Do you remember the Ford Pinto? The 1970s car had a nasty tendency to explode into flames in rear end collisions. But the piece de resistance was when litigation exposed a Ford internal memo that showed the company was not only aware of the problem, but had run the math and concluded reinforcing the car would be more costly than compensating victims.
Similar logic is at work in the protests coming from the asset backed securities sector over plans to reform their ratings. Mind you, one of the ideas that is generating stiff resistance is an incredibly tame change, namely, that a structured finance instrument is a structured instrument by adding a special designation, such as “sf”.
Now why is this change warranted? Even though research has found that ABS have less desirable performance characteristics than corporate bonds, banks were required to hold only 1/5 the capital against mortgage backed securities rated AAA or AA than they would be required to hold against corporate bonds. For institutional investors, the problem appears to be more mundane: they evidently didn’t differentiate much (in terms of credit exposure) between ABS and other rated instruments.
In case you have any doubts that the differences aren’t trivial, please read the excellent paper by Joshua Rosner and Joseph Mason, “Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions.” Among the issues they raise are:
1. Corporations are dynamic, and companies can and do take action to forestall credit downgrades (particularly below the investment grade level, which greatly restricts access to capital). Indeed, with a corporate instrument, investors can experience an upgrade. But with a structured vehicle, the only changes possible are adverse2. When mortgage pools underperform, they will not be downgraded as quickly as under traditional methods
3. The statistical loss performance of asset pools is skewed compared to corporate investments
Their analysis is exhaustive, and includes a section that argues vehemently (for an academic paper) against the rating agencies’ First Amendment exemption from litigation for their opinions.
It’s not hard to conclude that ABS need to be scored differently, yet the industry reaction is vociferous. I was appalled by the Bloomberg story, “SEC `Scarlet Letter’ Drive Hurts Asset-Backed Market .” Normally, Bloomberg is pretty even-handed, but this piece was one-sided and alarmist. It was telling that the first quote came from the head of the American Securitization Forum, the industry lobbying group.
What was most disturbing was the that problem that the industry was worried about was that a new system would force investor to rethink how they use these instruments. My God, if it really is true that they haven’t done so already, despite the considerable evidence that some of these products need a black-box warning, and this move can force the lazy to get off their duffs and make badly needed changes in investment policies, it is exactly what is needed. Similarly, banking regulators want their charges to hold more equity, so they would not oppose this move.
The whole discussion has an Alice in Wonderland quality, and it says a great deal about the overrated quality of institutional investors. The reaction is something along the lines of “Oh, if the rating agencies tell us these instruments are different, then gee, we might have to treat them differently.” Huh? It takes the SEC hitting you over the head for you to recognize that these instruments aren’t what you thought they were?
These sources pretend to be investment professionals and they didn’t understand these ABS well enough to know they didn’t perform the same as corporate credits? Worse, even if they naively thought so pre-2007, they still carry the same beliefs despite repeated instances of ABS being downgraded multiple grades in a single rating review (and some CDOs going from AAA to junk)? That never happens with corporate debt issues except for accounting fraud or a major disaster, yet it is routine in ABS land.
Despite the evidence above that his prod is badly needed, the securitization proponents are reacting as if a patient that has just had a quadruple bypass shouldn’t be pushed to quit smoking, go on a diet and start exercising. Oh, it will restrict access to credit! Oh, it will hurt the banking industry! Now isn’t the time to do such a horrid thing! By definition, there is never a good time to toughen regulations. When the markets are weak, the incumbents protest that the change is another blow when they are already down (even when, as in this case, the changes are in response to a mess they helped create). And of course, when markets are favorable, the argument goes, “Things are just fine. Obviously, there is no need for change.”
The telltale sign that the article was unduly influenced by ABS backers: evidently no reporter bothered talking to Mason and Rosner or anyone familiar with their work. Deleveraging isn’t pleasant. Get with the program.
From Bloomberg:
Regulators’ plans to add a letter to credit ratings of asset-backed debt may constrict the $4.6 trillion market and choke off consumer credit at a time when Federal Reserve Chairman Ben S. Bernanke wants more lending to bolster the economy.The U.S. Securities and Exchange Commission may recommend this week that Moody’s Investors Service, Standard & Poor’s and Fitch Ratings include a new designation to the scale created by John Moody in 1909, according to people familiar with the plans. The changes may force investors to reassess the way they gauge the risk of securities backed by mortgages, student and auto loans and credit cards, said one of the people, who declined to be named before the announcement. The action could force banks to add capital to guard against losses or curb lending.
The banking industry is “very significantly concerned,” said George Miller, executive director of the American Securitization Forum, a New York-based group representing 370 companies that package assets into bonds. “If the rating itself is substantively changed, or the symbology is changed, it’s not just investment guidelines that have to be examined.”…
The SEC staff is recommending giving ratings companies two choices, the people familiar with the agency’s plans said. One option is to publish a report on how they came up with each ranking and how it could go wrong. The other would add a designation distinguishing the assessment of asset-backed debt from a corporate bond.
Florida State Board of Administration Interim Executive Director Robert Milligan, who oversees pension funds and local government investment pools with more than $159 billion of assets, said changing the ratings symbols for structured finance would force a review of whether funds in his state could buy such securities.
The International Organization of Securities Commissions, a Madrid-based association of global regulators, issued a code of conduct on May 28 that also recommended a change in ratings codes for asset-backed securities. Moody’s said in February it may add “.sf” to assessments to signify structured finance. S&P said a day after the IOSCO announcement that it may add an “s” to rankings.
“If, all of a sudden, the security has a scarlet letter on it, maybe regulators won’t judge that so well,” said James Grady, a managing director in New York at Deutsche Asset Management, which oversees $240 billion in fixed-income securities. “What will it do to liquidity, valuation and capital requirements?”….
The number of collateralized debt obligations failing since October has reached 186, with $202 billion of assets, data compiled by S&P and Bloomberg show. That’s 40 times the total for the previous four years, according to the rating company.
To be considered “well-capitalized” under U.S. regulations, banks are required to hold five times as much capital against corporate debt than they are for commercial or residential mortgage-backed securities rated AAA and AA by S&P, Fitch Ratings and Moody’s…..
The treatment granted to asset-backed securities helped fuel a record $7 trillion of sales in the past three years, excluding debt packaged by government-chartered entities such as Fannie Mae, according to Asset-Backed Alert, an industry newsletter…
The changes are opposed by ratings companies, banks, securities firms and bond buyers. Seventy-one percent of investors surveyed by Moody’s, representing $9 trillion in assets, didn’t want new assessments, the company said in May. A special designation might diminish the value of investors’ holdings by making debt from different asset classes harder to compare, the survey said….
Investors may steer clear of structured-finance in the future, said Richard Metcalf, director of the corporate affairs department of the Laborers’ International Union of North America.
“ If there are going to be certain financial products which are flagged as having increased volatility or risk, then we may have to look at whether such products fit into our portfolios and, if so, where,” Metcalf said.
a 
Posts
The (main) problem with the proposal is that it will create massive headaches for investors, regulators and issuers, without actually providing any useful information. The big lesson of the credit crisis is that investors relied too much on the triple-A ratings instead of doing their own analysis. How is this idea going to help that?
It’s hard to believe that many if any investors simply didn’t know they were buying a structured product. The point is that many investors didn’t know or didn’t care what that entailed.
What the industry is pushing for instead is supplementary ratings of non-default risk, covering things like loss given default, rating volatility, collateral quality (regardless of structural features) and sensitivity to changes in assumptions. Moody’s and Fitch have already begun consulting on them (S&P is looking at the idea, but has so far only gone down the SEC favoured identifier route). Surely these would be far more useful to investors and would achieve the purpose of an identifier without ghettoising all of structured finance because the rating agencies cocked up in certain sectors.
It’s important to recognise that outside of those sectors (far too many, it’s true), structured ratings have actually been more stable than corporate ratings. There’s still sensitivity to assumptions, and it’s right to flag those up prominently, but it makes no sense to think that anything meaningful will come from labelling all structured products alike.