Credit rating agencies

Needless to say, that was the question everyone was asking: some of these investors are really smart folks, how come they got duped into buying things that no-one understood? In fact many of them were not duped, they just delegated some of their investment responsibilities to a third party, and thinking they were being smart.

I made reference to the risk of these securitization deals are complex and sometimes almost impossible to fully understand. In the real world, it is often impossible to know the risk of even the most well known household names. However, there are some really smart folks to provide opinions on the abilities of companies to repay their debt. These are the credit rating agencies. There are three internationally recognized: Moody’s Investors Service, Standard & Poor’s and Fitch Ratings.

Just what these credit rating agencies do for the investors? Here are some ‘About us’ taken from the websites of the rating agencies:

Moody’s: “Moody's Investors Service is a leading provider of credit ratings, research, and risk analysis. Moody's commitment and expertise contributes to transparent and integrated financial markets. The firm's ratings and analysis track debt covering more than 110 sovereign nations, 13,000 corporate issuers, 26,000 public finance issuers, and 109,000 structured finance obligations”

Standard & Poor’s: “Standard & Poor’s is a leading provider of financial market intelligence. The world’s foremost source of credit ratings, indices, investment research, risk evaluation and data, Standard & Poor’s provides financial decision-makers with the intelligence they need to feel confident about their decisions. Many investors know Standard & Poor’s for its respected role as an independent provider of credit ratings and as the home of the S&P 500 benchmark index.”

Fitch: “Fitch Ratings is a global rating agency committed to providing the world’s credit markets with independent and prospective credit opinions, research, and data. With 50 offices worldwide, Fitch Ratings’ global expertise, built on a foundation of local market experience, spans across capital markets in over 150 countries. Fitch Ratings is widely recognized by investors, issuers, and bankers for its credible, transparent, and timely coverage.”

That’s all great stuff and if you previously have no idea what the rating agencies do, you should be impressed by the marketing schpill. Credit rating agencies are in a privileged position. Let’s look at their business model and then how this model translated to the structured credit sector.

All three agencies operate on an “issuer pay” model which means that if a company wants its debt rated by one or more rating agencies, the company has to pay for the rating. Once mandated (and paid up), the rating agency will assign a small team of credit analysts to look at the company’s financial accounts and performance in details over a number of years, to meet with the management and possibly taking a first hand look at the company’s operations. They will look at the company’s operating efficiency, profitability, market franchise, management capability, asset quality, cash flow, leverage and a number of different things. Some are quantitative and others qualitative. In the end, the rating agency, after discussion with the management, will publish the company’s rating, effectively providing the market an estimate of the likelihood of the company meeting its credit obligations. In turn, the market will price the company’s debt based on the credit rating to reflect the amount of risk involved in lending to the company.

The best rating any rated entity can achieve is “AAA” and this rating is reflects strong cash flow generation with typically low leverage, hence very high probability of full repayment as the debt falls due. After AAA, there is “AA”, then “A”, then “BBB” and all the way down to “C”. A rating of “D” means the company has defaulted and the bankruptcy process has begun. If a borrower enters debt restructuring or creditor protection, which means the existing creditor may be at risk of being asked to exchange debt for equity or have debt maturities extended or repayment delayed, its debt will be lowered to “SD”, selective default. By the way, there are smaller grades between main grades; so for example, there are three grades of “AA”: “AA+”, “AA” and “AA-”.

While credit rating is not a ‘must have’ for most borrowers, for those who want to access the debt capital markets, ie. the public debt market, it is an essential requirement. The logical question is: “why?” Since the emergence of credit rating agencies early in the 20th century, they have built up strong market reputation for the quality of their analysis and many investors have relied on the rating agencies. Effectively many investors have stopped carrying out their own detailed credit analysis but delegating it to the rating agencies and instead concentrate on pricing the risk based on the credit ratings. The fact that rating agencies operate on an “issuer pay” model means that investors of a company’s debt cannot influence the credit rating of the company by paying more for a better one.

This model worked very well for traditional corporates, sovereigns and financial institutions; and over the years, these rating agencies have amassed a long history of the credit performance of rated entities and they publish regular opinion updates on the rated entities and investors became more aware of the risk involved in lending to these entities and investing in these companies’ debt securities. They, in turn, can, if they choose to, carry out similar analysis on potential borrowers based the financial details and compare them against rated entities. In another word, the debt market has become more transparent.

Of course, not all debts are created the same. Some debt gets repaid earlier than others. The more ‘senior’ the debt, the higher it is placed in the priority of payment. The debt that investors least likely to suffer losses are “senior secured” debt where it ranks ahead of all other debt obligations and it is secured against some or all of the borrower's assets. So if there is insufficient cash to repay, the lenders have the right to cease certain cash-generating assets to obtain payment until they are repaid in full or have exhausted the assets. Nice! The lowest ranking debt is what people called ‘hybrid capital’, debt with payment priority so low that they rank just ahead of the equity investors. Then there are all the different rankings in between. As different seniorities have different levels of recovery, they all have different ratings, so for a single company, it is entirely possible to have multiple debt ratings from rating agencies, each specific to a level of seniority. This concept became very important when rating agencies started giving out ratings to structured credit securitizations.

As mentioned before, the process of securitization typically results in the creation of multiple tranches of debt. Looking back to an ABS, it is basically debt securities secured against a pool of interest-paying assets. So unlike a company, a pool of assets has multiple debt profiles, one for each asset. However, thanks to all the statistics on default probabilities and recovery values collected by rating agencies through their long histories, there is a statistical method to create highly rated assets (AAA) based on having a sufficiently buffer to absorb all the losses, statistically speaking.

So there it was. Securitization has allowed the creation of a piece of highly rated debt security from a bunch of rated or unrated borrowers through pooling and statistical means. Of course, there are higher risk pieces that are not rated AAA, but these will be behind the AAA piece in terms of payment priority. This doesn’t take away the fact, investors, should they choose to, can acquire a marketable security with an excellent credit rating which is secured by a pool of assets. A nice bit of magic.

What about the rest of the ABS capital structure? How are they sliced up? That is entirely driven by investor demand. Take the example of an RMBS, the sponsor bank may have to take the first loss piece to support the deal and the senior piece would have been sold to investors who demand AAA-rated assets. In between, a whole collection of different investors with different risk appetite will want risk-return profiles that suit their investment objectives within their rating parameters. What is considered as good stuff by a hedge fund manager may not be attractive to a pension scheme manager and visa versa. What the structurer of the deal has to do is to slice the remaining parts of the capital structure to satisfy as many investors as possible to get the deal sold. The more notes are sold to investors, the smaller the rump the sponsor and lead manager has to deal with.

Now, there is a subtle shift in the role of the credit rating here. Originally, the credit rating is determined by the financial conditions of the company, bank or country and to change a credit rating you have to generate more cash, raise more capital, make the business more efficient, expand the market, etc. These are hard things to do and results are not immediate. In the structured credit space, instead of having the financials to drive the rating, structurers were (and most probably still are) using the ratings and the accompanying historical statistical properties (default probabilities, expected losses, recovery values, jump to default ratios, etc) to structure the capital structure of an ABS. The rating agencies and their ratings have gone from providing analysis and opinions on a certain borrowers to become yardsticks structurers used to make their deal work.

What we have here is known as ‘rating arbitrage’. The structurers have been doing is using the known properties of rating categories and structure their securitizations to meet those properties. Nothing more, nothing less. Now, there was nothing wrong with this practice. However, we need to keep one thing in mind: most ABS deals, not including CDOs and CLOs, the collateral pools are static. By structuring a securitization to achieve a certain rating means that if a particular pool has suffered high levels of defaults, there is no possibility in substituting those affected collateral assets with performing ones. That is unlike banks and corporates which, by way of their managements reacting to market circumstances, can carry out certain activities (cut cost, issue new capital, divest certain non-core assets, etc) to address any rating concerns. As such, ABS noteholders are essentially stuck with the assets they’ve invested in and once the deterioration takes place, there is very little can be done to cure the situation.

The problem extends further down the line. While CDO managers usually have the ability to substitute assets in the collateral pool, in reality it may be impossible for them to do anything to cure the failings of their pools. Rating agencies tended to create a model for a specific asset class and once the model is accepted, very few changes are made to it. Therefore, deals from all parts of the economic cycle have the same assumptions applied to them. As such, once the market began to fail, and previous assumptions turned out to be inaccurate, all deals were affected to a greater or lesser degree. So what we have is that a traditional set of assumptions on ratings being applied to securitizations. For a CDO collateral manager, there are no worthwhile assets to substitute into the pool - their values were all falling at the same time. That is the reason why a great many ABS CDOs were so heavily affected when the sub-prime market fell and their ratings slashed by the rating agencies.

In the end, all these securitizations that have deployed rating arbitrage, relying on the rating agencies' statistical tools to structure their transactions to give optimum returns and costs of funding, were ultimately undone by the rating agencies' imperfect data and models.