Thursday, August 16, 2007

Rating Agency Problems #2 - Credibility

Yesterday’s post on the rating agencies and the part they played in the current credit market problems was fairly popular. In it the question was posed “how do the rating agencies function independently”. Today’s article in Bloomberg answers the question – they probably don’t. The rating agencies had to give up something and it should come as no surprise that it may be their credibility.

Moody's Investors Service and Standard & Poor's, the arbiters of creditworthiness, are losing their credibility in the fastest growing part of the bond market.

The New York-based ratings firms last month gave a new breed of credit derivatives triple-A ratings, indicating they were as safe as U.S. Treasuries. Now, investors are being offered as little as 70 cents on the dollar for the constant proportion debt obligations, securities that use credit-default swaps to speculate that companies with investment-grade ratings will be able to repay their debt.

``The rating doesn't tell me anything,'' said Bas Kragten, who helps manage the equivalent of about $380 billion as head of asset-backed securities at ING Investment Management in The Hague. ``The chance that a CPDO won't be triple-A tomorrow is a lot greater than it is for the government of Germany.''

Ratings are ``a measure of risk on a buy-and-hold basis and say nothing about the pricing volatility of an investment,'' said Gareth Levington, a senior analyst at Moody's in London. ``The market level isn't hugely relevant for the rating.''

Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

The rating firms help borrowers structure debt securities in a way that will get the highest possible credit rankings while allowing managers of the securities the most profit, according to Charles Calomiris, the Henry Kaufman professor of financial institutions at New York's Columbia University.
Moody's earned $884 million last year, or 43 percent of total revenue, from rating so-called structured notes, according to Neil Godsey, an equity analyst at Friedman, Billings, Ramsey Group Inc. in Arlington, Virginia. That's more than triple the $274 million generated in 2001.

Ratings firms ``used to be seen as good, objective folks dressed in white, who you could count on to give reliable opinions,'' said Christopher Whalen, an analyst at Institutional Risk Analytics, a research firm in Hawthorne, California, that writes software for auditors to determine if banks are accurately valuing their assets. ``But when they got involved in structuring and pricing these deals, I think they crossed the line. They have lost a lot of credibility.''

CPDOs were first created last year by banks ranging from Amsterdam-based ABN Amro Holding NV, the largest Dutch lender, to New York-based Lehman Brothers Holdings Inc. HSBC Holdings Plc in London and Dresdner Kleinwort in Frankfurt also sold CPDOs.

CPDOs sell credit-default swaps, contracts that would pay a buyer face value for bonds if the company that issued the debt can't meet interest payments or otherwise defaults. CPDOs provide insurance on a basket of 250 companies, borrowing up to 15 times their initial capital, boosting their investments to as much as $60 billion.

ABN Amro's Surf CPDOs fell to as little as 70.2 cents from almost 104 cents on June 6, and were quoted at 76.73 cents yesterday, prices on Bloomberg show. An equivalent price decline on government notes would push the yield as high as 11.7 percent.

The increase in credit-default swap indexes means investors can expect to earn a higher premium for providing debt insurance as soon as new indexes are created in September. To make up for losses, CPDOs would typically increase their borrowing.

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