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Wednesday, October 20, 2010

The Importance of Being Investment Grade

While references to credit ratings are being removed from statutes and federal regulations (effective July 2012) their position in our existing investment framework remains secure.

We have discussed previously how credit rating downgrades might negatively influence a security's price by decreasing investor demand (some funds and companies, for example, can only buy debt of a certain credit quality) and increasing funding costs (collateral/margin requirements), which may lead to the inevitable vicious cycle.

The deeply embedded nature of ratings in financial contracts is even more apparent when we look at the ramifications of a downgrade on H&R Block's corporate debt (CUSIP 093662AD6), which has been the recent focus of negative attention from the rating agencies. If the debt is downgraded by Moody's to Ba1 or below and/or by S&P to BB+ or below, the coupon on these notes will increase, and the debt will thereby become more expensive to HRB. In other words, if a downgrade is an indication that a company is struggling to meet its obligations, the downgrade in its enactment (by construction) might make said obligations more expensive, which precipitates further difficulty in meeting them. As such, the rating provided is integral to, and certainly not de-linked from, the performance of the security being rated.

These bonds are currently Baa or BBB, investment-grade bonds. However, as the table illustrates, if either rating agency alone downgrades the debt to the Ba1 or BB+ level, the coupon on the bond will increase by 25bps from 7.875% to 8.125%. If both rating agencies downgrade the debt to this level, the result will be a 50bps increase to 8.375%. The interest rate increase is capped at 2%, which will be effectuated if Moody's downgrades the bond to B1 or below and S&P downgrades it to B+ or below.

The (unfortunate) consequence: a downgrade immediately increases the coupon on the bond, which decreases the price. That's in addition to the decreased demand for the bond, the heightened illiquidity, and the increased funding costs for holding the bond. If downgraded, a devaluation of the bond is inevitable, irrespective of the market's opinion of the accuracy of the rating agencies' opinions.

Tuesday, October 5, 2010

Phantom Pricing

Mario Draghi, head of the Financial Stability Board, is making a splash about the loosely regulated “shadow banking system.” While estimates of the size of the system are tough to come by (the FRBNY report suggests $16 trillion) what makes this system a “shadow” system is not its size, but the location of the assets. Who owns what, where?

The provisions of off-balance-sheet accounting made it very difficult to know the exposures of your counterparties, one of the reasons Mr. Draghi felt the shadow banking system to be a key contributor to the crisis: if you don’t know what else your counterparty’s holding, you won’t lend to it in a time of crisis. The lending freeze, then, only serves to exacerbate the crisis for those parties in need of short-term liquidity. A minor disconnect in a small part of the market can therefore lead to panic, bank runs, and mass deleveraging. The scenario painted exaggerates what happened in our financial downturn, but the elements remain true.

The challenge becomes how best to cure this lack of transparency. Unfortunately there are at least three parts at play in this multidimensional version of Heisenberg’s uncertainty principle: we cannot measure the exposure because we cannot see it (questionable balance sheet transparency), we know not what it is (questionable asset transparency) and we cannot rely on the value being associated with it (questionable pricing transparency).

If we could cure the “balance sheet transparency” element, the difficulty would by definition be removed from the shadow banking system. Enhancing asset transparency practices is a regulatory initiative that has begun. The process toward improving pricing transparency, however, remains in its infancy.

Why the lack of transparency? The answer: a lack of transparency in the market creates a money-making opportunity for those parties in the know. The informational asymmetries in the market allow the better-informed market participants to take advantage of those who are guessing at certain characteristics. From The Big Short:

[Yale professor] Gary Gorton guessed that the piles were no more than 10 percent subprime. [Gene Park] asked a risk analyst in London, who guessed 20 percent. “None of them knew it was 95 percent,” says one trader. “And I’m sure that [AIG’s Joe Cassano] didn’t either.” In retrospect their ignorance seems incredible—but, then, an entire financial system was premised on their not knowing, and paying them for this talent.
Absent the ability to perform due diligence internally, market participants grew increasingly dependent on the soundness of advice being offered to them by their broker-dealers, a situation which has created forum for BD litigation. From Confidence Game:

Meanwhile, [MBIA’s lawsuit against Merrill Lynch alleged that] because MBIA “did not and could not perform a cost-effective loan-level valuation analysis of the ML-series CDOs, it relied on and trusted Merrill Lynch’s statements about the quality of the underlying loans.”
Pricing transparency is similarly powerful and problematic. In the deeply veiled world of broker-dealer intermediation, the buyer and seller seldom know each other. The bidder (for example a regional bank or a hedge fund trader) doesn’t know the offerer, nor the offer itself, nor the number of offerers out there, and vice versa.

In other words, neither party knows the bid-offer spread being made by the broker-dealer and they don’t know whether there are many bids or just a few. Buyers and sellers are guessing at the price and the liquidity.

The larger problem, of course, is that for leveraged funds your margin is being dictated by the seller’s price, and that price is not necessarily an independent, unbiased opinion. Back to The Big Short:

“Whatever the banks’ net position was would determine the mark,” [Scion Capital’s Michael Burry] said. “I don’t think they were looking to the market for their marks. I think they were looking to their needs.”
One solution, thus, is to centralize the pricing operations among one or more independent bodies — perhaps among existing regulatory bodies to the extent we can avoid conflicts of interests between their supervisory agenda and their pricing power. Else, why not create a new agency that creates various economies of scale in promoting pricing transparency and consistency in the name of, wait for it, consumer protection.