Thursday, June 28, 2007

Who's the more foolish? The fool, or the fool who follows him?

I know, I know, I already used that title before...

Anyway, in the wake of Bill Gross claiming the ratings agencies were "fooled" into giving certain ratings on ABS CDO deals, I thought I'd give a little explanation of how the ratings process works in CDOs and my take on why it is breaking down now.

First let me say that just because bonds aren't performing well doesn't mean the rating agencies were wrong. For example, according to Moody's, historically there is a 2.5% chance a Aa-rated bond will default over 10-years. So the fact that any given Aa bond winds up defaulting doesn't mean that the rating was wrong to begin with. By extension, if the ratings agency believed a certain event was a low probability, just because that event comes to fruition, doesn't mean they weren't right about it being a low probability. If you are asked to predict the roll of two dice, what single number will you pick? 7 right? If you are asked to pick a 3 number range, you'd say 6-8 right? If the number rolled turns out to be 10, were you wrong in your prediction? If a priori, you correctly predict the odds, its still possible something unusual happens. That doesn't make your initial analysis wrong.

Now back to CDOs. The CDO rating process is very quantitative. Basically the process works like this. Each agency has their own Monte Carlo simulation software. They take a CDO portfolio, make certain assumptions about correlation of defaults, then use the Monte Carlo to figure out what the probability of suffering various levels of defaults.

The correlation of defaults is absolutely critical. If you have a portfolio of similar credits, the odds are good that several of them will default at once. Think of default probability as a two part function: a issue specific variable and a common variable among a group of issues. For example, if its GM and Ford, the common variable would be the health of the US auto market. We could extend this into a more complex function, where you might have GM, Ford, and Dollar General. GM and Ford are both impacted by the auto industry, but all three are impacted by general consumer spending.

The Monte Carlo simulation takes this correlation into account. The consequences of high correlation is that the results become very bimodal. There becomes a high probability of very low defaults or very high defaults. Keep this in mind for later.

Once we've established the expected level of defaults, the rating agencies then run a cash flow simulation of the CDO structure at various default levels. They used "stressed" default patterns, basically trying to bunch the defaults together to find the most stressful situation. They each have slightly different methods of interpreting the results. S&P and Fitch set a level of defaults at which a given tranche must survive (not default) to earn a given rating. Moody's sets an "expected loss" which means that they take the range of portfolio defaults, the level of loss at each default level, and do a probability weighting.

Where can this process break down? What's happening in the sub-prime market that is causing CDOs to perform so poorly? The obvious answer is "defaults are high, stupid!" Granted. Obviously high default levels can break a CDO. But if we were merely going through a high default period, I'd argue that doesn't amount to a "mistake" by the ratings agencies. They acknowledge in their models that there is a chance defaults come in high. Basically, they said its possible that you roll a 2, just not likely. Just because you actually do roll a 2, doesn't make the rating agencies wrong.

I argue that misinterpreting the correlation of defaults is the bigger problem. Two things happened in the sub-prime market to alter historical correlations. First, lending standards declined significantly. Second, interest rates got extremely low, then rose sharply. So questionable loans were being made, and since most sub-prime loans are 2/28, these weaker borrowers are (or will be soon) getting hit with huge payment shocks all at the same time. Therefore the correlation of defaults in this market is substantially higher than was assumed.

Thinking back to our multi-part default function, every bond in a portfolio of residential MBS has multiple common variables: interest rates, home prices, and employment trends. Even if we assume the rating agencies didn't know that sub-prime lending standards were weakening, anyone with a basic understanding of economics, real estate, or mortgage lending knew that loan performance was going to be, in part, a function of those three elements. While the inner workings of rating agencies Monte Carlo simulators are proprietary, I feel confident to say that the power of these common variables in creating high correlation was underestimated.

Commenter Chris among others has pointed out there should have been some caveat emptor here. He's 100% right. In fact, I talked to a Bear Stearns CDO trader about 2 years ago about ABS CDOs, and he said he liked the CLO market better specifically because he was worried about correlation of defaults in RMBS. Baa/BBB rated tranches of ABS CDOs have been trading cheaper than the same tranches in CLOs for several years. So its not like the correlation issue was a big secret.

I think this is another example of investors assuming that one Baa/BBB bond is the same as another just because the rating agency assigned the same rating. But the market traded Baa/BBB rated ABS CDO tranches far far cheaper than similarly rated CDOs with other collateral, or for that matter, plain vanilla corporate bonds. As an investor, you have to realize that stuff trades cheap for a reason. The market isn't stupid. Bill Gross may think the rating agencies are fools, but in this case, anyone who blindly follows them is the more foolish.


Anonymous said...

Excellent post -- thank you for the crystal-clear explanations!

Agustin said...

Good work! From a "market liquidity" point of view, this blog is now a key resource. Agustin Mackinlay (

Accrued Interest said...

By the way, just saw a report from MER on CDO issuance. Last week Blackrock did a HY Loan deal where the Baa tranche had a +225 spread. Meanwhile Babcock and Brown did a HELOC deal with two Baa tranches: +750 and +850!

Anonymous said...

Great post. Great explanations. Thosr spreads are insane.

Tom, what will those spreads do the ABS CDO market? How much second-half 2007 issuance do you see? I could see issuance falling threehold from 2006 levels given that spread you cited.

Accrued Interest said...

I don't know, its a good question. I'm surprised they are still getting deals done right now, honestly.

Another interesting question is how long before new issue sub-prime CDOs are worth buying? I mean, once underwriting standards correct and housing prices stabilize, the gigantic returns offered on CDO equity might actually be realized.

Unknown said...

This is just a type of cognitive bias called OUTCOME BIAS. You cannot judge the quality of a decision simply by eventual outcome.

Accrued Interest said...

Exactly. Drives me crazy how many people can't understand outcome bias...

Anonymous said...

Thanks, Tom, for all the commentary. Your blog has become one of my favorites. I have just one nitpicky comment about a statement you made today: "most sub-prime loans are 2/28."

According to Loan Pricing Corp., 2/28 loans comprised 26% of subprime originations by $ volume in 06 and 30% each in 05 and 04. 2/28s, 3/27s and 1-year ARMS together comprised 46% of subprime originations in 06, 53% in 05 and 50% in 04. I was surprised when I saw these data that more of the subprime market isn't ARMs that float after 1, 2 or 3 years.

Unknown said...

The levered loan mkt should be watched carefully. A record $250-plus billion is in the calendar, over 3/4 from PE/LBO debt financing. US Foodservice's pulled bond/loan issuance (later the bank provided bridge equity) is only the tip of the iceberg. FDCs $8 billion upcoming issue should be the "tell" to whether PE will continue their buying spree, or whether financing large deals just got a whole lot more expensive at a time when the equity mkts are extended on a EV/EBITDA basis making future LBO deals hard to do. The floor put in the mkts by PE and corporate stk buy-backs could be pulled out from underneath investors resulting in a hard-and-fast correction in equity prices. I could see where PE takes a break, companies pull back their stk buy-back programs to focus on IG ratings/debt buy-back.

A side note - a friend that brings to mkt CDO deals for a financial institution told me he is happy to see the repricing of risk premia accross non-contangion asset sectors so that the economics of the 'next wave' in CDOs make sense and happen more quickly than if subprime hadn't happened and spreads continued their grinding ways.

Anyway, my thoughts. Great blog you have here!


Unknown said...


Longer ARMs are hard to sell via securitization by the banks/origination co's. From an investors point of view, I want my coupon to float when interest rates are rising (reduces reinvestment risk due to the extension). The underwriter can also "tease" borrowers into ultra-low rates for a short period of time, and also guarantee the borrower will have to refi into fixed at a much higher coupon sooner. And from the borrowers' point of view, he/she had expectations that the value of their new home would appreciate +10%/yr for 2yrs and then refi into a new fixed mortgage and lower their LTV from 100% to 80%. So instead of paying double the mortgage for a 5yr ARM, the borrower could pay almost nothing and build 20% of equity. Both the 2yr ARM and 5yr ARM amortization schedule is based on a 30yr loan, so there's almost no difference in principal accrual over 2yrs between the two loan types.

Accrued Interest said...


I suppose that means that most sub-prime is fixed rate? Surprises me.


I've talked to a lot of people on the street about how bad the financing deal can get before a LBO is actually canceled. The consensus is that banks set things up to basically assure that won't happen. But that strikes me that banks are taking on a lot of this risk themselves, which they most certainly lay off in the CDS market. I think this is why CDS spreads on some LBO names, like FDC or AT, have widened way beyond their rating cohorts.

Banks won't be able to sell this risk in the CDO market, not in a big way, because CDO equity investors are very careful about specific name risk. Talk to any CDO salesman, and he'll tell you that the big hedge funds he covers scour the CDO portfolio for certain names. So it will come to CDO arrangers refusing to include those names in their deals.

Anonymous said...

It's a mix. Some are longer-term hybrid ARMS, some are fixed, etc. Here's a break down of B/C originations by loan type from LPC for 06.

Fixed balloon 3%
ARM balloon 1
Other balloon 1
2-year hybrid 26
3-year hybrid 3
5-year hybrid 14
7-year hybrid 3
10-year hybrid 3
Fixed 20
I/O fixed 8
1-year ARM 17
I/O 1-year ARM 1

Accrued Interest said...

So some type of resetting structure is most common.

capitalhill said...

I am told that commitments for a lot of LBO bridge loans are syndicated out to hedge for commitment fees of, say, 50 bp. During the salad days very few of these commitments actually got taken down. Now there's a worry that many more outstanding bridge loan commitments may get exercised if, like US Food Service, longer term debt can't be secured.

50 bp for not making a loan is a good business. 50 bp for making a loan to a company that can't find any other financing isn't such a good business.