Now for Part 2 on Gary Gorton’s theory of "information-insensitive debt" in which we continue to study the question, "Is it a bad thing or is it a really bad thing?" :)
One big problem: the concept happens to be quite unnatural.
Fiat currency is probably the best example of information-insensitive debt, but it's essentially a trivial, artificial case. Retail banking deposits also qualify as a good example, but they're something different: a special case. Exactly how they're special is important to understand.
WHAT MAKES BANKING DEPOSITS REALLY, REALLY SAFE?
Gorton likes to illustrate the information insensitivity of retail banking deposits by using an example involving a check. Let's say I write a check for a $14 haircut. That piece of paper isn't worth $13.89 or $14.05 to my barber. It's worth exactly $14.
Likewise, if I go directly to my bank instead to withdraw that $14, I can be sure of getting the full amount, even if my bank is Lehman Brothers Savings Inc. and everyone's glumly packing their desk contents into boxes when I arrive. The FDIC insures my deposits up to $250,000. I can breathe easily.
So it doesn't behoove me, or anyone I trade with, to spend time investigating the financial soundness of my bank. No matter what terrible information surfaces about that bank, my deposits are covered.
See a problem already? The debt isn't naturally insensitive to information. It achieves this property by being insured. But the value of anything -- your collection of Pokemon cards or seashells -- can become information insensitive if insured. So, becoming information insensitive this way feels like cheating a bit.
That leaves the tantalizing question: which debt is naturally information insensitive?
None of it, really. On its face, the phrase is oxymoronic, like “jumbo shrimp.” (Note: Gorton parses the term in a special way, which we'll look at later.)
DEBT IN THE WILD IS NATURALLY SENSITIVE TO INFORMATION
Pretty much all debt in its natural state is information sensitive. Markets trade on this information. Some is public. Some is private (e.g., a stock price spikes right before a merger announcement, as the news leaks out). Much information arguably occupies a gray area between public and private. Is private analysis of public data showing that a bond is undervalued private or public information?
Even fear and wild speculation is information of a sort. Say there's a rumor that a neutron bomb will be detonated in Microsoft's main cafeteria tomorrow, based on absolutely nothing. If enough stupid investors believe it (ever hear the phrase "dumb money"?), they may sell their bond holdings in the software giant. Information about this crazy rumor will prompt a smart trader to jump in, scoop up Microsoft debt, and score a neat profit when the price rebounds.
A smart theory would posit that just about all debt is information sensitive. The theory might make an argument that there are varying degrees of sensitivity, and that a particular instance of debt lies on a continuum between very information sensitive and not-that-information sensitive. Okay, fine -- that would at least be nuanced and cautious. But instead, in Gorton's world, we get debt that is either "information insensitive" or "information sensitive" -- and of course debt that lurches from the former to the latter during a financial panic, as if undergoing a change of phase, like ice to water.
SO WHY SHOULD ANYONE CARE ABOUT ANY OF THIS IN THE FIRST PLACE?
Because there’s a shadow banking system in the U.S. that’s larger than the retail banking system. It’s where the financial crisis began in 2008.
Information-insensitive debt plays a key role in shadow banking’s repo market, according to Gorton (later, we’ll look at how repo works). Asset-backed securities, for example, are posted as collateral against repo borrowings. During the financial crisis, the securities suffered huge haircuts once they became "information sensitive" (or once investors discovered they more closely resembled magic pigs than Treasuries). At the same time, Gorton notes, other kinds of debt suffered very minor haircuts.
So here’s something to ponder: If we must have "information-insensitive" debt in our financial system, shouldn't we look to these other types for what it should look like, and not to securitizations that are opaque and become thinly traded with alarming suddenness?
Next: Gorton’s own definition of information-insensitive debt comes up short.
Sunday, August 21, 2011
Everything You Always Wanted to Know About Information-Insensitive Debt But Were Afraid to Ask
Over the last few months, I’ve spent a lot of time studying the idea of "information-insensitive debt" (also known less gracefully as "informationally insensitive debt"). Gary Gorton, a professor at Yale’s graduate business school, appears to be the intellectual progenitor (or one of them) of this concept. In 1990, he wrote an academic paper with George Pennacchi titled "Financial Intermediaries and Liquidity Creation."
My fascination with information-insensitive debt arose from a sneaking suspicion that it was a bad thing (except for a couple of notable exceptions). My keen interest in writing about it, after all this research, arises from a conviction that it is a bad thing, and that the theory itself isn't much good either.
A rough-and-ready definition of information-insensitive debt -- we'll return later to Gorton's own more nuanced and precise definition -- is this, by way of Felix Salmon:
MAKING BACON OFF MAGIC PIGS
To begin this series of posts about information-insensitive debt (there’s waaay too much to fit into a single piece, unfortunately), let me introduce you to my magic pigs.
Each magic pig is worth exactly $1 million. Its astonishing value resides in something I call a noumenon. When asked what this noumenon is, which is a thing unseen, I gladly provide a 9,000-word document, with much high-level math and abstruse concepts and economic formulas, to justify its value. I trade a lot in financial markets, and whenever my counterparty demands collateral, I offer bonds entitling him to a number of my magic pigs, should I fail to deliver on whatever I have promised.
So when $10 million of collateral is requested, I hand over certificates for 10 magic pigs. My counterparty doesn't object: the whole market has accepted that these pigs are magic and worth $1 million apiece (after all, I do have documentation and the pigs have been rated top grade by Standard & Poor’s -- ignore for the moment their pro-animal bias, as one of their officials once famously observed, “It could be structured by cows and we would rate it”).
Sometimes I sell a magic pig for $1 million, and the holder of that pig then uses it for collateral, or sells it. Or whatever. Because the value of the pig lies in this complex noumenon, no market participant has any advantage in trying to profit on my pigs (through trading), by first gaining private information. And if a leg falls off a pig, that doesn't matter because its noumenon isn't affected. Even if the pig dies, its noumenon stays intact. So it's still worth $1 million.
The certificates for my magic pigs are truly information insensitive debt -- at least, until I am revealed as a fraud, at which point they very rapidly become information sensitive and start rising and falling in accordance with the market on hog futures.
Next: What do “jumbo shrimp” and “information-insensitive debt” have in common?
My fascination with information-insensitive debt arose from a sneaking suspicion that it was a bad thing (except for a couple of notable exceptions). My keen interest in writing about it, after all this research, arises from a conviction that it is a bad thing, and that the theory itself isn't much good either.
A rough-and-ready definition of information-insensitive debt -- we'll return later to Gorton's own more nuanced and precise definition -- is this, by way of Felix Salmon:
Financial assets which (normally) don’t change in price when new information about them emerges.Now if you're a markets-oriented person, this very idea should make your skin crawl from the get go. What kind of zombie asset doesn't change in price when new information about it emerges? How weird is that?
MAKING BACON OFF MAGIC PIGS
To begin this series of posts about information-insensitive debt (there’s waaay too much to fit into a single piece, unfortunately), let me introduce you to my magic pigs.
Each magic pig is worth exactly $1 million. Its astonishing value resides in something I call a noumenon. When asked what this noumenon is, which is a thing unseen, I gladly provide a 9,000-word document, with much high-level math and abstruse concepts and economic formulas, to justify its value. I trade a lot in financial markets, and whenever my counterparty demands collateral, I offer bonds entitling him to a number of my magic pigs, should I fail to deliver on whatever I have promised.
So when $10 million of collateral is requested, I hand over certificates for 10 magic pigs. My counterparty doesn't object: the whole market has accepted that these pigs are magic and worth $1 million apiece (after all, I do have documentation and the pigs have been rated top grade by Standard & Poor’s -- ignore for the moment their pro-animal bias, as one of their officials once famously observed, “It could be structured by cows and we would rate it”).
Sometimes I sell a magic pig for $1 million, and the holder of that pig then uses it for collateral, or sells it. Or whatever. Because the value of the pig lies in this complex noumenon, no market participant has any advantage in trying to profit on my pigs (through trading), by first gaining private information. And if a leg falls off a pig, that doesn't matter because its noumenon isn't affected. Even if the pig dies, its noumenon stays intact. So it's still worth $1 million.
The certificates for my magic pigs are truly information insensitive debt -- at least, until I am revealed as a fraud, at which point they very rapidly become information sensitive and start rising and falling in accordance with the market on hog futures.
Next: What do “jumbo shrimp” and “information-insensitive debt” have in common?
Saturday, August 6, 2011
S&P Demonstrates Its Utter Hypocrisy
This morning, I saw S&P had "bravely" downgraded the U.S. to AA+.
What horsecrap.
If nothing else, this shows how irrelevant ratings have become.
Yields on 10-year Treasuries are about 2.5 percent, nearly at historical lows. Every time the market catches a whiff of fear, investors pile into Treasuries. U.S. debt is considered about the safest stuff out there, bar none, as indicated by the yield.
The yield is truth, the market itself speaking.
Meanwhile, S&P is still willing to rate lots of securities AAA -- if you call them CDOs and pay S&P a handsome fee for the rating, even when these securitizations are paying a yield that far exceeds that on U.S. government debt.
What we're seeing today is just rank hypocrisy from a ratings service that has the gall to claim that AAA is AAA, across asset classes.
Tip to Washington: just figure out a way to combine and tranche your Treasuries in some kind of god-awful complex structure -- make it really, really complicated -- then go back and pay S&P a fat fee to rate the mess. You'll get your AAA back. I guarantee it.
What horsecrap.
If nothing else, this shows how irrelevant ratings have become.
Yields on 10-year Treasuries are about 2.5 percent, nearly at historical lows. Every time the market catches a whiff of fear, investors pile into Treasuries. U.S. debt is considered about the safest stuff out there, bar none, as indicated by the yield.
The yield is truth, the market itself speaking.
Meanwhile, S&P is still willing to rate lots of securities AAA -- if you call them CDOs and pay S&P a handsome fee for the rating, even when these securitizations are paying a yield that far exceeds that on U.S. government debt.
What we're seeing today is just rank hypocrisy from a ratings service that has the gall to claim that AAA is AAA, across asset classes.
Tip to Washington: just figure out a way to combine and tranche your Treasuries in some kind of god-awful complex structure -- make it really, really complicated -- then go back and pay S&P a fat fee to rate the mess. You'll get your AAA back. I guarantee it.
Saturday, April 16, 2011
Felix Salmon: Quote of the Week
I was beginning to despair this week. It seemed like the theme was Free Market Idiots Run Amok and someone had forgotten to tell me to put on my Atlas Shrugged underwear.
First, there was Larry Summers saying don't blame financial innovation, but rather, the housing bubble, for the Financial Crisis on Steroids that we went through. Which leaves me wondering: This guy was the president of What-vard? You gotta be kidding.
Larry has nary a disparaging word to utter about any CDO, CLO, CDS, SIV, RMBS, CMBS, REMIC, re-REMIC, structured note. None of those products are bad, fee-gouging, or in any way contributed the teensiest to systemic instability?
Thus, I sentence the estimable Mr. Summers to hereafter receive all his compensation as an income stream from the bottom tier of a synthetic CDO squared.
The second forehead-slapper was Peter Wallison, who at this point isn't even interesting any longer. He's too busy riding his ideological hobbyhorse: Fannie and Freddie are the chief perps in the financial crisis, get the government out of the housing market, private enterprise can do no wrong, blah blah blah. His latest wildly inaccurate piece, on the Bloomberg Web site, was easily shredded by Daily Kos.
Which brings me to Salmon's quote of the week ... the antidote to all the uninformed opinion.
Responding to Gary Gorton's assertion that we need "informationally insensitive financial assets" (debt whose price doesn't change when new information about it emerges), Salmon is quick to respond, "No, we don't."
Gorton likes to think there was an irrational panic in the shadow banking system. He's right there was a panic, but it was more the sort of panic you experience when you realize the gold bars you're holding are bricks of horse manure spray-painted gold. It wasn't all that irrational. And to prevent that kind of panic, you need assets to be more informationally sensitive, and constantly adjusting for risk -- not less sensitive.
First, there was Larry Summers saying don't blame financial innovation, but rather, the housing bubble, for the Financial Crisis on Steroids that we went through. Which leaves me wondering: This guy was the president of What-vard? You gotta be kidding.
Larry has nary a disparaging word to utter about any CDO, CLO, CDS, SIV, RMBS, CMBS, REMIC, re-REMIC, structured note. None of those products are bad, fee-gouging, or in any way contributed the teensiest to systemic instability?
Thus, I sentence the estimable Mr. Summers to hereafter receive all his compensation as an income stream from the bottom tier of a synthetic CDO squared.
The second forehead-slapper was Peter Wallison, who at this point isn't even interesting any longer. He's too busy riding his ideological hobbyhorse: Fannie and Freddie are the chief perps in the financial crisis, get the government out of the housing market, private enterprise can do no wrong, blah blah blah. His latest wildly inaccurate piece, on the Bloomberg Web site, was easily shredded by Daily Kos.
Which brings me to Salmon's quote of the week ... the antidote to all the uninformed opinion.
Responding to Gary Gorton's assertion that we need "informationally insensitive financial assets" (debt whose price doesn't change when new information about it emerges), Salmon is quick to respond, "No, we don't."
Informationally-insensitive debt is the best repository the world has ever constructed for housing tail risk in an invisible and impossible-to-measure manner.That's a great line. Because "informationally insensitive debt" (except when applied to common currency, which is arguably a trivial usage) is a dangerous, oxymoronic twist of phrase. The varieties of "informationally insensitive debt" spawned in the shadow banking system, and used in the repo market before the financial crisis, didn't collapse because of a panic. Rather, the values plunged because investors realized this debt was complex, misrated and overvalued.
Gorton likes to think there was an irrational panic in the shadow banking system. He's right there was a panic, but it was more the sort of panic you experience when you realize the gold bars you're holding are bricks of horse manure spray-painted gold. It wasn't all that irrational. And to prevent that kind of panic, you need assets to be more informationally sensitive, and constantly adjusting for risk -- not less sensitive.
Monday, March 7, 2011
In Case You Were Thinking That Lawsuits Might Reform the Credit Raters ...
Well, think again.
Time to play connect the dots, with the New York Times getting us started in fine fashion. First, the article linked above notes a disturbing trend taking shape:
And the SEC blinked. Actually, double-blinked. Check out this whopping beaut of negligence:
Okay, now let's do the New York Times one better and finish connecting the dots for them. Because left unanswered is a big question: why the hell are credit rating services so scared of being held responsible for how they grade asset-backed products?
Jeez, I think I know this one -- in fact I think I blogged this one -- twice over! Just go here for a full explanation:
The Ratings Charade Continues: a CLO Investigation, Part I
The Ratings Charade Continues: a CLO Investigation, Part II
You see, the credit rating companies can't afford to be held legally responsible for the grades they assign to asset-backed securities, such as collateralized loan obligations, because they know they would lose in court if these ratings were challenged! The ratings are clearly bogus. I show that above, using nothing more sophisticated than sixth-grade math.
Further, these companies must know their ratings on asset-backed securities are wrong, unless they're incompetent to a mind-blowing degree.
And now the SEC is giving Standard & Poor's and Moody's a free ride on their bogus ratings, aiding and abetting the crime ...
What a great country we live in, eh? Where does the U.S. rank on that global corruption scale again? ;)
Time to play connect the dots, with the New York Times getting us started in fine fashion. First, the article linked above notes a disturbing trend taking shape:
... since Dodd-Frank passed, Congress’s noble attempt to protect investors from misconduct by ratings agencies has been thwarted by, of all things, the Securities & Exchange Commission. The S.E.C., which calls itself “the investor’s advocate,” is quietly allowing the raters to escape this accountability.What accountability? As Gretchen Morgenson tells us:
The Dodd-Frank financial reform law, enacted last year, imposed the same legal liabilities on Moody’s, Standard & Poor’s and other credit raters that have long applied to legal and accounting firms that attest to statements made in securities prospectuses. Investors cheered the legislation, which subjected the ratings agencies to what is known as expert liability under the securities laws.Why would the SEC do anything that subverts Dodd-Frank so openly? Aren't these our brave regulators, our white knights (yes, with a fondness for porno, but what do you expect in the postmodern age)? Ah, but see, there was a problem when push came to shove on this "expert liability" point.
When Dodd-Frank became law last July, it required that ratings agencies assigning grades to asset-backed securities be subject to expert liability from that moment on. This opened the agencies to lawsuits from investors, a policing mechanism that law firms and accountants have contended with for years. The agencies responded by refusing to allow their ratings to be disclosed in asset-backed securities deals.So basically, the credit rating services said, "We'll hold our breath until we turn blue."
And the SEC blinked. Actually, double-blinked. Check out this whopping beaut of negligence:
At the time, the S.E.C. said its action (i.e., the agency temporarily removed the "expert liability" threat and said it wouldn't bring enforcement actions against issuers that did not disclose ratings in prospectuses) was intended to give issuers time to adapt to the Dodd-Frank rules and would stay in place for only six months. But on Jan. 24, the S.E.C. extended its nonenforcement stance indefinitely.Indefinitely. Golly, that has a sort of open-ended ring to it. Hey, let's face it: Like diamonds, indefinitely may be forever.
Okay, now let's do the New York Times one better and finish connecting the dots for them. Because left unanswered is a big question: why the hell are credit rating services so scared of being held responsible for how they grade asset-backed products?
Jeez, I think I know this one -- in fact I think I blogged this one -- twice over! Just go here for a full explanation:
The Ratings Charade Continues: a CLO Investigation, Part I
The Ratings Charade Continues: a CLO Investigation, Part II
You see, the credit rating companies can't afford to be held legally responsible for the grades they assign to asset-backed securities, such as collateralized loan obligations, because they know they would lose in court if these ratings were challenged! The ratings are clearly bogus. I show that above, using nothing more sophisticated than sixth-grade math.
Further, these companies must know their ratings on asset-backed securities are wrong, unless they're incompetent to a mind-blowing degree.
And now the SEC is giving Standard & Poor's and Moody's a free ride on their bogus ratings, aiding and abetting the crime ...
What a great country we live in, eh? Where does the U.S. rank on that global corruption scale again? ;)
Saturday, February 5, 2011
The Ratings Charade Continues: A CLO Investigation, Part II
To bring you up to speed on this exciting melodrama:
Last time I showed you why CLO (collateralized loan obligation) ratings are almost certainly a scam, and why Mr. Ratings Guy from Standard & Poor's should know as much. It was (I hope) a math-lite and entertaining trip through the bowels of high-finance complexity, Wall Street style.
Of course I reached the end of the rather long post with more questions than answers. Why does this ratings scam exist in the first place? Who benefits? Who loses? In today's conclusion, we'll look at the not-so-surprising answers. Center stage in this discussion will be the misrated AAA tranche. It's the largest CLO piece by far, a good 70 percent or so of the overall fund -- and, as you're about to find out, that's no accident.
So why does Mr. Ratings Guy turn a blind eye to ratings that, deep in the pit of his stomach, he knows can't be correct?
Remember Upton Sinclair's little gem of wisdom:
So S&P gets paid more to rate CLOs. If the company started to challenge specific CLOs -- if it dared to say, "You know, these ratings don't make sense for this CLO" and began to push back against investment banks, one of two things would happen. (1) The bank, realizing its screwy models had been sussed out, would not structure more CLOs. (2) The irritated bank, which is paying the ratings firm, would simply find another ratings patsy -- Moody's? -- to play along with the bogus rankings for a big fee check.
Either way, it's clear what happens to S&P: It loses a rather fat revenue stream.
Now, why does the investment bank want to structure these things in the first place? This is pretty easy to answer too. Fees, fees, fees, fees. Underwriting fees for CLOs run to 1.75 percent, compared with an average of 0.4 percent for investment-grade bonds, according to Bloomberg News data.
Okay, that explains what's going on on the supply side. But it takes at least two to play in the markets. What's the incentive for the investor to buy misrated CLOs? Is the investor just the naive fool here, hoovering up misrated junk that will later plunge in value, leading him finally to clap a hand against his forehead and exclaim, "Oh, what a terrible mistake I have made!"
Probably not. At least not anymore. Recall that well-worn saying, "Fool me once, shame on you, fool me twice, shame on me."
There was a lot of complex, securitized crapola that cratered during the financial crisis (and has since recovered in value to some degree, but not to the degree that its initial AAA ratings would suggest is proper). So investors got caught playing with the effluvia from the sewer pipe and got burned. Are they really as stupid as they once were?
Nope. In fact, just return to my first post and look at what the tranches of a CLO pay these days. The "AAA" piece that, pre-credit crisis, would have paid 25 basis points plus the Libor rate, now yields 160 to 170 basis points plus Libor. Big, big difference. For those who aren't finance geeks, here's what that means in actual interest rates: three-month Libor is about 0.3 percent, so the CLO buyer who in 2006 would have accepted 0.55 percent as initial interest (assuming today's Libor) now insists on more than three times as much, or as much as 2 percent.
Last time we proved the ratings are an illusion, a clever chimera ... so let's say today's investor, being smarter about these CLOs, knows the game too. What does the 2 percent imply about the true rating? Well, you'd have to skip down S&P's ratings scale a bit to find the "true" rating, based on what investors are willing to pay. And that happens to be about six or seven rungs below the professed rating: much closer to "junk" level than AAA.
This is essentially what the investor is saying to the investment bank selling this stuff: "Sure, I'll take some of that 'AAA.' I know the market is just irrationally frightened of CLOs right now -- (nudge, nudge, wink, wink). I know that I'm getting real AAA at a great price, just because this asset class is out of favor because of the lingering taint from the financial crisis that has unfairly tarred securitized products! (nudge, nudge, wink, wink)."
Inside the investor is thinking: "Yeah, AAA my ass."
Now you may be wondering: What's the incentive for an investor to do this? What's the point of going along with this charade? And this is where things get interesting. There are a number of good reasons to play along with the fake "AAA" ratings:
1. You can use the AAA ratings to burnish your investment results. Say you manage a money market fund that can buy only AAA securities. You can sneak some pseudo AAA into your portfolio and goose your returns. How? Because it's rated AAA, but it pays about 165 basis points more than Libor, or more than three times ordinary AAA. So you'll look like a genius, outperforming your peers, until this junk explodes in your hands (and that could take a while -- remember, it's still probably investment grade, just a good deal lower than AAA).
Update: Ah, the perils of working too quickly! I meant to check out investing requirements for money market managers because I feared -- and I was right -- that my example doesn't work because they can't buy certain AAA products. It turns out money market funds must contain investments with a maximum weighted average maturity of 60 days. (A lot of structuring does spin out tranches with special A-1 or P-1 ratings that are of this shorter, desired maturity, but I don't think any CLOs do.) However, the idea still holds for other AAA-only fund managers: They can use pseudo-AAA from a CLO to burnish their results. A relevant fund for such a strategy might look more like one of these (note: the funds on this Web page invest in "AAA-rated fixed-income products" so I'm not sure if "structured fixed-income products" could qualify for the portfolio, but clearly if they could, the money manager will quickly jump to the head of the class, using pseudo-AAA from a CLO as "performance steroids," if you will.)
2. Certain entities, such as insurance companies and pension funds, have limits on what they can invest in. They can buy only AAA, or a certain percentage of their investments must be rated AAA. So these "AAA" (wink, wink) CLO tranches fit that criterion. This then becomes a neat little way to do an end run around an investing mandate that seems too restrictive to them, especially when they are under pressure to achieve higher returns (pension funds).
3. AAA securities are very useful in the huge "repo" market, where they are used to secure overnight loans, sometimes being rolled over continually. While AAA CLOs may be subject to higher haircuts (or discounts) than say a AAA Treasury, they still may find an important role once again in the repo market.
4. The new Basel III rules are coming, the new Basel III rules are coming! They are intended to make sure that a bank has enough capital to withstand shocks. These rules determine capital adequacy based partly on -- surprise! -- ratings of assets a bank holds. So having a bunch of misrated AAA on its books will help a bank heap on the risk again and plump up profits.
From Minyanville (my bold):
For one, the existence of this ratings scam has the potential to create a distortionary effect in the market. It hasn't yet -- CLO issuance has dropped off a cliff since the glory days of several years ago -- but if the CLO machine cranks up again, suddenly there will be greater investor appetite for the securitizations. Now what's the hamburger that needs to go into the CLO meat grinder to produce these sweet patties of higher-than-normal yield? Leveraged loans. And who takes out leveraged loans? Private-equity firms. And why do they? To engineer sometimes-destabilizing takeovers that load up companies with debt.
So we encourage distortionary economic activity, higher leverage, more debt ... though in the short run, all this will give us a little meth-type boost in prices of stocks and other assets, and investors will feel a little richer, and we'll buy a few more big-screen TVs, and take a few more Acapulco vacations, and exult about how it's great we survived that bad ol' financial crisis ...
Now for the $64,000 question, the one that really matters.
Who's on the hook when all this collapses?
When CLOs go belly up, and massive wealth is destroyed, and credit freezes, and money market funds are about to break the buck once more, and we gnash our teeth and scream, "How can this be happening again?!?" and Jamie Dimon tells us not to worry because we go through financial crises every five years or so, so just take a pill and chill and stop standing on his bonus check?
That would be you. And me. That's right. Joe Taxpayers. A bailout will be orchestrated, overt or covert, and we'll all shoulder the burden.
Perhaps Ben Bernanke will do a slow-bleed of seniors and savers by infusing liquidity, rescuing the large and foolish banks (and other too-big-to-fail pieces of the financial infrastructure).
Just remember: It all starts with a misratings scam your Congress, snugly in the pockets of the banking lobby, never bothered to fix ... ;)
Last time I showed you why CLO (collateralized loan obligation) ratings are almost certainly a scam, and why Mr. Ratings Guy from Standard & Poor's should know as much. It was (I hope) a math-lite and entertaining trip through the bowels of high-finance complexity, Wall Street style.
Of course I reached the end of the rather long post with more questions than answers. Why does this ratings scam exist in the first place? Who benefits? Who loses? In today's conclusion, we'll look at the not-so-surprising answers. Center stage in this discussion will be the misrated AAA tranche. It's the largest CLO piece by far, a good 70 percent or so of the overall fund -- and, as you're about to find out, that's no accident.
So why does Mr. Ratings Guy turn a blind eye to ratings that, deep in the pit of his stomach, he knows can't be correct?
Remember Upton Sinclair's little gem of wisdom:
It is difficult to get a man to understand something when his salary depends on his not understanding it.Structured finance (e.g., CLOs) is very lucrative for ratings agencies. Even if you're the Jim Carrey character in "Dumb and Dumber," you can rate U.S. Treasuries with your eyes closed. Can you say "AAA"? With a bit more work, you can rate investment-grade bonds and loans. But once you dip into junk-rated and structured finance stuff -- ah, that's where it gets complicated. And complicated = higher fees.
So S&P gets paid more to rate CLOs. If the company started to challenge specific CLOs -- if it dared to say, "You know, these ratings don't make sense for this CLO" and began to push back against investment banks, one of two things would happen. (1) The bank, realizing its screwy models had been sussed out, would not structure more CLOs. (2) The irritated bank, which is paying the ratings firm, would simply find another ratings patsy -- Moody's? -- to play along with the bogus rankings for a big fee check.
Either way, it's clear what happens to S&P: It loses a rather fat revenue stream.
Now, why does the investment bank want to structure these things in the first place? This is pretty easy to answer too. Fees, fees, fees, fees. Underwriting fees for CLOs run to 1.75 percent, compared with an average of 0.4 percent for investment-grade bonds, according to Bloomberg News data.
Okay, that explains what's going on on the supply side. But it takes at least two to play in the markets. What's the incentive for the investor to buy misrated CLOs? Is the investor just the naive fool here, hoovering up misrated junk that will later plunge in value, leading him finally to clap a hand against his forehead and exclaim, "Oh, what a terrible mistake I have made!"
Probably not. At least not anymore. Recall that well-worn saying, "Fool me once, shame on you, fool me twice, shame on me."
There was a lot of complex, securitized crapola that cratered during the financial crisis (and has since recovered in value to some degree, but not to the degree that its initial AAA ratings would suggest is proper). So investors got caught playing with the effluvia from the sewer pipe and got burned. Are they really as stupid as they once were?
Nope. In fact, just return to my first post and look at what the tranches of a CLO pay these days. The "AAA" piece that, pre-credit crisis, would have paid 25 basis points plus the Libor rate, now yields 160 to 170 basis points plus Libor. Big, big difference. For those who aren't finance geeks, here's what that means in actual interest rates: three-month Libor is about 0.3 percent, so the CLO buyer who in 2006 would have accepted 0.55 percent as initial interest (assuming today's Libor) now insists on more than three times as much, or as much as 2 percent.
Last time we proved the ratings are an illusion, a clever chimera ... so let's say today's investor, being smarter about these CLOs, knows the game too. What does the 2 percent imply about the true rating? Well, you'd have to skip down S&P's ratings scale a bit to find the "true" rating, based on what investors are willing to pay. And that happens to be about six or seven rungs below the professed rating: much closer to "junk" level than AAA.
This is essentially what the investor is saying to the investment bank selling this stuff: "Sure, I'll take some of that 'AAA.' I know the market is just irrationally frightened of CLOs right now -- (nudge, nudge, wink, wink). I know that I'm getting real AAA at a great price, just because this asset class is out of favor because of the lingering taint from the financial crisis that has unfairly tarred securitized products! (nudge, nudge, wink, wink)."
Inside the investor is thinking: "Yeah, AAA my ass."
Now you may be wondering: What's the incentive for an investor to do this? What's the point of going along with this charade? And this is where things get interesting. There are a number of good reasons to play along with the fake "AAA" ratings:
1. You can use the AAA ratings to burnish your investment results. Say you manage a money market fund that can buy only AAA securities. You can sneak some pseudo AAA into your portfolio and goose your returns. How? Because it's rated AAA, but it pays about 165 basis points more than Libor, or more than three times ordinary AAA. So you'll look like a genius, outperforming your peers, until this junk explodes in your hands (and that could take a while -- remember, it's still probably investment grade, just a good deal lower than AAA).
Update: Ah, the perils of working too quickly! I meant to check out investing requirements for money market managers because I feared -- and I was right -- that my example doesn't work because they can't buy certain AAA products. It turns out money market funds must contain investments with a maximum weighted average maturity of 60 days. (A lot of structuring does spin out tranches with special A-1 or P-1 ratings that are of this shorter, desired maturity, but I don't think any CLOs do.) However, the idea still holds for other AAA-only fund managers: They can use pseudo-AAA from a CLO to burnish their results. A relevant fund for such a strategy might look more like one of these (note: the funds on this Web page invest in "AAA-rated fixed-income products" so I'm not sure if "structured fixed-income products" could qualify for the portfolio, but clearly if they could, the money manager will quickly jump to the head of the class, using pseudo-AAA from a CLO as "performance steroids," if you will.)
2. Certain entities, such as insurance companies and pension funds, have limits on what they can invest in. They can buy only AAA, or a certain percentage of their investments must be rated AAA. So these "AAA" (wink, wink) CLO tranches fit that criterion. This then becomes a neat little way to do an end run around an investing mandate that seems too restrictive to them, especially when they are under pressure to achieve higher returns (pension funds).
3. AAA securities are very useful in the huge "repo" market, where they are used to secure overnight loans, sometimes being rolled over continually. While AAA CLOs may be subject to higher haircuts (or discounts) than say a AAA Treasury, they still may find an important role once again in the repo market.
4. The new Basel III rules are coming, the new Basel III rules are coming! They are intended to make sure that a bank has enough capital to withstand shocks. These rules determine capital adequacy based partly on -- surprise! -- ratings of assets a bank holds. So having a bunch of misrated AAA on its books will help a bank heap on the risk again and plump up profits.
From Minyanville (my bold):
In the afterglow of yesterday’s “hugely oversubscribed” bond issue by the European Financial Stability Facility, (the “EFSF”), EFSF CEO Klaus Regling noted that demand was growing for AAA-rated assets “spurred by Basel III capital rules."From Bloomberg (my bold):
Three years after collateralized debt obligations (note: a CLO is a type of CDO) helped trigger the worst financial crisis in 70 years, Wall Street’s math wizards are exploring how to use them to deflect rules intended to prevent the next crisis.Okay, a cynic might say after reading up to this point, so what? Investment banks make out like bandits, the ratings firms get their cut, and everyone enjoys goosed returns and higher leverage. Why should I care?
Credit Suisse Group AG traders are testing a risk model that may help them reduce capital charges imposed by the Basel Committee on Banking Supervision on derivative products.
Claudio Albanese, a quantitative economist who is advising the lender on the plan, says it could also help banks to limit one of their biggest risks by allowing them to offload through a CDO the risk that one of their trading partners, or counterparties, defaults. Critics say such CDOs could trigger a new crisis.
Albanese’s plan shows how banks are likely to try and mitigate rules that impose higher capital requirements on their operations and threaten profit ...
For one, the existence of this ratings scam has the potential to create a distortionary effect in the market. It hasn't yet -- CLO issuance has dropped off a cliff since the glory days of several years ago -- but if the CLO machine cranks up again, suddenly there will be greater investor appetite for the securitizations. Now what's the hamburger that needs to go into the CLO meat grinder to produce these sweet patties of higher-than-normal yield? Leveraged loans. And who takes out leveraged loans? Private-equity firms. And why do they? To engineer sometimes-destabilizing takeovers that load up companies with debt.
So we encourage distortionary economic activity, higher leverage, more debt ... though in the short run, all this will give us a little meth-type boost in prices of stocks and other assets, and investors will feel a little richer, and we'll buy a few more big-screen TVs, and take a few more Acapulco vacations, and exult about how it's great we survived that bad ol' financial crisis ...
Now for the $64,000 question, the one that really matters.
Who's on the hook when all this collapses?
When CLOs go belly up, and massive wealth is destroyed, and credit freezes, and money market funds are about to break the buck once more, and we gnash our teeth and scream, "How can this be happening again?!?" and Jamie Dimon tells us not to worry because we go through financial crises every five years or so, so just take a pill and chill and stop standing on his bonus check?
That would be you. And me. That's right. Joe Taxpayers. A bailout will be orchestrated, overt or covert, and we'll all shoulder the burden.
Perhaps Ben Bernanke will do a slow-bleed of seniors and savers by infusing liquidity, rescuing the large and foolish banks (and other too-big-to-fail pieces of the financial infrastructure).
Just remember: It all starts with a misratings scam your Congress, snugly in the pockets of the banking lobby, never bothered to fix ... ;)
Sunday, January 30, 2011
The Ratings Charade Continues: A CLO Investigation, Part I
The role of the ratings agencies in the financial crisis went largely unexamined by the powers that be. That's a crying shame. Because the game hasn't changed: Investment banks fork over big fees for ratings agencies to sign off on phony ratings for complicated products.
Today I'm going to prove it, step by step. I'm not going to show all my work (I don't want this expanding to the length of a Scribd academic paper), but I can separately (in the comments section or in a separate post) for anyone who's interested.
We start with one of Wall Street's darlings of complexity, called a collateralized loan obligation.
If you're going to hang with me here, you have to grasp the basics of how one works. It's like this: An investment bank bundles together say 30 leveraged loans (this is the risky debt that companies take on in leveraged buyouts). Now, recognizing that different investors have different risk appetites, the bank creates "tranches" of securities that receive payments in a "waterfall" structure, which is the complicated heart of the CLO.
Okay, that sounds confusing. But there's a simple way to look at it. Each of these 30 leveraged loans makes periodic payments (of interest, or interest and principal). Once you strap all the loans together, individually they still make the same payments on the same schedule. But how the money is distributed becomes a bit more complex.
That "pot of yield" generated by the 30 loans is divided as follows. The investors in the top, or safest tranche, get paid first. This tranche is generally ranked AAA. Investors in the next tranche down, which we'll say is AA rated, get paid after that. Then the A rated tranche holders receive their money, or "water." And so it goes, right down to the bottom layer of this structure, sometimes called equity (though it's not technically equity, for you finance nerds -- and there's often also something called an "overcollateralization" feature in a CLO, but we don't need to get into that here.)
When times are good, with all the leveraged loans paying on schedule, the waterfall is bountiful and everyone gets "wet" (i.e. paid). When some of the loans default, and the gushing waterfall of yield slows to something more akin to a trickle, there won't be enough money to go around. But you always start paying off investors at the top (AAA), then move down the structure. If the loans start to sour, the AAA guys are supposed to have an ample cushion before they feel any pain.
So, in a nutshell, an investment bank has taken 30 leveraged loans, tied to 30 companies that have 30 different stories, and roped them all together into a securitization that pours forth a stream of money that satisfies investors in the manner described above. If you're Standard & Poor's, it's a walk in the park to rate any one of those 30 loans compared with rating the slices of this Rube Goldberg-ian CLO. Which is probably why banks helpfully "suggest" the ratings to the ratings agencies and provide models to demonstrate their reasoning behind those "suggestions."
Now let's say you're Mr. Ratings Guy at Standard & Poors, in charge of signing off on CLO ratings. Your bull***t detector ought to be pinging pretty hard when something with these proposed ratings lands smack dab in the middle of your desk (I've condensed this from a Jan. 13 Bloomberg story):
Now structuring isn't free. Citigroup isn't creating this CLO out of altruism. Here are some categories of CLO expenses: 1. The cost to structure the CLO and earn a profit. 2. The yearly costs to manage the CLO (for example, there's a reinvestment period, during which the manager must replace loans in the portfolio that pay down) 3. All other expenses, including paying the ratings agency.
Let's fill in some blanks. Let's say management fees average 51 basis points, or about half of 1% (source: 2009 report from PF2 Securities Evaluations). Let's say structuring fees run about 1.75 percent (this is according to a Bloomberg story). And, finally, let's say the life of the CLO will be six to eight years. Even though the management fee must be paid yearly, the structuring is a one-time expense, and can be averaged over the life of the securitization.
Do a little math and you get about 76 basis points as the yearly cost that has to be extracted from that 10% pot of yield you're getting every year. Now the size of that pot has been whittled down to 9.24% effectively.
So, as Mr. Ratings Guy at S&P, you should be getting a little suspicious at this point, even before you look at the proposed ratings: Citigroup claims to be able to strap these loans together and, through some bit of diversification/alchemy, just sort of poof! -- extract 76 basis points a year. If these loans, after being structured, were somehow "de-structured" but with all the fees still intact, you'd be left with the original 30 loans, but paying 76 basis points less apiece, which is a pretty significant gap in bond land.
That should make you go "hmmm." But once you look at the actual numbers for the proposed ratings, your reaction should be something like, "no way."
Just look at the generous yields on the tranches of the CLO! The AAA slice is 160 to 170 basis points over Libor. That's a super-juiced AAA yield. A AAA corporate bond -- once you make a few tweaks (for the fixed-to-floating swap rate, the difference in Libor vs. Treasury -- I won't show my work now but can later for anyone interested) has a comparable yield of about 54 basis points. How can this be, at a time when the credit markets are relatively calm, when even junk debt is selling like hotcakes? This isn't a period of high market stress and irrationality.
(Brief aside: Some readers may object: "Well, a AAA bond doesn't imply the same risk profile as a AAA slice from a securitization." If you think that, you may want to look at S&P's own writing on the issue from January 2010: "In developing our updated corporate CDO criteria (note: a CLO is a type of CDO), we collaborated with Standard & Poor's corporate and government ratings group to promote comparability of CDO ratings with ratings in corporate, municipal and sovereign, as well as other areas of structured finance. When we assign the same rating level to debt instruments in varying sectors, we are expressing the opinion that they have comparable credit risk.")
Back to our unfolding narrative! This is what Citigroup is essentially saying to you, Mr. Ratings Guy: "Hey, ya know, we just structured it and all, and found this great big pot of yield left over! Son of a bitch, funny huh? I mean, there was so much yield we shook out of this thing, thanks to our genius in structuring, that we could pay the structuring fees, pay the annual manager fees, pay all other fees, PLUS hand out extra yield like candy canes right up and down the waterfall structure!"
Because here's what you have: AAA is getting 111 basis points (1.11 percentage points) more than comparable corporate bonds. AA is raking in an extra 149.5 basis points, BBB an extra 229.5, BB an extra 218.5 ... (the spread for the A rated isn't given, but it's got to be consistent with the others because this grade lies between AA and BBB, so I extrapolated that one.)
That gives us another 116 basis points of yield a year, over the size of the entire CLO, that the structuring genies claim to have conjured from somewhere, for a total of 1.92%.
[Update: Reader “Anonymous” makes a good point below about the need to adjust the numbers to account for a call option premium. A fuller explanation of what that means appears at the end of this post. So the structuring genies are actually conjuring up closer to 152 to 180 basis points of yield out of thin air -- not 192 -- but that’s still a whole heck of a lot.)]
Think about that. These individual loans pay 10% overall. That was presumably their fair value. Somehow Citigroup is claiming, through the miracle of structuring, that it has been able to shave almost 2 percentage points -- one whole fifth -- of that risk away.
This structure makes no sense, right on the ground floor. You can't extract a bunch of fees, pay a bunch of rich yields, and have the math work out, considering there's finite money being paid out by the underlying loans. Structuring, in and of itself, can't produce such enormous savings. If it could, everything in the corporate debt universe would be immediately structured for huge and immediate gains.
Now, Mr. Ratings Guy, you should be saying, "Something smells really fishy here." And if you were thinking like this, you would reach an obvious conclusion:
These ratings have to be bull***t. The AAA tranche of this CLO, for example, deserves a grade closer to junk than to AAA.
Yet Mr. Ratings Guy still signs off on the ratings. Why? Hmmmm...
Stay tuned for Part II in which we answer: Why does Mr. Ratings Guy sign off on ratings he knows can't be correct and why does this farce exist at all? Is what's going on a benign "nobody gets hurt" kind of transgression? And who gets burned if these ratings blow up down the line?
Update: One objection that's been raised: S&P doesn't actually see the pricing when these ratings are proposed. It doesn't see that the AAA tranche, for example, would pay 160 basis points over Libor. Okay, that's somewhat exonerating for S&P, but it doesn't change the math. And what's more, Mr. Ratings Guy isn't that stupid. He can figure out what's going on.
He can easily find out what AAA rated debt pays for other asset classes. Even if he doesn't have the CLO pricing in front of him, he'll discover the same problem I outlined above. This structure supports a tremendous amount of what should be low-yield AAA, and even after you add in yields for the other stuff, there's an awful lot of leftover yield to go around (some of which is used to pay structuring and management fees). All of which leads back to the same questions: How does that act of structuring manage to create so much extra yield? How can these CLO ratings be accurate?
Update, Part II: I wanted to sneak in a second update for those readers who will say -- rightly -- wait a moment, don't loans amortize? So aren't you really receiving the interest rate on the loan plus a certain chunk of principal each year? That's typically correct, and I reference that up high in the post. But just to make clear: I am keeping this example simple with a focus on the interest rate portion only, because the yield is the sexy part. That's what you make over and above your initial investment -- the return of principal is just making you whole. If anyone has further questions/comments, put 'em below and I'll tackle them. The bottom line is the math doesn't really change.
Update, Part III: Explanation of the accounting for the call option: the equity investors (the ones who hold the junkiest tranche) have a call option on the CLO fund, which typically can be exercised after 3 to 5 years. The existence of that call option is undesirable for the other investors, so they’ll demand a premium to compensate for it. So in other words, if investors wanted to be paid 30 basis points above Treasuries for a AAA CLO tranche that can’t be redeemed early, once you add a call option, they’ll want even more.
How much more? That’s the key question. See more details in my reply in the comment section, but basically I give the example of a Wells Fargo note that’s effectively 6-year debt with a call option in two years, where the option appears to be worth 18.5 basis points. In a longer-dated note, the option is worth more: a Bank of America note that matures in 13 years has a call option that kicks in 3 years from now that’s worth 39.9 basis points.
Of course those examples aren’t CLO tranches. Still, for CLOs, the call seems even less valuable. Babson Capital Management looked at spreads for CLO bonds and found in the first quarter of 2007, they were 22 - 26 basis points for the triple A tranche. So even if you assume the investor is assigning negligible credit risk (say 10 basis points, which is paltry) to the asset itself, that leaves only 12 to 16 bps for the call option.
So, relating this to the example above, you can subtract somewhere from 12 to 40 basis points from the 192 estimate to account for the call option. Still, you get a good 152 to 180 bps of mis-rating -- which is quite a lot.
Today I'm going to prove it, step by step. I'm not going to show all my work (I don't want this expanding to the length of a Scribd academic paper), but I can separately (in the comments section or in a separate post) for anyone who's interested.
We start with one of Wall Street's darlings of complexity, called a collateralized loan obligation.
If you're going to hang with me here, you have to grasp the basics of how one works. It's like this: An investment bank bundles together say 30 leveraged loans (this is the risky debt that companies take on in leveraged buyouts). Now, recognizing that different investors have different risk appetites, the bank creates "tranches" of securities that receive payments in a "waterfall" structure, which is the complicated heart of the CLO.
Okay, that sounds confusing. But there's a simple way to look at it. Each of these 30 leveraged loans makes periodic payments (of interest, or interest and principal). Once you strap all the loans together, individually they still make the same payments on the same schedule. But how the money is distributed becomes a bit more complex.
That "pot of yield" generated by the 30 loans is divided as follows. The investors in the top, or safest tranche, get paid first. This tranche is generally ranked AAA. Investors in the next tranche down, which we'll say is AA rated, get paid after that. Then the A rated tranche holders receive their money, or "water." And so it goes, right down to the bottom layer of this structure, sometimes called equity (though it's not technically equity, for you finance nerds -- and there's often also something called an "overcollateralization" feature in a CLO, but we don't need to get into that here.)
When times are good, with all the leveraged loans paying on schedule, the waterfall is bountiful and everyone gets "wet" (i.e. paid). When some of the loans default, and the gushing waterfall of yield slows to something more akin to a trickle, there won't be enough money to go around. But you always start paying off investors at the top (AAA), then move down the structure. If the loans start to sour, the AAA guys are supposed to have an ample cushion before they feel any pain.
So, in a nutshell, an investment bank has taken 30 leveraged loans, tied to 30 companies that have 30 different stories, and roped them all together into a securitization that pours forth a stream of money that satisfies investors in the manner described above. If you're Standard & Poor's, it's a walk in the park to rate any one of those 30 loans compared with rating the slices of this Rube Goldberg-ian CLO. Which is probably why banks helpfully "suggest" the ratings to the ratings agencies and provide models to demonstrate their reasoning behind those "suggestions."
Now let's say you're Mr. Ratings Guy at Standard & Poors, in charge of signing off on CLO ratings. Your bull***t detector ought to be pinging pretty hard when something with these proposed ratings lands smack dab in the middle of your desk (I've condensed this from a Jan. 13 Bloomberg story):
Citigroup Inc. has revised the proposed interest rates on a collateralized loan obligation to be managed by WCAS Fraser Sullivan Investment Management LLC, according to people familiar with the terms.Why? Remember how our CLO was constructed: out of 30 leveraged loans. These loans pay a certain floating interest rate over Libor (the London interbank offered rate, or what banks charge when they lend to each other). And that's it. You can't wring out any more yield. So the size of our "waterfall" is constrained by what those underlying loans pay. Let's say it's 10% overall right now (not a bad assumption: a CCC and lower bond index right now is at 9.97%).
A $15 million piece rated BBB by Standard & Poor's will pay lenders 400 basis points (note: there are 100 basis points in one percentage point) to 450 basis points more than the London interbank offered rate, while a $19 million slice, graded BB, will pay lenders 600 basis points more than the benchmark...
A $273 million piece rated AAA will pay lenders 160 basis points to 170 basis points more than Libor and a $13.5 million portion graded AA will pay lenders 250 basis points more than the benchmark, the people said. There is also a $31.1 million piece with an A rating and a $51.075 million slice of subordinated notes, the people said.
Now structuring isn't free. Citigroup isn't creating this CLO out of altruism. Here are some categories of CLO expenses: 1. The cost to structure the CLO and earn a profit. 2. The yearly costs to manage the CLO (for example, there's a reinvestment period, during which the manager must replace loans in the portfolio that pay down) 3. All other expenses, including paying the ratings agency.
Let's fill in some blanks. Let's say management fees average 51 basis points, or about half of 1% (source: 2009 report from PF2 Securities Evaluations). Let's say structuring fees run about 1.75 percent (this is according to a Bloomberg story). And, finally, let's say the life of the CLO will be six to eight years. Even though the management fee must be paid yearly, the structuring is a one-time expense, and can be averaged over the life of the securitization.
Do a little math and you get about 76 basis points as the yearly cost that has to be extracted from that 10% pot of yield you're getting every year. Now the size of that pot has been whittled down to 9.24% effectively.
So, as Mr. Ratings Guy at S&P, you should be getting a little suspicious at this point, even before you look at the proposed ratings: Citigroup claims to be able to strap these loans together and, through some bit of diversification/alchemy, just sort of poof! -- extract 76 basis points a year. If these loans, after being structured, were somehow "de-structured" but with all the fees still intact, you'd be left with the original 30 loans, but paying 76 basis points less apiece, which is a pretty significant gap in bond land.
That should make you go "hmmm." But once you look at the actual numbers for the proposed ratings, your reaction should be something like, "no way."
Just look at the generous yields on the tranches of the CLO! The AAA slice is 160 to 170 basis points over Libor. That's a super-juiced AAA yield. A AAA corporate bond -- once you make a few tweaks (for the fixed-to-floating swap rate, the difference in Libor vs. Treasury -- I won't show my work now but can later for anyone interested) has a comparable yield of about 54 basis points. How can this be, at a time when the credit markets are relatively calm, when even junk debt is selling like hotcakes? This isn't a period of high market stress and irrationality.
(Brief aside: Some readers may object: "Well, a AAA bond doesn't imply the same risk profile as a AAA slice from a securitization." If you think that, you may want to look at S&P's own writing on the issue from January 2010: "In developing our updated corporate CDO criteria (note: a CLO is a type of CDO), we collaborated with Standard & Poor's corporate and government ratings group to promote comparability of CDO ratings with ratings in corporate, municipal and sovereign, as well as other areas of structured finance. When we assign the same rating level to debt instruments in varying sectors, we are expressing the opinion that they have comparable credit risk.")
Back to our unfolding narrative! This is what Citigroup is essentially saying to you, Mr. Ratings Guy: "Hey, ya know, we just structured it and all, and found this great big pot of yield left over! Son of a bitch, funny huh? I mean, there was so much yield we shook out of this thing, thanks to our genius in structuring, that we could pay the structuring fees, pay the annual manager fees, pay all other fees, PLUS hand out extra yield like candy canes right up and down the waterfall structure!"
Because here's what you have: AAA is getting 111 basis points (1.11 percentage points) more than comparable corporate bonds. AA is raking in an extra 149.5 basis points, BBB an extra 229.5, BB an extra 218.5 ... (the spread for the A rated isn't given, but it's got to be consistent with the others because this grade lies between AA and BBB, so I extrapolated that one.)
That gives us another 116 basis points of yield a year, over the size of the entire CLO, that the structuring genies claim to have conjured from somewhere, for a total of 1.92%.
[Update: Reader “Anonymous” makes a good point below about the need to adjust the numbers to account for a call option premium. A fuller explanation of what that means appears at the end of this post. So the structuring genies are actually conjuring up closer to 152 to 180 basis points of yield out of thin air -- not 192 -- but that’s still a whole heck of a lot.)]
Think about that. These individual loans pay 10% overall. That was presumably their fair value. Somehow Citigroup is claiming, through the miracle of structuring, that it has been able to shave almost 2 percentage points -- one whole fifth -- of that risk away.
This structure makes no sense, right on the ground floor. You can't extract a bunch of fees, pay a bunch of rich yields, and have the math work out, considering there's finite money being paid out by the underlying loans. Structuring, in and of itself, can't produce such enormous savings. If it could, everything in the corporate debt universe would be immediately structured for huge and immediate gains.
Now, Mr. Ratings Guy, you should be saying, "Something smells really fishy here." And if you were thinking like this, you would reach an obvious conclusion:
These ratings have to be bull***t. The AAA tranche of this CLO, for example, deserves a grade closer to junk than to AAA.
Yet Mr. Ratings Guy still signs off on the ratings. Why? Hmmmm...
Stay tuned for Part II in which we answer: Why does Mr. Ratings Guy sign off on ratings he knows can't be correct and why does this farce exist at all? Is what's going on a benign "nobody gets hurt" kind of transgression? And who gets burned if these ratings blow up down the line?
Update: One objection that's been raised: S&P doesn't actually see the pricing when these ratings are proposed. It doesn't see that the AAA tranche, for example, would pay 160 basis points over Libor. Okay, that's somewhat exonerating for S&P, but it doesn't change the math. And what's more, Mr. Ratings Guy isn't that stupid. He can figure out what's going on.
He can easily find out what AAA rated debt pays for other asset classes. Even if he doesn't have the CLO pricing in front of him, he'll discover the same problem I outlined above. This structure supports a tremendous amount of what should be low-yield AAA, and even after you add in yields for the other stuff, there's an awful lot of leftover yield to go around (some of which is used to pay structuring and management fees). All of which leads back to the same questions: How does that act of structuring manage to create so much extra yield? How can these CLO ratings be accurate?
Update, Part II: I wanted to sneak in a second update for those readers who will say -- rightly -- wait a moment, don't loans amortize? So aren't you really receiving the interest rate on the loan plus a certain chunk of principal each year? That's typically correct, and I reference that up high in the post. But just to make clear: I am keeping this example simple with a focus on the interest rate portion only, because the yield is the sexy part. That's what you make over and above your initial investment -- the return of principal is just making you whole. If anyone has further questions/comments, put 'em below and I'll tackle them. The bottom line is the math doesn't really change.
Update, Part III: Explanation of the accounting for the call option: the equity investors (the ones who hold the junkiest tranche) have a call option on the CLO fund, which typically can be exercised after 3 to 5 years. The existence of that call option is undesirable for the other investors, so they’ll demand a premium to compensate for it. So in other words, if investors wanted to be paid 30 basis points above Treasuries for a AAA CLO tranche that can’t be redeemed early, once you add a call option, they’ll want even more.
How much more? That’s the key question. See more details in my reply in the comment section, but basically I give the example of a Wells Fargo note that’s effectively 6-year debt with a call option in two years, where the option appears to be worth 18.5 basis points. In a longer-dated note, the option is worth more: a Bank of America note that matures in 13 years has a call option that kicks in 3 years from now that’s worth 39.9 basis points.
Of course those examples aren’t CLO tranches. Still, for CLOs, the call seems even less valuable. Babson Capital Management looked at spreads for CLO bonds and found in the first quarter of 2007, they were 22 - 26 basis points for the triple A tranche. So even if you assume the investor is assigning negligible credit risk (say 10 basis points, which is paltry) to the asset itself, that leaves only 12 to 16 bps for the call option.
So, relating this to the example above, you can subtract somewhere from 12 to 40 basis points from the 192 estimate to account for the call option. Still, you get a good 152 to 180 bps of mis-rating -- which is quite a lot.
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