Wednesday, October 7, 2009

S&P’s CDO rating methodology is unpatriotic, outrage du jour

Posted on FT's Alphaville by Tracy Alloway:

Here’s a vitriolic demonstration of the current dilemma facing the ratings agencies.

Having been accused of ratings puffery — not being realistic or pessimistic enough when they first evaluated structured assets like collateralised debt obligations - the agencies are now being accused of being too bearish. To wit: the latest HCM Market Letter’s comments on Standard & Poor’s (H/T Sam Jones).

First, a bit of background:

On Sept. 17, S&P published a revised methodology for CDOs — the slice and dice securitisations backed by mortgages or other debt - after having flagged its revision proposal since at least March. The rating agency said the new methodology would affect nearly 5,000 deals, mostly based on corporate loans and worth about $578bn. Outstanding synthetic CDOs would likely get a downgrade of four notches, S&P said at the time. The upside was that CDOs which received triple-A ratings under the new criteria had to be able to withstand Depression era-esque default rates.

A fair trade-off? Not according to some commentators.

Here are the relevant excerpts from that HCM letter (emphasis ours):

With this announcement, S&P accomplished several things. First, the revisions constitute an admission that its prior ratings were based on profoundly flawed intellectual assumptions and ratings models. Unfortunately, they have replaced their original mistakes with equally serious ones. Second — and most important from a systemic standpoint — the revisions effectively hammer the final nails into the coffin of the securitization of corporate debt. Third, with these revisions S&P unilaterally changed the rules governing hundreds of billions of dollars of Collateralized Loan Obligations that were issued over the past few years. It did so without giving investors in these transactions any right of appeal, or any recourse to recover their potential losses. Investments were made based on earlier ratings which arguably constituted an implied promise by the ratings agencies to maintain the original set of assumptions underlying their ratings. By unilaterally changing these assumptions to account for the first time for Black Swans, S&P has broken its compact with the entire financial world that came to rely on its ratings. This post hoc approach reflects extremely poorly on the intellectual abilities of the credit rating agency.

Err, ouch.

If that wasn’t enough, though, HCM are also accusing S&P of being ignorant of the current economic environment:

Fifth, S&P is effectively raising the cost of capital for less than investment grade companies that are already suffering from a dearth of available capital sources. Moreover, it is doing so after credit conditions have improved. While the rating agency is a private sector entity, it has enjoyed the imprimatur of the Securities and Exchange Commission that requires so many areas of finance to rely on its ratings. Moves like this, which are dressed up in intellectual clothing but are little more than ex post facto attempts to correct its prior mistakes, have large systemic effects. The problem is that these systemic effects are being inflicted by an organization that has surrendered any claim to intellectual legitimacy by its prior errors. Moreover, it is compounding those errors by making changes to its ratings assumptions that fly in the face of current data that suggests that corporate credit conditions are improving, rendering its heightened default scenarios highly unlikely to occur and unsuitable for application to these structured credit products.

And what’s more, S&P’s actions pose wider problems for collateralised loan obligations — a type of CDO which securitises commercial loans:

The tragedy is that S&P’s recent move suggests that they are being permitted to stick it to investors again. The rating agencies fail to understand that corporate loans are different from bonds or mortgages. Instead, they are applying the same standards they erroneously applied to Collateralized Mortgage Obligations and Collateralized Bond Obligations to Collateralized Loan Obligations. As a result, they are downgrading CLOs and limiting their ability to provide capital to less than investment grade companies in an already difficult financing environment. They are doing this without regard to the consequences of their actions, which is to render financing harder to come by for viable companies that need access to capital. Despite improved credit conditions, less-than-investment grade companies remain faced with the same situation that they have always faced, i.e., the rationing of credit. Banks long ago exited the lending business in favor of the originate-and-distribute model, and in the aftermath of the crisis have little desire to add assets to their balance sheets. As Chart 1 on the previous page illustrates so graphically, the banks are still in the process of exiting the lending business and nobody appears to be filling the gap. One of the last men standing to purchase less-than-investment grade securities in large volumes were CLOs, and an increasing number of these are being frozen out of the market by these downgrades just as market conditions are improving. This is directly contrary to the efforts the Obama Administration is making to encourage lending, and is another reason why credit agencies should be subject to far stricter regulation in view of the damage they have already done and continue to do.

Woah — downgrading CDOs/CLOs is now unpatriotic and against Obamanomics?

Evil ratings agencies. Perhaps we can have a McCarthy-style witch hunt to purge them of their new-found realism bearishness soon.

Or maybe just another ratings flip-flop.

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