and experience low volatility. However, the links between low default rates, low volatility and high liquidity are not logical necessities. Particularly with respect to certain highly-rated, though thinly-traded subprime RMBSs and CDOs, a high credit rating has not been indicative of high liquidity and low market volatility.

The credit crunch was largely just another episode of animal spirits and irrational exuberance. There are certainly some relatively innocent victims – those unable to get a mortgage, for instance, or who have to refinance as usurious rates – but really, no more or less unpleasant than any other episode. I graduated from university during a recession. Life’s unfair. Get used it to it.

To the extent that serious harm was done, it was largely the product of regulation. Regulators in many cases did not impose a rational cap on the Assets to Capital Multiple for many banks; guarantees (both explicit and implicit) for off-balance sheet instruments were not charged against capital at a high enough rate (one example is money market funds, not just SIVs); concentration risk was not charged to capital (at least, not sufficiently) and big changes in capital requirements upon credit downgrade fostered cliff risk and crowded trades. It also strikes me that capital requirements on debt could be adjusted by issue size (as an objective, albeit sometimes incorrect, proxy for liquidity) … there is clearly a difference between US Treasuries, where investors want a minimum $20-billion issue size and a tranche of RMBS with perhaps $300-million issued.

But the credit raters are a convenient target.

Accrued Interest has come out in favour of Exchange Traded Credit Default Swaps in a new post:Bailouts, Wall Street, and the Bad Motivator, although he does not go so far as some in claiming that over-the-counter trading should be (effectively) banned.

I addressed a similar exhortation in my post Leverage, Bear Stearns & Econbrowser.

I’m not a proponent of Exchange Trading for CDSs – I can see a useful purpose being served by a clearinghouse, but exchanges are set up so that non-institutional players get to play. I will defer to any those with better information, but I don’t sense any clamour from retail to trade in Credit Swaps … several attempts to set up an exchange have died on the vine (see Update #4 to the ‘Econbrowser’ post) although I don’t know to what extent retail was invited to the party. By me, exchange trading will involve enormous listing fees and a huge bureaucracy to list a plethora of CDSs that will trade by appointment only at 100bp spreads. What’s the point?

While I have great respect for Accrued Interest, I think there are a number of misconceptions embedded in his post:

Had Bear Stearns been allowed to fail, banks world wide would have lost their counter-party on various derivative transactions.

Well, no. As I pointed out on the ‘Econbrowser’ post:

as far as the counterparties were concerned, their counterparty was not BSC per se, but wholly-owned, independently capitalized, highly rated subsidiaries of BSC. Just how adequate the capital, accurate the ratings, and ring-fenced the assets actually were is something I am not qualified to judge – seeing as how I haven’t even seen any of the guarantees and financial statements in question. But neither, it would appear, has Prof. Hamilton.

I should note that I brought this up in the comments to the Accrued Interest post:

JH: I don’t believe that this is correct. See my post Leverage, Bear Stearns & Econbrowser
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James: I read your piece at the time. My reaction is that we don’t really know what would have happened if BSC actually declared bankruptcy.

Accrued Interest goes on to postulate:

Let’s say you allow Bear Stearns to fail and that caused XYZ bank to fail. Is that capitalism? Forcing XYZ to suffer for the sins of Bear Stearns?

I say … yes, that is capitalism, but no, it’s not forcing XYZ to suffer for the sins of BSC. It is forcing XYZ to suffer for their own sins in not demanding adequate collateralization from BSC when their position started winning (if XYZ’s trade was losing, BSC’s bankruptcy would not affect them). If XYZ failed, it would be due not only to insufficient collateralization, not only due to their extending far too great a credit line to BSC, but also a failure of regulation in not having previously assigned a capital charge to XYZ that reflected their risk.

When a position – of any kind – gets marked-to-market, P&L changes. If the position is winning and profit increases, then shareholders’ equity increases. So far, so good. But the credit exposure to the counterparty has also increased … it’s a loan to the counterparty and gets charged as such. In any reasonable regime, collateralization will reduce the risk measured from the gross exposure. It may, upon sober review of the evidence, be deemed necessary to fiddle with these various calculations of Risk Weighted Assets, but I fail to see a need for anything more.

Next! Accrued Interest then claims:

The first step is obvious. Credit-default swaps need to be exchanged-traded.

I don’t see that at all. If we accept for a moment that counter-party risk is out of hand (I don’t accept it, but let’s continue the discussion) then exchange trading is only one option. The option that minimizes change would be a clearing-house, whereby the clearing house acts as the counterparty for all trades and the clearing-house itself is guaranteed by each of its members. An exchange would incorporate this function, but the functionality does not require an exchange.

Accrued Interest continues:

There would be some relatively simple ways to bring such a thing about. What if banks were required to recognize the credit risk of their counter-parties directly?

They are. Assiduous Readers will remember that I looked at Scotiabank’s capitalization today. According to page 23 of their supplementary information, their Basel-I Risk-Weighted-Assets of 252.8-billion includes 240.5-billion of credit risk, which includes 34.0-billion of “Off-Balance Sheet Assets – Indirect Credit Instruments”. If we go to the OSFI website and look at Scotia’s 1Q08 “BCAR Derivative Components”, we find that they have Credit Derivative Contracts [OTC] of $108.9-billion outstanding (and those are REAL dollars, none of that sub-par American muck) giving rise to a replacement cost of $3.1-billion and a credit equivalent amount of $8.1-billion which (when combined with other derivatives) gives rise to a Risk-Weight-Equivalent of $10.7-billion … just over 4.2% of their total risk-weighted assets.

One may wish to twiddle with the numbers – converting the notional amounts and unrealized P&L in different ways to get different Risk-Weighted-Assets. But it is not correct to imply that the credit risk is not currently recognized.

Accrued Interest continues:

I think back to banks needing to reserve for losses dealt to them by XLCA/FGIC/Ambac/MBIA’s potential failure to perform on CDS contracts.

Now, this is a legitimate concern. According to OSFI Guidelines (Section 3.1.5, page 31) claims on Deposit Taking Banks of an AAA to AA- sovereign carry a risk-weight of 20%, which is the same as similarly graded corporates (section 3.1.7). Single A comes at 50%, BBB+ to BB- is 100% and let’s not go further.

If we look at the quarterly report for CM, we find:

During the quarter, we recorded a charge of US$2.30 billion ($2.28 billion) on the hedging contracts provided by ACA (including US$30 million ($30 million) against contracts unrelated to USRMM unwound during the quarter) as a result of its downgrade to non-investment grade. As at January 31, 2008, the fair value of derivative contracts with ACA net of the valuation adjustment amounted to US$70 million ($70 million). Further charges could result depending on the performance of both the underlying assets and ACA.

The problem here is: they (effectively) made a loan of USD 2.37-billion to ACA and have now written down 2.30-billion of it. Why were they making (effective) loans of this size to a single (effective) borrower?

It is my understanding that many of the monolines were refusing to write protection unless they were exempted from collaterallization, on the grounds that they were AAA rated. It is my further understanding that this was just fine by some of the banks and brokerages. Well, it’s a business decision. As long as it’s adequately charged, it can remain a business decision.

I will certainly agree that loans of this size to a single party (equivalent to about one-sixth of their October 2007 capital) should have attracted a concentration charge, on top of the regular charge for corporate debt. But this – the existence or lack thereof of concentration charges in capital requirements – is what we need to talk about, without jumping into mandatory exchange trading of CDSs!

Accrued Interest concludes:

Why not just make them reserve a larger amount for this possibility up front? Efforts to start an exchange would begin the next day.

Well … maybe. To the extent that the exchange’s clearing-house’s credit would be better than the sum of its sponsoring parts, it is entirely reasonable to suppose that $1-billion exposure to a clearing-house would be charged at less than 10x$100-million to its individual members. It may also be assumed that netting and novation will be facilitated with a clearing house, which will further reduce exposure.

Whether or not the improvement in credit quality and consequent (we hope) reduction in capital requirements balances the guaranteed extra costs and reduced flexibility implied by a clearing-house is something that can be discussed … and the decision regarding institutional participation in such a scheme becomes just another business decision. But let’s see some numbers first.

Update, 2008-5-28: Naked Capitalism reprints a Financial Times rumour of an announcement tomorrow. This will, as far as I can tell, make formal a proposal aired in April that has been well reported:

“There is not one element that is going to solve all the problems, but it is one piece of the puzzle that will help us create a more robust framework. The timing is right – whether it will be successful or not, only time will show,” says Athanassios Diplas, chief risk officer and deputy chief operating officer, global credit trading, at Deutsche Bank, speaking at Isda’s twenty-third annual general meeting in Vienna on April 17.

The initial focus of those involved in the discussions has been on index products. Over time, efforts will extend to single-name CDSs. According to Diplas, this will remove risk from the system and the worry that the failure of one dealer could cause a hazardous shock in the market.

No details were given on a time frame for when a central clearing house would be established, but Diplas says the admission criteria for participants would be strict. “The criteria will take into account how well capitalised the firm is, how the risk is dealt with, how the variation margins are going to be posted and what the expected gap risk is going to be. All these issues have to be dealt with carefully – we are not going to jump into something unless we are very confident it will work.”

Update, 2008-6-19: See the market update of June 9 for news of how the proposal is moving along. Accrued Interest has posted another good piece about CDS clearing and exposures.