Saturday, 5 February 2011

The Ratings Charade Continues: A CLO Investigation, Part II

To bring you up to speed on this exciting melodrama:

Last time I showed you why CLO (collateralized loan obligation) ratings are almost certainly a scam, and why Mr. Ratings Guy from Standard & Poor's should know as much. It was (I hope) a math-lite and entertaining trip through the bowels of high-finance complexity, Wall Street style.

Of course I reached the end of the rather long post with more questions than answers. Why does this ratings scam exist in the first place? Who benefits? Who loses? In today's conclusion, we'll look at the not-so-surprising answers. Center stage in this discussion will be the misrated AAA tranche. It's the largest CLO piece by far, a good 70 percent or so of the overall fund -- and, as you're about to find out, that's no accident.

So why does Mr. Ratings Guy turn a blind eye to ratings that, deep in the pit of his stomach, he knows can't be correct?

Remember Upton Sinclair's little gem of wisdom:
It is difficult to get a man to understand something when his salary depends on his not understanding it.
Structured finance (e.g., CLOs) is very lucrative for ratings agencies. Even if you're the Jim Carrey character in "Dumb and Dumber," you can rate U.S. Treasuries with your eyes closed. Can you say "AAA"? With a bit more work, you can rate investment-grade bonds and loans. But once you dip into junk-rated and structured finance stuff -- ah, that's where it gets complicated. And complicated = higher fees.

So S&P gets paid more to rate CLOs. If the company started to challenge specific CLOs -- if it dared to say, "You know, these ratings don't make sense for this CLO" and began to push back against investment banks, one of two things would happen. (1) The bank, realizing its screwy models had been sussed out, would not structure more CLOs. (2) The irritated bank, which is paying the ratings firm, would simply find another ratings patsy -- Moody's? -- to play along with the bogus rankings for a big fee check.

Either way, it's clear what happens to S&P: It loses a rather fat revenue stream.

Now, why does the investment bank want to structure these things in the first place? This is pretty easy to answer too. Fees, fees, fees, fees. Underwriting fees for CLOs run to 1.75 percent, compared with an average of 0.4 percent for investment-grade bonds, according to Bloomberg News data.

Okay, that explains what's going on on the supply side. But it takes at least two to play in the markets. What's the incentive for the investor to buy misrated CLOs? Is the investor just the naive fool here, hoovering up misrated junk that will later plunge in value, leading him finally to clap a hand against his forehead and exclaim, "Oh, what a terrible mistake I have made!"

Probably not. At least not anymore. Recall that well-worn saying, "Fool me once, shame on you, fool me twice, shame on me."

There was a lot of complex, securitized crapola that cratered during the financial crisis (and has since recovered in value to some degree, but not to the degree that its initial AAA ratings would suggest is proper). So investors got caught playing with the effluvia from the sewer pipe and got burned. Are they really as stupid as they once were?

Nope. In fact, just return to my first post and look at what the tranches of a CLO pay these days. The "AAA" piece that, pre-credit crisis, would have paid 25 basis points plus the Libor rate, now yields 160 to 170 basis points plus Libor. Big, big difference. For those who aren't finance geeks, here's what that means in actual interest rates: three-month Libor is about 0.3 percent, so the CLO buyer who in 2006 would have accepted 0.55 percent as initial interest (assuming today's Libor) now insists on more than three times as much, or as much as 2 percent.

Last time we proved the ratings are an illusion, a clever chimera ... so let's say today's investor, being smarter about these CLOs, knows the game too. What does the 2 percent imply about the true rating? Well, you'd have to skip down S&P's ratings scale a bit to find the "true" rating, based on what investors are willing to pay. And that happens to be about six or seven rungs below the professed rating: much closer to "junk" level than AAA.

This is essentially what the investor is saying to the investment bank selling this stuff: "Sure, I'll take some of that 'AAA.' I know the market is just irrationally frightened of CLOs right now -- (nudge, nudge, wink, wink). I know that I'm getting real AAA at a great price, just because this asset class is out of favor because of the lingering taint from the financial crisis that has unfairly tarred securitized products! (nudge, nudge, wink, wink)."

Inside the investor is thinking: "Yeah, AAA my ass."

Now you may be wondering: What's the incentive for an investor to do this? What's the point of going along with this charade? And this is where things get interesting. There are a number of good reasons to play along with the fake "AAA" ratings:

1. You can use the AAA ratings to burnish your investment results. Say you manage a money market fund that can buy only AAA securities. You can sneak some pseudo AAA into your portfolio and goose your returns. How? Because it's rated AAA, but it pays about 165 basis points more than Libor, or more than three times ordinary AAA. So you'll look like a genius, outperforming your peers, until this junk explodes in your hands (and that could take a while -- remember, it's still probably investment grade, just a good deal lower than AAA).

Update: Ah, the perils of working too quickly! I meant to check out investing requirements for money market managers because I feared -- and I was right -- that my example doesn't work because they can't buy certain AAA products. It turns out money market funds must contain investments with a maximum weighted average maturity of 60 days. (A lot of structuring does spin out tranches with special A-1 or P-1 ratings that are of this shorter, desired maturity, but I don't think any CLOs do.) However, the idea still holds for other AAA-only fund managers: They can use pseudo-AAA from a CLO to burnish their results. A relevant fund for such a strategy might look more like one of these (note: the funds on this Web page invest in "AAA-rated fixed-income products" so I'm not sure if "structured fixed-income products" could qualify for the portfolio, but clearly if they could, the money manager will quickly jump to the head of the class, using pseudo-AAA from a CLO as "performance steroids," if you will.)

2. Certain entities, such as insurance companies and pension funds, have limits on what they can invest in. They can buy only AAA, or a certain percentage of their investments must be rated AAA. So these "AAA" (wink, wink) CLO tranches fit that criterion. This then becomes a neat little way to do an end run around an investing mandate that seems too restrictive to them, especially when they are under pressure to achieve higher returns (pension funds).

3. AAA securities are very useful in the huge "repo" market, where they are used to secure overnight loans, sometimes being rolled over continually. While AAA CLOs may be subject to higher haircuts (or discounts) than say a AAA Treasury, they still may find an important role once again in the repo market.

4. The new Basel III rules are coming, the new Basel III rules are coming! They are intended to make sure that a bank has enough capital to withstand shocks. These rules determine capital adequacy based partly on -- surprise! -- ratings of assets a bank holds. So having a bunch of misrated AAA on its books will help a bank heap on the risk again and plump up profits.

From Minyanville (my bold):
In the afterglow of yesterday’s “hugely oversubscribed” bond issue by the European Financial Stability Facility, (the “EFSF”), EFSF CEO Klaus Regling noted that demand was growing for AAA-rated assets “spurred by Basel III capital rules."
From Bloomberg (my bold):
Three years after collateralized debt obligations (note: a CLO is a type of CDO) helped trigger the worst financial crisis in 70 years, Wall Street’s math wizards are exploring how to use them to deflect rules intended to prevent the next crisis.
Credit Suisse Group AG traders are testing a risk model that may help them reduce capital charges imposed by the Basel Committee on Banking Supervision on derivative products.
Claudio Albanese, a quantitative economist who is advising the lender on the plan, says it could also help banks to limit one of their biggest risks by allowing them to offload through a CDO the risk that one of their trading partners, or counterparties, defaults. Critics say such CDOs could trigger a new crisis.
Albanese’s plan shows how banks are likely to try and mitigate rules that impose higher capital requirements on their operations and threaten profit ...
Okay, a cynic might say after reading up to this point, so what? Investment banks make out like bandits, the ratings firms get their cut, and everyone enjoys goosed returns and higher leverage. Why should I care?

For one, the existence of this ratings scam has the potential to create a distortionary effect in the market. It hasn't yet -- CLO issuance has dropped off a cliff since the glory days of several years ago -- but if the CLO machine cranks up again, suddenly there will be greater investor appetite for the securitizations. Now what's the hamburger that needs to go into the CLO meat grinder to produce these sweet patties of higher-than-normal yield? Leveraged loans. And who takes out leveraged loans? Private-equity firms. And why do they? To engineer sometimes-destabilizing takeovers that load up companies with debt.

So we encourage distortionary economic activity, higher leverage, more debt ... though in the short run, all this will give us a little meth-type boost in prices of stocks and other assets, and investors will feel a little richer, and we'll buy a few more big-screen TVs, and take a few more Acapulco vacations, and exult about how it's great we survived that bad ol' financial crisis ...

Now for the $64,000 question, the one that really matters.

Who's on the hook when all this collapses?

When CLOs go belly up, and massive wealth is destroyed, and credit freezes, and money market funds are about to break the buck once more, and we gnash our teeth and scream, "How can this be happening again?!?" and Jamie Dimon tells us not to worry because we go through financial crises every five years or so, so just take a pill and chill and stop standing on his bonus check?

That would be you. And me. That's right. Joe Taxpayers. A bailout will be orchestrated, overt or covert, and we'll all shoulder the burden.

Perhaps Ben Bernanke will do a slow-bleed of seniors and savers by infusing liquidity, rescuing the large and foolish banks (and other too-big-to-fail pieces of the financial infrastructure).

Just remember: It all starts with a misratings scam your Congress, snugly in the pockets of the banking lobby, never bothered to fix ... ;)