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Friday, April 22, 2011

Ratings Reversals

Back in our December 2010 piece (The Psychological Biases of Holding Downgraded Bonds) we commented on what was to us a rather unusual trend in the collateralize loan obligation space, where these bonds were being downgraded at a time when their fundamentals were already (generally) rebounding.


“[One] rating agency began downgrading collateralized loan obligation (CLO)securities between September 2009 and May 2010, well after the market shock had ended, with loan prices generally having begun returning to 'normal' levels in December 2008. Depending on what indices you examine, loan prices generally went up roughly 40% during calendar year 2009, and this trend has continued in 2010. CLO prices improved too, as have their underlying portfolios. So while the rating agency was aggressively downgrading almost 3,000 bonds during this time period, the underlying loan market and the CLOs themselves were markedly improving.”
Moody’s recently produced some very informative data on their ratings reversal rates in structured finance. Not surprisingly – at least to to us and the avid readers of our blog – CLOs lead the list of ratings reversals, at a rate of approximately 5 times that of other CDOs (excluding CLOs) and more than 6 times the rate of all global structured finance ratings provided by Moody’s.



The downgrading (if it is premature) of a long-term bond only to subsequently upgrade it falls broadly within what is referred to as a “Type II” ratings error.

Holding lower-rated bonds can be more expensive for investors. This may encourage holders to sell the bonds to the extent the cost of funding the lower-rated bonds is too high, or they may even become forced sellers to the extent the lower ratings fall outside of their investment guidelines or their vehicles’ eligibility criteria. Thus, in addition to the (rather unfortunate) increased cost of funding on a downgraded bond, one may be forced to sell the bond at an inopportune time, only to see the bond subsequently re-upgraded.

Ratings reversals can include downgrades followed soon after by upgrades, or upgrades accompanied by subsequent downgrades.

Examples of Moody’s ratings reversals:

1 - Gresham Street CDO Funding 2003 class B notes (CUSIP 39777PAB9): Originally rated Aaa in 2003. Downgraded (Moody’s) to A1 in Aug. 2009. Upgraded to Aaa in May 2010. (S&P maintained rating at AAA throughout.)

2 - Halcyon Loan Investors tranche B (CUSIP 40536YAJ3): Downgraded from A2 to Ba1 (March ’09) to B3 (June ‘09); upgraded back to Ba3 (May ’10) and Ba1 (Dec. ’10).

Happy Easter everybody!
- PF2

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For more on this topic, click here.

Wednesday, April 13, 2011

Split Ratings

Given the high correlation between security prices and their ratings, we wanted to follow up on some of our prior pieces that contemplated the wide discrepancies between ratings opinions provided on certain securities (see for example here and here). Split ratings, of course, present trading opportunities.

Our analysis considered securities that were acted upon by a single rating agency between June and August of 2009. We then had a look at the average ratings split as of March 28 this year: one and a half years later. The outcome was quite astonishing.

While at inception the rating agencies seem typically to achieve the same rating, down the line they tend to substantially disagree with one another. (We have broken the differential down depending on how many rating agencies rated each security. If all three of Moody's, Fitch and S&P rated the security, we'll show both a max split and a minimum split. If only two raters rated the security as of March 28, 2011, the max split equals the min split.) The average max differential: 4.23 rating subcategories (or "notches"). The median differential - 3 notches. One rating subcategory would be the difference between a AAA and a AA+.

This table shows examples of the 748 structured finance securities considered in our database at each ratings split level, including one of the 20 securities on which there was a ratings differential of between 14 and 18 ratings subcategories.


For the purposes of this analysis, securities were only considered to the extent they had ratings outstanding from at least two of the Big Three credit rating agencies as of March 28, 2011.

Thursday, April 7, 2011

Contested Pricings List

The capacity for price manipulation or price inflation presents a major challenge for the market to overcome, especially in the illiquid markets where live trading data are seldom made available to the general public. Like "ratings shopping," investors may be incentivized towards seeking the highest price, or most accomodating price provider, for their securities.

We will continue to maintain this growing database of situations in which parties disagree as to the prices used, or pricing practices employed.

  1. Feb. 2014: SEC Looking at How Alternative Funds Value Investments

  2. Feb. 2014: Danske Bank Faces Broader Probe of Bond Price Fixing in 2009: "The trades, conducted in February and March 2009, raised mortgage bond prices in a way that “harmed customers at Realkredit Danmark A/S,” Danske’s home-loan unit, the crime squad said."

  3. Jan. 2014: Federal Probe Targets Banks Over Bonds: Inquiry Looks for Deliberate Mispricing of Mortgage Bonds Key to Financial Crisis

  4. Aug. 2013: 2 more targeted in JPMorgan's London Whale case: "Prosecutors in the office of U.S. Attorney Preet Bharara in the Southern District said Martin-Artajo and Grout manipulated and inflated the value of position marks in the Synthetic Credit Portfolio, or SCP, which the government said had been very profitable for the bank's chief investment office."

  5. Dec. 2012: Deutsche hid up to $12bn losses, say staff

  6. Nov. 2012: KCAP fund, execs settle charges of overstating assets.

  7. May 2012: FINRA Fines Citigroup Global Markets $3.5 Million for Providing Inaccurate Performance Data Related to Subprime Securitizations: "Citigroup failed to supervise mortgage-backed securities pricing because it lacked procedures to verify the pricing of these securities and did not sufficiently document the steps taken to assess the reasonableness of traders' prices."

  8. May 2012: JPMorgan CIO Swaps Pricing Said To Differ From Bank

  9. May 2012: Ex-UBS Trader Sues After Firing for Mispricing Securities

  10. Feb. 2012: SEC Looking Into PE Firms’ Valuation of Assets

  11. Feb. 2012: Massachusetts Subpoenas Bank of America Over CLOs: examining whether Bank of America knowingly overvalued the assets in the portfolios in order to get the loans off its books

  12. Feb. 2012: Ex-Credit Suisse traders face US charges: Case relates to alleged CDO mispricing

  13. Jan. 2012: SEC Charges UBS Global Asset Management for Pricing Violations in Mutual Fund Portfolios)

  14. Nov. 2011: PwC and KPMG criticised over audits (of their clients' valuations of mortgage-related securities)

  15. Oct. 2011: Oversight board faults Deloitte audits

  16. July 2011: Polygon Faces Accusations It Used Tetragon For Cash

  17. April 2011: Report says Goldman duped clients on CDO prices

  18. April 2011: Wachovia cheated investors by inflating markups, SEC says

  19. March 2011: Buffett’s Berkshire Questioned on Accounting

  20. Feb. 2011: What Vikram Pandit Knew, and When He Knew It

  21. Feb. 2011: Mutual Funds' Muni-Debt Prices Are Questioned

  22. Oct. 2010: SEC Continues Crackdown on Overvaluations of Hedge Fund Assets

  23. Aug. 2010: Merrill's Risk Disclosure Dodges Are Unearthed

  24. May 2010: HK watchdog slaps fine on Merrill units

  25. April 2010: Legal Woes for Regions Financial

  26. Nov. 2009: Ambac Misstates Financials to Meet Minimums

  27. July 2009: Under Fire, NIR Group Switches Valuation Firms

  28. June 2009: Evergreen Pays Over $40 Million to Settle SEC Charges that it Overvalued Mortgage-Backed Investments

  29. April 2009: FHLB Executive Who Left Cites Securities Valuations

  30. Aug. 2008: "Large Number" of Banks Miss-Marked Assets, U.K. Regulator Says

  31. Aug. 2008: Financial Services Authority’s "Dear CEO: Valuation and Product Control" Letter

  32. July 2008: The Subprime Cleanup Intensifies: Did UBS Improperly Book Mortgage Prices? Several Probes Expand

  33. Feb. 2008: IN RE REGIONS MORGAN KEEGAN SECURITIES, DERIVATIVE and ERISA LITIGATION:"(g) The Fund's Board of Directors was not discharging its legal responsibilities with respect to “fair valuation” of the Fund's assets and had abdicated these responsibilities to the Fund's investment advisor, which had an inherent and undisclosed conflict of interest because its compensation was based on the amount at which which the Fund's assets were valued"

  34. Feb. 2008: AIG's bad accounting day

  35. Feb. 2008: OCC Supervisory Letter to Citi (identifies as one of two key concerns "CDO Valuation and Risk Management in the Capital Markets & Banking Group")

  36. Oct. 2007: Ex-RBC trader says colleagues mismarked bonds

  37. Oct. 2007: Pricing Tactics Of Hedge Funds Under Spotlight

  38. Aug. 2007: BNP Paribas halted withdrawals from three investment funds because it couldn't "fairly" value their holdings

  39. Aug. 2007: Goldman Disputes AIG Valuations and Office of Thrift Supervision Instructs AIG to Revisit Modeling Assumptions

  40. Jan. 2006: Deutsche suspends trader over £30 million 'cover-up’

  41. June 2002: An Analysis of Allied Capital:Questions of Valuation Technique

  42. Aug. 1994: Behind the Kidder Scandal: How Profit Was Created on Paper

Let us know if there are any we're missing.